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Loan quality made in heaven.

Loan Quality Made in Heaven

Mortgage insurers are vitally interested in promoting quality loan origination. Our business success depends on it. We insure high-risk mortgages. Therefore, we need to be careful that the risk is exactly what we believe it to be and the risk is not increased by low quality origination practices.

Unfortunately, the mortgage market itself is overloaded with junk. The mortgage insurance applications that we see are a mixed stream of good materials and waste paper. Our job is to sort through the mixed bag of loans that come to us, separate out the waste paper, and pick out the good mortgage insurance applications.

Some evidence of this uneven quality is apparent from 1989, when mortgage insurers committed to insure only 80 percent of the applications they received. That means that 20 percent of the applications were not of insurable quality. That's almost a quarter of the mortgage insurance applications prepared in this country for high loan-to-value borrowers. And that means those applications were solicited, taken, processed, verified, appraised, photocopied and sent to a mortgage insurer - only to find out that they weren't insurable. That's quite an economic waste both for the originators and the mortgage insurers.

Further evidence of the low quality in today's mortgage lending industry is found in the reasons for foreclosure. We recently summarized our foreclosure experience over the last three years and found that only one-third of those foreclosures were attributed to marital difficulties, loss of employment, reduction in income or illness - all the things we think of as natural causes of foreclosure. Real economic reversal and real financial reversals for a family were the cause for only one-third of the foreclosure. Another third of the foreclosures were attributed to "use of credit" or "disregard of obligations." And the last third of the foreclosures was attributed by the servicer to "other" reasons for foreclosure.

To me, that means that we don't know why the foreclosure occurred. If the foreclosure had been attributable to marital difficulties, loss of employment or one of those standard causes of financial reversals, we would know it. The fact that we don't know why the foreclosure occurred, tells me that it probably occurred for undesirable reasons.

We're not the only ones to see the change or recognize the need for improvement in quality. The Federal Home Loan Mortgage Corporation has taken actions to improve quality. They staffed a fraud unit in spring, 1989. Effective August 1, 1989, they required all seller/servicers to have an active, independent quality control effort. They carefully specified what that independent quality control effort was supposed to do and required that it report to top management at all their seller/servicers. There's evidence that Freddie Mac, Fannie Mae and the FHA are all more concerned with fraud and misrepresentation. They're developing special units to prosecute it. So there is an overall, industry-wide concern for quality loan origination.

The mortgage lending industry has become an industry of specialists. There are lenders who originate and do not have any idea what happens to the mortgage after they've sold it. There are also lenders who service. There was a time when mortgage servicing was a highly specialized activity that centered around concern for what happened to the loans and what happened to the borrowers. Today, it seems that servicing is more a commodity to be bought and sold in order to adjust your current period's reported net income. And finally, there are investors.

And many investors are forced into the position of making investment decisions about delinquent mortgages. Some of them are very conscientious, but some of them treat defaults just like stock that has declined in value. They may not understand why. They may not care why. They just know that they don't think it is going to go back up so they're going to sell it. Many decisions to foreclose are made by people remote from the situation who have, at best, third-hand knowledge of the situation of the borrower and of the property value. Too often investors' decisions are not based on a full appreciation of the facts.

Of course another piece of the problem is that there are big incentives for originators to produce. Builders, Realtors, brokers and commission solicitors all get paid regardless of the quality of a loan. We see further evidence of that during the good times that produce a sort of euphoria. Unfortunately, I have come to learn that those who live in the middle of the "boom," (for example, the people in Houston in 1982, the people in California in 1980 and the people in Boston in 1986) are the last ones to see the bust. It's widely reported now that some New England institutions are reporting declining earnings because of problem loans. People just get caught up in how good the times are and how quickly the properties sell. The guy next door just sold his house for double what he paid three years ago, so I want to do the same.

There's another possible explanation. That is that origination quality really hasn't changed. The only problem is now we don't have inflation to cover up the mistakes anymore. While that's a possibility, I don't think it's the entire story. There really is a difference. I think there has been a decline in loan origination quality and we all need to take steps to improve it. But before we can take those steps, we need a good definition of what we mean by a quality loan.

As I've talked with various people from the lending industry, I find that many people have a very limited view of what they mean by loan quality. So let me try to expand our horizons a little bit. Let me share with you a pretty broad definition of quality loans. Quality loans are loans that close. Quality loans are loans that are repaid timely, and quality loans are those that can be sold in the secondary market.

Let's expand on that a bit. A quality loan is one that closes so that everyone gets paid and the borrower gets the home. To produce the kind of quality loans that close, you need good screening of borrowers upfront, and you need to be sure that they are properly guided in making a sound decision about what property they are going to buy and what kind of a loan they are going to use.

Quality loans are repaid on a timely basis so that servicers and investors get paid. For that, mortgages need to have acceptable risk characteristics - risks that promote restful sleeping. Quality loans are easy to sleep on. Borrowers are able and willing to pay according to the loan program, and property value remains stable or it may even improve. At least it's not likely to decrease.

Risk characteristics are a funny thing because different people seem to have different attitudes about what makes good risk and what makes bad risk. So to satisfy these different appetites for risk, what we really need are loan packages that fully disclose the situation of the borrower and the property. I call that truth-in-borrowing. Years ago, Congress gave us truth-in-lending. Now, we need honesty on the other side of the transaction. We need truth-in-borrowing. Loan applications and insurance applications must fully and accurately disclose the borrower's situation and the property. The second aspect of quality loans are that they are repaid on time.

The third component of quality loans is that they can be sold in the secondary market. To have hassle-free loan sales, you need complete documentation and investment quality loan terms. That sounds simple enough. I know that actually accomplishing it requires professional work on the part of loan originators.

Let me dwell for a moment on one very simple, pragmatic difinition of quality loan origination. A quality loan is one that the originator will only see once. You won't get any calls from the home office asking why this loan was originated. There won't be any demands from an investor to buy it back because it didn't fit his investment criteria. The originator will only see a quality loan once - at the time it is originated.

Now that's a quality loan. How do we get it? There are five P's. They are promotion, prevention, prudence, protection and prosecution. Those five P's work together to produce a quality loan program.

The first on the list is "promotion" which means simply to preach the importance of quality, much as I am doing here. But let me give you a personal example.

I became president of Commonwealth Mortgage Assurance Company (CMAC) in late 1983, and early in 1984, as I reviewed our default statistics, I was concerned with the proportion of loans that were going into default within the first 12 months. I thought, "What can happen to a borrower so soon after making the purchase decision to cause him to get into trouble?" While I can imagine several reasons, I couldn't imagine that circumstances for so many borrowers would change so rapidly. So, I started talking about it to my underwriters saying. "This is a problem. We want to reduce these early defaults." It took two and a half years for all of that talking to produce the desired effect. But by the middle of 1986, we had reduced early defaults to one-tenth of the 1983 level. That's an example of positive preaching about quality.

You need to be careful because there is also a negative kind of preaching that you can do. Let me paraphrase this as, "Originate unto others as you would have them originate unto you."

I heard a lender talking about deep teaser-rate ARMs and he said, "I would not originate them for myself, but if some investor wants to buy them, I'll make them."

What was he conveying to his employees about quality? He was telling them that it doesn't really matter if you think it's a good idea, or if you think it's a good loan. All that matters is that you can get someone else to buy it, or you can get somebody to insure it.

The other part of promotion is to praise good work - to create heroes and heroines in effect. For example, occasionally one of our underwriters detects a fraud or a misrepresentation in a loan package. When that occurs, we write it up in our employee newsletter to communicate the need for diligence to all of our employees.

Then, another step is to punish the lack of care. Again, one of the techniques we use for this is an underwriter's incentive. Each underwriter is given a little monetary incentive to underwrite as many applications as possible - piece rate, if you will. But that payment is reduced substantially for any loans that default within one year. (Maybe that's one of the reasons that our early defaults declined. But if so, it works.)

The three major components of promotion are to preach the importance of quality, praise good work and punish the lack of care.

The second "P" of a quality loan origination program is "prevention." One way to get good quality is to prevent bad quality. One of the easiest steps is to simply report creditors/borrowers to credit bureaus. I wish we could get every servicer in this country to report all borrowers to credit bureaus - not just those that are delinquent, but all borrowers.

One of the most common concealments on a mortgage application is the failure to disclose the existence of other mortgages. If services would report borrowers to credit bureaus, the credit report would tell us that people have other mortgages. Then, we wouldn't have people in the marketplace thinking that they can hide it with impunity.

There is a by-product benefit to servicers, also. After you have been reporting borrowers to credit bureaus for 12 months, the credit bureaus can rate the credit based on 12 months of data. You won't have to respond to mortgage verifications anymore. People won't even have to send you a request for a mortgage verification because the information will be right there in the credit report. So one part of prevention that actually provides a benefit to servicers, is to report to credit bureaus.

Another aspect of prevention is to offer safe loan programs. It's very important that the loan program fits the borrower. Don't put an hourly wage earner, such as a steel worker, or salaried wage earner, such as a teacher, into a loan program that's going to have rapidly increasing monthly payments. They don't have the prospects for income increases to deal with it.

Another preventive step is to take time to handle the loan application properly. In this age of 30-second, nodoc lending, we are just asking to be taken. Mortgage insurers turn around mortgage insurance applications typically the same day, and certainly within 24 hours - at least as long as we've received complete documentation to review. It can be done. You can prepare a complete package in reasonable time. It's important to take time to be sure.

The third "P" in a quality loan origination program is "prudence." The primary part of prudence is to know that you are dealing with quality people. One of the steps that we take at CMAC is to code each insurance application that we receive for package and risk quality. Our underwriters code each of them on a scale of one to five. Then we get a monthly computer report that summarizes these ratings for each originator. We then concentrate our attention on those originators that have high marks for package quality and risk quality.

Loan originators could do the same thing for appraisers, credit reporting agencies, and for all the people who provide services to them. The better job we do of identifying quality people, the better we can concentrate on working with them. The more prudent we are, the more certain we can be of producing good, quality loan origination.

Prudence also means providing appropriate incentives. Our account executives have part of their commissions at stake for early defaults. We also reduce their commission for claims that are paid. We try hard to be sure that all of our people have incentives appropriate to their responsibilities and functions.

That leads to the third view of prudence. And that's to organize and ensure proper motivation. You don't let people with a volume incentive order the credit reports or the appraisals. Be sure that the people who guard the keys to the kingdom don't report to people who have an incentive to produce volume. That's simply prudence - just thinking a little bit about the impact your organizational structure can have on quality.

Verification documents are not just forms to be filled out with ink so that someone else can review them and say, "Yes, indeed, there is a verification here." They are beacons to focus attention on the borrower to make sound decisions.

One lender told me that he telephones the employer the day of closing to be sure that the borrower still works there. Now, that's true quality verification.

Another part of protection is to have a strong quality control department. You have to staff it with good people and you have to support it. We have a quality control department at CMAC. They make sure that at least 10 percent of the insurance applications we've received have been re-underwritten reports on what they find as they do the re-underwriting.

This has led to an interesting problem for us. How do we close the loop between people in our default and claims department, which corresponds to lender servicing departments, with people at the front-end know what was found by people in quality control, defaults and claims? We've tried many different ways of doing it, but the only way we found that seems to work is to send the file back to the original underwriter with a comments sheet from quality control.

Then we can get a discussion going as to whether or not the original underwriter saw something that quality control hasn't or if they just weighed things differently or if, in fact, the original underwriter just missed something important. The work of quality control is important, but another step is also important.

You absolutely must require supervisory review. It's an old saying around CMAC that people do what you inspect, not what you expect. One of the most important jobs for the underwriting supervisor at CMAC is to inspect employee's work and re-instruct them as needed.

Another possibility for protection is to use a post-closing follow-up. We've used a borrower audit letter. The letter simply says: Dear Mr./Mrs. Jones: We are pleased to have been able to help you. We're the private mortgage insurance company that helped you get your home with a small down payment. Part of our routine follow-up is to be certain that we understand the loan correctly. Here's what we understand the loan amount to be, what the interest rate was, what the monthly payment is, and yes, we understand that you are occupying the property.

The response that we receive from those borrower audit letters is absolutely astounding. One month we received 60 percent of them back. Another month we received 70 percent back -absolutely an excellent response.

By the way, for loan originators, having that kind of post-closing follow-up is also an opportunity to follow-up on whether or not your people are providing the level of customer service that you except. Communicating to borrowers after that fact can produce useful feedback.

And finally, we can prosecute. Prosecution is easy to talk about. But say it and you have to do it. At CMAC, we have joined with lenders in joint pursuit of perpetrators of fraud and misrepresentation. We've shared legal costs, and we've shared the costs of investigations. We want to be sure that people who don't play the game straight, ge stopped.

Another important step in the event of default is to determine that the property is now owner-occupied. If, in fact, there is a tenant in the property, be sure to get an assignment of rent. Lenders should not look the other way and not demand payment from the borrower, while that borrower is pressing the tenant to be sure the tenant pays him. Understandably, there are some legal difficulties with getting assignments of rent which can lead to some special difficulties, but I am convinced that if you make an overall program of it, you will find that, overall, it pays for itself. It also reduces the incentive for borrowers to think they are going to be able to have unjust enrichment.

Here's another step to consider. If you find that real estate brokers, mortgage brokers or appraisers have not done a good job, report them. Report them to their real estate boards, licensing boards and their associations. Yes, I understand some of those associations and licensing boards aren't very good about following up on complaints. But, perhaps if they get enough complaints and if Congress holds their feet to the fire, we may find there are more and more of them that start doing what California is doing - really following up on complaints, and in fact, revoking licenses from the people that have been dishonest.

There's another way to do it. The industry as a whole needs to develop a database. We need to end this "code of silence" that keeps us from publicly identifying people who have done their job badly. Each company certainly needs to develop its own internal watch list, but we really need an industry "Better Business Bureau." There's discussion about Freddie Mac, Fannie Mae and the FHA getting together on such a list. All of us should get together and participate. And it should be available to all of us.

There's one more "P." And that's "profit." High quality loans cost less to originate. You don't spend as much time photocopying them. You don't have as much unproductive effort. They simply cost less. It's more efficient to produce a quality loan than the other kind.

The Mortgage Bankers Association reports that in 1980, it cost 16 cents per loan in servicing to process foreclosure, and in 1987, that was up to $20.00.

Twenty dollars of servicing costs for every loan was spent on foreclosure activity. So it's simple. High quality loans are more valuable to servicers and investors, and they cost less to originate.

James C. Miller s president of Commonwealth Mortgage Assurance Company, Philadelphia.
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Title Annotation:preserving mortgage loan quality
Author:Miller, James C.
Publication:Mortgage Banking
Date:Apr 1, 1990
Previous Article:Mid-course correction.
Next Article:Mandatory home inspections? Is it a structurally sound idea or a proposal lacking a foundation?

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