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Beyond mere compliance.

Going above and beyond the minimal parameters of quality control helps lenders weed out bad originators and fraudulent loans. But beyond that there is a deep and convincing business argument to be made for far more intensive quality control.

Norman Peterson, director of risk management at Fannie Mae, has said that almost half the REOs on Fannie Mae-held mortgages for California-based properties involve loans with indicated loan-to-value ratio (LTV) of 80 percent or less. Why would a borrower allow repossession of a property when there is substantial equity in it? Unless the property values had declined, or the loan arrears had accumulated enough to wipe out the equity, the quality of the loan may be suspect. Concerned about quality control by originators, Fannie Mae has initiated an aggressive audit program on early payment defaults.

The possibility of fraud is a concern for all lender/servicers, as it can result in costly repurchases or in severe cases prompt the termination of servicing privileges.

Ironically, it is perhaps the runaway loan volume, which has brought substantial profits recently into the mortgage banking business, that has led to too much emphasis on the production side of the business. This new emphasis may have come at the expense of loan quality.

To gauge the explosion that has occurred in mortgage lending, you need only look at a few obvious indicators. For example, Fannie Mae's loan portfolio has grown to more than 6.5 million loans. Fannie Mae also has an active list of more than 1,500 seller/servicers. Similarly, in about 20 years since the creation of Freddie Mac, Freddie Mac-held mortgages have grown to nearly 3 million loans, serviced by more than 3,000 seller/servicers.

Despite such rapid growth, much potential remains. For example, the potential market for securities backed by home equity loans is more than $4 trillion, according to an industry source. However, further profitable growth of the industry is jeopardized unless it can deal effectively with the crucial issue of quality control.

Let us not forget how poor-quality loan portfolios held by many thrifts led to the radical demise of many institutions in that once-booming industry, not to mention thousands of lost jobs and a staggering cost of untold billions to the taxpayers.

Market trends

Figure 1 shows the average foreclosure rate on one-to-four-unit residential properties between 1987 and 1991. The foreclosure rate averaged 0.27 percent from 1987 to 1988. It increased rapidly to 0.36 percent by the second quarter of 1989. Thereafter, the rate showed a decline until the end of 1990, when it stood at 0.29 percent. During 1991, however, the average foreclosure rate again increased, reaching 0.35 percent by the end of 1991.

Figure 2 details some general economic factors prevailing during this period that one could logically expect to help explain this rising trend in the foreclosure rate. As the table shows, the average unemployment rate declined from 6.2 percent during 1987 to 5.3 percent for 1989. Thereafter, it rose substantially to 7.4 percent by the end of 1992.

Figure 2 also shows the average purchase price on homes financed by a conventional mortgage from 1987-1991. (This price is a good proxy for the market value of all residential properties.) The table shows that the average price increased rapidly from 1987 to 1988. It rose further in 1989. Thereafter, it has been essentially flat.

The table also shows the average interest rate on one-year T-bill (which serves as a proxy for the rates on adjustable-rate mortgages) and the average yield on GNMA securities for 30-year fixed-rate mortgages. The short-term rate increased until 1989 and declined rapidly since. The long-term rate was fairly stable until 1990 and declined substantially between 1990 and 1992. Finally, the table shows that LTV for new loan originations remained fairly stable at about 75 percent during these years.

It does not appear from the data in Figure 2 that there is any simple explanation for the increase in the average foreclosure rate that first arose between 1988 and 1989 and remained visible thereafter. All of the economic factors listed, no doubt, can explain some of the changes in the foreclosure rate. However, a deterioration in the overall quality of loans can't be ruled out as an explanation, especially in the case of early payment defaults.
Mortgage Foreclosure Rates
(One-to-four Unit Residential Properties, Percent(*)
Year Quarter Started
1991 Fourth 0.35
 Third 0.36
 Second 0.35
 First 0.31
1990 Fourth 0.29
 Third 0.33
 Second 0.31
 First 0.31
1989 Fourth 0.32
 Third 0.33
 Second 0.36
 First 0.32
1987-88 Avg. 0.27
* Source: Mortgage Bankers Association

Fannie Mae's Peterson estimates that about 60 percent of California-based property loans sold to Fannie Mae are being originated by third parties. In his estimation, third-party originations have increased more than 35 percent in the last five years. Traditionally, third-party originators have not retained servicing and have been exposed to very limited credit quality risk. While most third-party originators are reputable businesses with a large stake in maintaining their good name, a few shortsighted originators can give the industry a bad name. With the rise in overall delinquency rates and an appreciation of incentive problems with third-party originators, we are beginning to see efforts to make them more accountable.


The fraud issue

Institutions such as Freddie Mac and the Mortgage Asset Research Institute, concerned about the potential for fraudulent loans that exists in the mortgage lending industry, decided to publish an "exclusive list" of names of originators suspected of producing fraudulent loans. Freddie Mac sellers are barred from selling loans from any of the listed originators. This may be just a first step toward more effective alignment of incentives between originators and investors.

Today there is great pressure on lenders to implement effective quality control programs. Warehouse banks are scrutinizing lenders' quality control programs before providing financing, while investors and other regulatory agencies have increased the frequency and the thoroughness of their audits. Regulatory agencies and investors are aware that without adequate quality control, the liquidity of mortgage-backed securities may be diminished. As such, the function of a quality control program must be redefined as a vital part of the overall operation as opposed to a more tangential concern.

How to set up an effective quality control program

Historically, quality control programs were established by most lenders to be in compliance with the basic FHA, Freddie Mac and Fannie Mae requirements. These early quality control efforts were essentially a back office-type operation. A comprehensive quality control program is essential for a lender to remain a low-cost and high-quality provider of service. For mortgage servicers, it may be the best proactive method to ensure the marketability and the profitability of their loan servicing portfolio. Sun West Mortgage Company, Inc. (SWM), Cerritos, California, has started to address these issues and is in the process of implementing a total quality control program (TQCP).

TQCP takes a comprehensive approach geared toward continuous improvement. The TQCP program focuses specifically on mortgage banking, employing many of the elements of total quality management. While traditional quality control programs focus on verifying the loan documents after the loan is funded, TQCP takes a proactive approach. The quality control effort begins when a loan application is received and continuously monitors the entire operation, including underwriting, funding and loan servicing. The goal of TQCP encompasses enhancing the efficiency of the operation, ensuring the quality of loan documents, providing good customer service and screening out problem originators.

It is essential to design a process flow chart as a first step in implementing a total quality control program. The flow chart should clearly map out the procedures of each department, the information flows, the average work time to complete the procedure and the overall time. The process flow chart can clearly identify the weak points in operations and can help determine the source of quality problems. It can also help in streamlining the operation. For example, if quality control detects too many errors in the loan processing department, the source of the problem may be identified as inadequate training of a particular processor, inadequate staffing or miscommunication between processing and another department. This may seem simple enough, but with the ever-increasing complexity of the mortgage banking business, such charts can be crucial.

A total quality control program is composed of five steps, outlined in Figure 3:

* Pre-quality control program (pre-QC);

* Post-quality control program (post-QC);

* Delinquency analysis program;

* Regulation-compliance program; and

* A customer relations program.

Pre-quality control program--Effective pre-QC is the main proactive component of TQCP. Once a poor-quality loan is funded, a lender has only very limited options. Furthermore, any action is expensive and time consuming. Pre-QC begins before the loan is sent to the underwriting department and is completed within 24 hours, before the loan is closed. Pre-QC verifies the integrity of credit documents (verification of employment, funds and mortgage, credit report, compliance with the Real Estate Settlement Procedures Act |RESPA~ and Truth-in-Lending Act and verification of signatures).

Within the first three months of starting pre-QC, we caught (and proved) several discrepancies including fabrications, forgeries and misrepresentations on crucial loan documents. Our aggressive efforts compelled our originators to be doubly careful and resulted in a dramatic improvement in the quality of loans submitted. We also screened out several originators with consistent problems.

In order to implement an effective pre-QC in a cost-effective fashion, it is important to design the sampling process to maximize coverage of high-risk loans. The determinants of default risk in mortgages are rather well understood. For example, loans with high LTV are more risky. Figure 4 outlines Sun West Mortgage's sampling process. We focus on loans from questionable sources (Sun West maintains its own "WATCH OUT" list); loans with high LTV; loans from new originating sources (within the first six months of doing business with a new originator, we perform pre-QC on at least 30 loans or 80 percent, whichever is greater); loans on non-owner-occupied properties; loans with cash-outs; and loans on two-to-four-units.

Pre-QC is cost effective because it may enable the lender to do less post-QC and still satisfy investor guidelines. For example, ira lender follows Freddie Mac's sampling process for selecting loans to perform post-QC, the percentage of loans subject to post-QC can rise much higher than the minimum requirement of 10 percent. However, with a strong pre-QC program, lenders need only perform post-QC on 10 percent of funded loans. Keeping the post-QC ratio low will significantly reduce the cost of obtaining new credit reports, appraisal reviews and loan reviews. Because each investor's requirements may vary, lenders should review their quality control guidelines with their investors.

Post-quality control program--Post-QC is performed after the loan is funded. Freddie Mac, Fannie Mae and FHA have thorough guidelines for post-QC. However, TQCP suggests that lenders should go further and evaluate the results from their post-QC to identify the weak spots in the operations and take appropriate measures. For example, too many mistakes in title information used for loan documents may reveal that neither loan closing nor loan underwriting departments were unambiguously responsible.

Delinquency analysis program--For servicers, the TQCP approach suggests that delinquencies be analyzed carefully to learn how to minimize risk in the future. Several factors can lead to delinquencies. Some, such as prevailing economic conditions and overall real estate market values, are beyond the lender's control. However, quality control can reduce delinquencies by identifying other contributing factors, such as operational deficiencies, including flawed underwriting or closing and failure to detect fraudulent documentation. This audit (similar to post-QC, but without the added expense of a new credit report and an appraisal review) should be performed on loans that have become delinquent within the first 12 months.

The quality control department should also analyze the originators of the problem loans. Lenders can then work with these originators to address deficiencies in their operations for their mutual benefit. In cases where an originator is either unable or unwilling to take corrective action, the lender can refuse to do further business with that firm.

Regulation-compliance program--With the proliferation in regulations, the quality control department should function as the "eyes and ears" of the industry. This department should play an active role in promoting awareness of and implementing compliance with new guidelines. Often, changes are publicized through memos, which can easily fall through the cracks unless the quality control department follows up.

Customer relations program--The last but perhaps the most important role of the quality control department is monitoring customer perception. Customers, having firsthand experience, can bring valuable insights into the overall operation. Customer complaints should not be taken lightly, as they could serve as an outside "alarm." Use of telephone and written surveys can be very useful in measuring customer perception. Such customer relations programs can also be an invaluable marketing tool, because they can be a very effective means of word-of-mouth advertising.

Both Freddie Mac and Fannie Mae are improving their information collection and processing to allow better monitoring of lenders. Investors are well aware that better quality control is the key to the liquidity of mortgage-backed securities in the secondary market. Such liquidity has significantly lowered the cost of funds to homebuyers and contributed to the tremendous growth of the mortgage banking industry in the last 20 years. Poor origination quality, by raising the cost-of-funds, threatens the continued growth and further development of this industry.

In implementing its total quality control program, Sun West Mortgage has learned a great deal. It is perhaps unfortunate that, given the back office image of quality control, the best and the brightest do not always seek quality control as a profession. It is our experience, however, that being involved with TQCP can provide comprehensive training in the mortgage banking business. It is also our belief that quality control will become a central feature of successful lending operations, and lenders with effective total quality control programs will gain a competitive edge as the lowest cost providers of the highest-quality service.

Anita S. Agarwal is vice president of Sun West Mortgage Company, Inc., Cerritos, California. Mukesh Bajaj, Ph.D., is assistant professor of finance and business economics at the University of Southern California.
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:total quality control programs for mortgage banks
Author:Agarwal, Anita S.; Bajaj, Mukesh V.
Publication:Mortgage Banking
Article Type:Industry Overview
Date:Apr 1, 1993
Previous Article:Don't sell California short.
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