Delinquency and default management: a detailed, step-by-step program for measuring the output and effectiveness of your default-management group is critical in today's environment.

According to a story in the July 2, 2007, issue of MBA NewsLink, entitled "U.S. Finance Firms Are Finding Themselves Major Real Estate Owners as Foreclosures Mount," the share of subprime loans entering foreclosure in the first quarter was 2.43 percent--its highest level in nearly five years. Late payments for these products increased from 11.5 percent a year earlier to 13.77 percent in the first quarter. [??] Everyone agrees that the number of delinquencies and foreclosures is rising and is likely to continue to do so. Because of the growing number of delinquencies and foreclosures, the pressure on servicing organizations is tremendous. Because of these concerns and the potential impact on the overall economy, the mortgage industry, and servicers in particular, are faced with myriad potential risks and a higher level of scrutiny than ever before.

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What are the risks?

The risks currently being faced cover the entire scope of risks inherent in the mortgage servicing business. The greatest risk, of course, is financial.

Losses on these assets will continue to grow as foreclosed houses flood the resale markets. Investors in these loans will pay close attention to each real estate-owned (REO) sold to make sure that losses are kept as low as possible.

Along with this comes the risk that regulators and agencies charged with the oversight of servicing organizations will become excessively diligent in monitoring their actions in light of stated policies and procedures. Regulatory risk, which includes safety-and-soundness issues as well as specific consumer regulatory protections, will be a significant part of each regulator's audit.

Finally, reputation risk based on consumer perceptions will continue to feed the headlines and put the focus on what has become a common news theme--that of alleged predatory lending practices. Finding themselves the object of media and/or regulatory inquiry for failing to meet consumer and investor needs is a potential nightmare dreaded by every servicing manager.

Without a doubt, poor credit quality and ineffective process controls in the origination of subprime loans have put default managers on the hot seat. So what can servicing organizations do to mitigate the risks?

The obvious answer is to make sure the default-management program that is in place works effectively, so that the organization can withstand the scrutiny of investors, regulators and consumers. While most servicing managers have confidence in their current programs, it is critical for them to understand their processes' strengths and weaknesses, the impact these problems will have on vendors and the high level of consumer support that will be required.

Also, new forbearance, refinancing and modification programs are being offered to affected borrowers that must be implemented and understood by the default-management staff. Once all these activities are incorporated into the process, there is an ongoing need to measure the outcomes.

How will managers know when 30-day calls are overdue or when consumer issues are not correctly addressed? What data do they have to tell them that forbearances are being denied because collectors do not understand the financial requirements or special standards for these loans? At what point in time does the volume exceed the organization's capabilities and begin to create more risk rather than mitigate it?

The answer to all these questions rests in the effective identification, monitoring and control of the activities that make up the default-management function.

An integrated approach

When evaluating organizational functions to ensure that all activities are integrated and effective, a comprehensive management orientation is critical. A comprehensive management orientation means that managers have mapped the flow of each piece of the process (the activities) and understand what must occur so that the next activity can be properly completed. To achieve this, management must have identified each piece of the process, mapped what it is supposed to do (the activity), identified the expected result, identified the risk associated with a failure to complete the activity correctly, and have a means to measure how frequently this type of activity failure occurs.

For example, let's say that a comprehensive management orientation requires the collectors to document in detail why the payments are not being made (the activity) in order for the loss-mitigation staff to proceed with identifying the best option for loss mitigation. Management recognizes that if the staff performing this activity does not understand or comply with the requirements of the activity, the loss-mitigation staff will have to take time to get the information or make decisions that may not effectively resolve the default. Management also recognizes that the risk associated with this failure is an increased chance that the default will not be cured--so it measures how frequently these failures occur as well as where and when they occur, in order to stop the failures through types of improvement such as training or additional technical support.

The first step in developing this approach is to list the customers in this process and determine what they expect for the fees being paid. Customers, in this case, are those individuals and/or entities that are the recipient of the activity. It is important to recognize that there are both internal and external customers. Internal customers are those individuals who perform an activity that is dependent on the results of the previous process. External customers are those that receive the end result of the entire process. An easy-to-understand example is auto manufacturing: The assembly line is made up of a series of processes that, when completed, result in an automobile. Each of the activities must be performed properly if the car is to be assembled correctly, so the individual completing each activity has as his or her customer the next activity worked on the line. The external customer here is the purchaser of the car.

Because the product delivered to the external customer is produced through a series of processes, each one of these must be viewed in the same way as the final delivery. As a result, every process must be recognized as being composed of inputs, actions and outputs. In the example of the collectors, they receive input from the autodialer indicating that a borrower who is behind in a payment is available to talk. This is the input. The actions the collectors take are to discuss the borrower's situation, and determine his or her circumstances and the cause of the default. The next action is to document this information in the system. The output is the information collected. The "customer" of this process is the loss-mitigation specialist who receives the collections output as input.

Once the larger process flow (i.e., collections and loss mitigation) is documented in this fashion, each part is able to understand how the pieces are integrated as well as acknowledge the impact on the next step of the process and the process as a whole.

Once all the inputs, activities and outputs are established, the next step is obtaining the resources needed to make this process work, then selecting the technology and programming it. Training and implementing the needed modifications are usually required as well. Finally, the process must be measured to ensure that it not only meets expectations but does so in a consistent manner so that the external customers can rely on the completed output of the organization.

While it is obvious who the external customer is in an automobile manufacturing plant, it is not always obvious who the external customers are in a default-management function.

Loan investors are definitely one category of customer, but so are borrowers and regulators. It is also important to recognize that the organization's senior management and stockholders also have expectations for how effective the default management unit has been in resolving delinquency issues.

Of primary interest is the investor that undoubtedly is focused on either curing the delinquency or foreclosing on the property and determining what the loss will be. Of equal concern are borrowers who are working to resolve their financial problems by finding a solution that allows them to remain in their home.

One way that the performance of a default-management operation can be assessed is by reviewing steps taken to resolve problems on a loan-by-loan basis and evaluating the individual outcomes. That is the perspective both investors and borrowers would use to assess the performance of a default management group.

However, other types of customers with a stake in the outcome are primarily interested in the management of the servicing organization as a whole, so they can be assured of its ability to manage risk and retain its value and viability. That assurance comes from the collective reliability of the internal processes in handling their required tasks.

System management

Management must ensure that it has in place a comprehensive approach to what activities must occur, how they should be done and the identification of the risk if they are not done or done incorrectly. This involves not just management staff, but the whole organization.

Company leadership is essential to drive the message down to all staff and resources about the importance of ensuring that all processes work as required. It also involves recognizing that all processes within an organization are interrelated, and that only by managing them as such will the outcome be successful.

As part of this system-management approach, everyone must recognize that each activity performed is part of a larger process and therefore must be organized based on the inputs received and the outputs expected. In organizing activities, it is important to ensure that the process can be completed as required.

For example, if your collections process includes an activity where collectors evaluate the borrower's current financial capability to cure the delinquency, but they have not been trained in how to conduct this evaluation, the process will fail. Because of their lack of knowledge, they may accept a payment plan that does not allow the borrower sufficient time to cure the delinquency. In this example, the process was defective, and as a result creates a risk of continued non-payment and eventual foreclosure.

This detailed approach to establishing the necessary inputs and required outputs, known as process management, is critical to the overall success of the entire system.

Vendor/supplier relationships

Because some of the processes involve working with external vendors and suppliers, managers must be sure that a strong working relationship is established. For example, property preservation is one of the keys to obtaining the highest sales price possible on foreclosed property. If, however, you do not have a strong relationship with the company that maintains the property, you cannot be confident that the property will sell for the expected price.

Strong relationships with these vendors provide assurances that the work is being done as requested, so that the internal processes these activities support will be able to function as required.

Fact-based decisions

As the processes begin to function, management must evaluate the outcomes. The key to this is not only evaluating results, but measuring each activity in each process to ensure it was done as required. Because if the procedure is not followed, the output can be defective. This creates risk--not only in that process, but in the outcome of the function.

These risks can affect either investor or consumer satisfaction. For example, if the process was not followed and as a result delays in foreclosure timeframes were experienced, the ability to market the property may be impacted, resulting in greater-than-expected losses for investors. On the other hand, if consumers are not given adequate time to meet prepayment plans, the property may end up in foreclosure unnecessarily.

In order to avoid either of these situations, the activities within this function must be working properly. Measuring these activities for variations from the expected is key to knowing where problems will occur and what types of excessive risks the organization may be experiencing. Once the measurements are completed, management can review the results and determine if everything is working as required. If not, it is easy to identify where processes are not functioning properly, making it efficient for managers to improve how the function operates. If, however, the outcomes are as expected, management can continue to monitor through these measurements.

In either case, management has the opportunity to make decisions based on the facts rather than on "gut feel" or just general dissatisfaction with the results. This measurement approach also is effective in pinpointing where the problems exist so that additional drill-down analysis can be used to identify what must change.

This type of fact-based decision-making is the most effective in changing how activities are performed. Only when you have the facts, and those facts are based on statistically valid information, can the results of the decision accomplish what is intended. While the ability to continually improve and maintain a consistent level of results is the key to long-term success in any market, it is even more critical in dealing with the current default crisis.

Measurement is key

Recognizing that facts are necessary to make valid decisions on how to improve and control your processes is only the first part of the equation. What you measure and how you measure are critical for presenting accurate information. If these are wrong, the facts will be wrong.

Good measurement is a discipline of its own. In order to measure effectively, you must know what you want to measure, why you want to measure it, how to measure it and how to ensure the results are valid.

One of the first concepts that must be understood in measuring is the difference between random variation and determinate or systemic problems. Everyone who has been involved in measuring or statistics knows that random sampling is the most effective means to evaluate any group of data.

For a sample to be random, every data element that is to be measured must have an equal chance of being selected. Therefore, it is possible when doing random sampling to get all the good results, all the bad results or some combination. In order for the results of the measurement to be meaningful, we somehow must deal with this uncertainty--and there are different means to do so.

Two of the most common are reducing this uncertainty by increasing the sample size, or by identifying how much uncertainty is contained in the sample. Larger samples help us cut through the random variations to detect more effectively the assignable causes of variation. However, one of the most commonly used ways to identify the uncertainty and one that most people are familiar with is by establishing a "confidence interval."

Confidence intervals describe what the result is as well as how much randomness is likely. This randomness is expressed in terms of precision, or as "plus or minus" from the result. Anyone living along the Gulf Coast region of the United States is familiar with this concept, because it is the one recurring theme heard from weather forecasters when a hurricane is imminent. While the expected path is identified, the weather forecaster also draws a "cone" or outer area on both sides of the path, which represents where the storm could possibly go. In other words, there is a result, but the cone is the "plus or minus" uncertainty in the prediction.

Knowing what and how to measure is critical to obtaining valid results. One of the most common mistakes made in measuring processes is to focus on the defective outputs rather than the process that created the defect.

For example, results may show that two of 10 loans reviewed did not have an acceptable repayment plan. This statement tells us nothing about why this occurred, and therefore there is no way to improve the process that created it. If instead the results stated that the collector inaccurately calculated the borrowers' financial obligations on two out of 10 loans, we immediately know where the process is failing.

The same issue also appears when determining what to measure. As shown earlier, the measurements being compiled are the end result, and while they may identify the problems, they do not identify where the process failed. One of the best ways to establish what needs to be measured is through the use of a series of tools developed for integrated system management.

These basic tools or types of analyses are numerically oriented, and provide the user with a means for identifying and solving process problems. The one most people are familiar with is the basic flowchart of the processes.

By developing a flowchart for each process, it is easy to identify where the process, if completed incorrectly, can create risks. This is also a key point to be measured when evaluating the process. Additional tools that provide further insight into the problem include histograms that show the frequency of the issue, stratifications that discern patterns that are the source of problems, control charts that allow the tracking of changes over time, scatter diagrams to identify correlations among the variables and pareto analysis that assists in prioritizing which variations should be addressed first.

One of the other commonly used tools, the cause-and-effect diagram, is designed to get to the root cause of the problem. There is also a series of more complex analytic tools that are intended to identify correlations between these issues and the overall risk they create for the organization.

This type of integrated management approach has been effective in addressing problems in numerous other industries, both manufacturing and service. Those individuals familiar with the ideas discussed here recognize this approach as an integrated quality system.

Recognizing that, historically, "quality control" has meant a time-consuming audit of loans that has resulted in little added value to management, it is easy to understand why servicing managers have overlooked this proven methodology. The American Society for Quality (ASQ), Milwaukee, has a wealth of information and guidance for those wishing to implement such a program. It is also a valuable resource for those who have become stymied at certain phases and need assistance in solving their problems. You will also find literature and other resources on ASQ's Web site (www.asq.org) to lead you through the entire development and implementation of this program.

Servicers are facing the highest default rates seen for some time. Yet, for those servicers that adopt the application and measurements that are part of a quality system, it is possible to not only survive this challenging period, but to end up with a vastly improved default-management program.

Rebecca Walzak is president and chief executive officer of Walzak Risk Analysis LLC, Boca Raton, Florida. She is a member of the American Society for Quality (ASQ), and has more than 28 years of mortgage banking and consulting experience, with an emphasis on quality and risk management. She can be reached at [e-mail].