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War stories from the due diligence zone.

WAR STORIES from the Due Diligence Zone

The talk today is all about servicing returns. But even with all the heady buzz about those double-digit servicing returns, many operational obstacles can stand in the way of servicers actually banking those much-touted profits.

Due diligence firms observe many operational flaws in servicing shops that cost money and prevent companies from maximizing returns on their portfolios. In many instances, the flaws are correctable once they receive recognition from top management and once critical servicing personnel receive training and systems support to do the increasingly complex job of servicing.

A review of 80 servicing operations performed during the past three years by a nationwide management consulting firm identified the aspects of servicing that suffer the most from an under-investment in staff training and some of the other commonplace problems that hurt servicing profitability. The reviews were conducted by Mortgage Dynamics, Inc. (MDI), a McLean, Virginia-based management consulting firm.

Most of the reviews were conducted for clients who were either buying servicing rights, mortgage servicing operations or entire companies. Approximately 20 were performed for clients seeking to improve servicing profitability and upgrade the quality of their servicing operations. In some cases, companies were using the review results to prepare for substantial servicing portfolio expansion.

The key conclusion MDI has drawn from the reviews is that substantial opportunities exist for servicers to lower their costs over time through investments that will boost their operational quality and efficiency. In most cases, the means of doing this are through investments to modernize the servicing plant and equipment and through investments in upgrading servicing staff. In addition, management changes and reorganizations will be required in many organizations.

Huge amounts of money are being invested in purchases of servicing these days, and the payback on those investments rides on the validity of many pricing assumptions. One critical pricing assumption that mortgage bankers have substantial control over is their cost of servicing. Given the impact of servicing cost on achieving value and MDI's finding that most bidders underestimate their servicing cost, lenders have an incentive to spend considerable time on this issue. Accordingly, MDI's findings suggest that mortgage servicers need to dig down into the inner workings of their servicing operations and identify the factors that are costing them more than they need to. This article identifies some of the more common operational flaws that can be fixed.

Obstacles for management

Although the group of servicing operations reviewed included many of the largest and best-known companies, fewer than a dozen could be described as achieving a high level of investor compliance and servicing efficiency. When the review was done simply for a client buying servicing rights, the review did not cover the profitability of the operation. However, in nearly every review, conditions were observed that, if corrected, would have improved the quality and/or profitability of the operation.

The MDI reviews covered a wide spectrum of operations where the portfolio size ranged from less than $100 million to close $20 billion. The median portfolio had an outstanding principal balance of more than $1 billion. MDI considers the group of 80 operations it reviewed as providing a good cross section of the mortgage servicing industry. The actual operations examined ranged from highly profitable firms buying and selling servicing to several currently under RTC supervision. Most of the firms were mortgage banking subsidiaries of financial institutions, but the group included several independent mortgage banking firms as well.

The operational shortcomings most commonly observed in all but a handful of the companies included far less than optimum use of computer systems, many serious investor compliance violations and inefficient workflow patterns.

These barriers to achieving top servicing profitability were noteworthy because of their apparent prevalence in a time when cost consciousness in the mortgage business has become the new religion. But even more surprising was the fact that in an estimated 75 percent of the companies, senior management was not aware of the extent of the servicing problems, MDI found.

What accounts for these sleeping problems being left to quietly erode the value of the mortgage industry's most precious asset? In our view there are several reasons why senior management was not fully aware of the extent of the servicing operational problems in the majority of the companies we reviewed. Those reasons are: generally poor communication between management and the servicing division; the prevalence of a corporate culture that discourages staff from bringing operational problems down in the trenches to light; and internal budgetary pressure that makes those suggesting additional expenditures out of step with corporate objectives - even if the added costs promise to pay for themselves over time.

On the issue of poor internal communication between top management and servicing department staff, some important points need to be made. Management's impression of servicing is often blurred because it doesn't look beyond the current profitability. Senior management is not being made aware of the full scope of costly technical problems down in the servicing area and the risks they pose. Similarly, the technicians are not being educated to the components of value in servicing so they can make decisions that will be in line with management's financial goals.

On the second obstacle that prevents these problems in servicing shops from being brought to light - the lack of incentives for staff to expose them - there needs to be a change in corporate culture that rewards such efforts. The prevailing attitude among servicing managers in many servicing operations MDI reviewed is "circle the wagons and we'll solve the problems ourselves." Senior managers may point to audits of their operations done for Freddie Mac, Fannie Mae, GNMA or HUD as evidence that they have a clean shop, without considering that these audits are brief and have little to do with profitability or efficiency. Agency audits were examined, when available, for the 80 reviews MDI conducted. Rarely did the agency audits uncover all of the out-of-compliance conditions found during the MDI review. The problem is that most servicing operations have few resources to direct towards uncovering problems, tackling them and clearing away the backlogs. None of the organizations reviewed had servicing problem-identification programs in place that would serve to encourage employees to bring problems to light.

Corporate audit programs, in most cases, were counterproductive in two respects. First, the auditors were not viewed by the servicing technicians as having the level of detailed knowledge about servicing operations and investor requirements needed to identify out-of-compliance conditions or to make meaningful suggestions to improve efficiency and profitability. Second, the audit process was viewed as "we versus they" and not as a forum for identifying problems and moving the organization ahead.

In only two operations, MDI found that internal compliance audits made meaningful contributions towards identifying and solving problems. In the rest of the servicing organizations that underwent such audits, serious compliance violations were not identified, while tremendous time and effort were spent on conditions that have little to do with value or compliance.

Identifying problems and areas for improvement in the context of strategic planning has been effective in a number of organizations MDI has worked with. Such projects have been designed and structured as task forces made up of members of the servicing operation and inside or outside resources knowledgeable in servicing, mortgage finance and management.

The "fear factor" must be substantially reduced by focusing on how to improve the organization rather than on placing blame for things that have gone wrong. A task force effort can play an important role in identifying and prioritizing problems that pose the greatest risk and identifying operations improvements that will improve profitability.

The final internal obstacle that works against top management being able to identify and fix servicing operational problems is the current industrywide squeeze on corporate expenses. The emphasis on cutting costs in the short run makes it difficult for a servicing manager to break out of the fold and suggest spending money to improve future productivity and profits. The tendency is to look at cutting staff instead of investing in upgrading staff, and training and systems enhancements to improve the quality and efficiency of the operation. The task force approach to identifying servicing problems can be an excellent means of building support for investments in the servicing operation.

Specific examples of the kinds of problems MDI found will help to illustrate the exact nature of the operational flaws that are hampering servicers from being as profitable as possible. We've selected prevalent problems that fall into three major categories: quality of staff, poor systems selection and utilization, and investor reporting.

Quality of staff

The most serious overall problems MDI found centered on poorly trained personnel. The prevalence of this condition was not a reflection of the work ethic of the staff in any way. In most of the servicing operations reviewed, the staff appeared to be diligent, yet several conditions were still widespread.

Overall, servicing employees did not seem to understand how what they were doing fit into the overall corporate picture - or to the servicing operation. They also lacked an understanding of exactly what creates servicing profitability. Many did not understand how their function related to other servicing functions and, therefore, did not communicate on their common problems. One example of this was an investor reporting department that could not balance its GNMA II ARM and GPM pools. They suspected they were not using their system properly - and they were right. But an additional problem related to improper adjustments of the underlying loans - an issue they had not explored with their Special Loans division.

MDI also found a serious lack of knowledge about major investor servicing requirements and, particularly, changes found in quarterly amendments to the investors' Seller/Servicer Guides. A surprising number of employees interviewed did not know where the guides were kept in their organizations and did not receive information about updates. In more than half of the organizations reviewed the Seller/Servicer Guides had not been updated with the most recent changes.

In another operation with both Freddie Mac ARC (accelerated remittance cycle) and non-ARC servicing, MDI found an employee who "simplified" operations by remitting all principal and interest payments to Freddie Mac according to the ARC remittance schedule. This "simplification" cost roughly two weeks of float on the principle and interest (P&I) payments on several hundred million dollars of loans that were non-ARC. In this case, the lost float income amounted to approximately $150,000 per year.

Very few servicing organizations reviewed by MDI had adequate policies and procedures manuals (a requirement of the major secondary market agencies) that reflected changes made by the agencies in the past year. Many of the manuals contained policies or procedures that were in violation of current investor requirements. Even in those organizations that had manuals, staff use of them appeared minimal. In many cases, the procedures that staff said they were following were not the ones specified in the manual.

When questioned by MDI about conditions in their areas that were not in compliance with investor requirements, more than half of the servicing employees and many of the supervisors were not aware that the conditions did not meet investor standards.

To many senior managers, most of the jobs in a servicing operation appear to be clerical. In reality, the technical requirements Freddie Mac, Fannie Mae and GNMA have imposed, as well as those imposed by state and federal laws, have created the need for people who can understand and perform complex tasks.

Errors made by servicing employees can result in penalties for late payments or reports to investors, denial of mortgage insurance claims, government penalties for late payment of taxes, responsibility for covering hazard losses due to failure to pay hazard insurance premiums and repurchases of mortgages that have not been serviced properly. Noncompliance with investor requirements can even result in having servicing pulled by the investor and can expose the servicer to lawsuits.

Equally important, however, is that poorly trained employees impede the ability of the servicer to generate income from the portfolio. In one servicing operation MDI reviewed, the computer had been programmed to apply the late fee charge only to the amount of principal and interest payment instead of the entire monthly payment (PITI). The condition had existed for several years without anyone noticing it.

The MBA Cost Study assessing industry performance in 1988 showed that personnel costs accounted for about 40 percent of the direct expenses tied to servicing for the average servicer. MBA's studies have also found that the average servicer spends less than 15 cents per loan to train its staff. With constantly changing servicing requirements, an undertrained staff and, typically, a high staff turnover rate, it is no wonder that many servicing operations function continuously in a state of semi-chaos. Actions that can reduce personnel costs will have substantial cost-saving impact. Furthermore, it is critical that job categories in servicing properly reflect the levels of skill needed and that pay levels promote retention of capable employees. The final goal should be upgrading personnel so each can handle a greater number of loans.

Poor systems selection and usage

The second most serious systemic problem in the servicing operations reviewed by MDI concerns the servicing computer system. There are still many operations that have inadequate servicing systems, most of which were generated in-house or as part of a "banking" software system - where mortgages were an afterthought. However, these organizations share common problems with servicing shops that have state-of-the-art systems.

In the majority of operations reviewed, staff members were not fully aware of the capabilities of their servicing computer software. As a result, they were either misusing the system or under-utilizing it. In many cases, employees were going to great lengths to circumvent the system.

In many cases, information about system enhancements was not being distributed to employees. Systems manuals were not being updated on a timely basis. In several reviews, we found that systems enhancement letters, a critical part of enhancement installation and use, had never been printed off the system. In several of these servicing operations, serious problems directly resulted, and costly corrective action is now needed. As a result, efficiency was being sacrificed, and in many instances, the company was being shortchanged. Out-of-compliance situations were being created in many cases.

In one review, MDI monitored the use of computer-generated reports each during the week and found that reports that should form the basis of the staff's daily work were not picked up for several days. Many were not examined at all. Also, many servicing operations were not using audit reports produced by their servicing systems to check their work. Instead they were addressing errors only as customers brought them to their attention.

Even where Computer Power, Inc. (CPI), a large service bureau, was used, MDI found that 50 percent of the staffs did not know what their systems could do.

In at least half the organizations reviewed, systems enhancements - many of which reflect changes in investor requirements or labor-saving methods - were not being installed on a timely basis. In many organizations that did install the enhancements promptly, installations were handled incorrectly and/or there was insufficient training to maximize the benefit of the enhancement.

MDI found serious data quality problems stemming from a variety of conditions. The conditions include failure to clean up data prior to conversions, poorly planned and executed systems conversions, improper loan set-ups and ongoing misuse of the servicing system. These conditions have created a number of problems for the servicers reviewed including: * Incorrect ARM and GPM adjustments - Overall,

the error rate MDI

found has been in excess of 20 percent

in the operations it reviewed.

In one recent review of more than

2,000 loans, ARM undercharges

were twice as prevalent as overcharges

to the borrower. In a surprising

number of cases, the

correct index value was selected,

but the allocation of the monthly

payment between principal and interest

was wrong. That suggests improper

loan set-up or circumvention

of the system. * Incorrect administration of buydown

subsidies * Inability to pay mortgage insurance

premiums by tape * The need for costly manual adjustments

to routine reports to investors

on a monthly basis * Errors related to tax payments - In

one organization, there were 20,000

systems errors related to the payment

of taxes, and as a result, the

servicer had incurred substantial

tax penalties.

Most servicing systems have tests that are generally run to determine the quality of data for a conversion. These reports can be used by servicer subscribers to determine the condition of their data for ongoing operations improvement. Under CPI's system, for example, the Master File Verification Report can identify problem areas within servicing by verifying the loan-level data contained in a loan master file. These errors can then be classified to identify ones that, if corrected, would enhance efficiency and accuracy. Some of the errors can be corrected with proper installation of enhancements and workstations, while nothing can be done or should be done about other categories. These reports must be used with caution if they have not been updated to reflect all enhancements made in the software.

For ARM, GPM and buydown loans, MDI recommends that beyond correcting problems that appear through data verification reports, servicers should sample their portfolios for set-up errors. If errors are found, verification of set-up data should be performed when the loan's next adjustment date occurs. In addition, a sample verification of all adjustments should be performed going back to the original loan set-up.

Nowhere were data and systems problems more serious than in investor reporting. In several instances, the conversions had been a total failure due to incorrect definitions and insufficient preconversion testing.

The 80 reviews also brought to light the shortcomings of many servicing systems. Many small- to medium-sized operations still have either home-grown servicing systems or a universal package of software that provides all routine data processing activities. In many cases the servicing system is not updated on a timely basis to accommodate recent changes in investor reporting requirements or to handle new ARM programs. There frequently are problems in performing routine servicing operations efficiently, such as processing loan payoffs or assumptions or calculating principal and interest advances. Even if a new system costs an extra $1.00 to $3.00 per loan per year to service, MDI has found it may save $5.00 or more per loan per year in personnel costs.

When substantial staff time is required to work around the shortcomings of the computer system, the cost of servicing goes up significantly. We have found that manual processing of ARM adjustments can add between $30.00 to $110.00 per year, per loan, in servicing costs depending upon the extent of the system inadequacy and the complexity of the ARM product.

MDI recommends that servicers review all ongoing servicing functions to determine whether any that are handled manually could be automated. We often find employees performing tasks manually that their systems can handle. Lacking sufficient information about their system, they tend to "override" the system and perform the task manually. Typically, spending money for staff training on an adequate computer system and servicing functions training will pay off greatly in the future.

Investor reporting

Investor reporting was the most poorly administered function in more than two-thirds of the companies reviewed. The training and systems problems discussed above were even more evident in the investor reporting departments of the companies reviewed.

Typically, these departments were behind in their reconciliations and were not up-to-date on investor requirements. For example, in recent months, few of the companies reviewed were in compliance with Freddie Mac's new custodial account requirements. Another common problem is failure to review and reconcile previous months' reports to investors with the reports received from investors.

In one operation, 55 percent of the GNMA GPM pools and 30 percent of the ARM pools had errors that had continued for two years. There was no plan in place to correct the problem, and senior management was unaware of the extent of the problem.

An $8 million over-remittance to Fannie Mae was found in one operation reviewed by MDI last summer. The remittances involved "excess" taxes and insurance (T&I) funds for fixed-rate loans sold before 1971 that were serviced at .50 percent of unpaid principal balance. The remittances were supposed to be based only on those loans affected, but the servicer based them on the entire Actual/Actual portfolio and remitted the total escrow balance shown on the monthly trial balance rather than escrow receipts. The servicer had no idea this was occurring even though the custodial bank account was overdrawn by millions of dollars.

Delinquent loans were not being liquidated from Fannie Mae MBS pools on the 120th day of delinquency in several organizations, resulting in unnecessary payment to Fannie Mae of scheduled principal and interest. MDI also found that funds due from Fannie Mae when such loans were liquidated were not requested in a timely manner, resulting in corporate advances for lengthy periods of time. In the case of two multifamily loans, Freddie Mac granted foreclosure request, but no one notified investor reporting personnel, and they continued to advance interest to Freddie Mac in the amount of $50,000.

In one operation, Fannie Mae Actual/Actual remittances to the agency were consistently sent in late because the servicer's system failed to generate the reports needed by investor reporting personnel on a timely basis.

In some companies, errors in balances "sold" to GNMA as shown on mortgage loan schedules were noted as well in servicing fee rates and pass-through rates in the system, resulting in miscalculation of remittances to security holders. This also produced errors in booking servicer's income. The servicer had to contact security holders to recover the amounts over-remitted.

In one operation, poor communication resulted in two sets of checks being sent to GNMA security holders for the same month.

Remittance mistakes that are not caught can lead to major long-term problems. One servicing operation reviewed had been paying the investor more than the investor was entitled to. The mistake was not caught because the original error was made with the first remittance many years ago. When the thrift servicer suspected a problem, it did not reconcile accounts back far enough to find the problem. Over a number of years it was found that the excess payments amounted to more than $300,000. This turned out to be a tremendous financial drain on the small association, and correcting the problem was time consuming and expensive. The investor was only willing to settle by transferring some loans in the securities pools to the servicer.

Investor reporting has been especially troublesome in the RTC-controlled operations MDI has reviewed. This stems from the prevalence of staff turnover in these operations and the difficulty of finding qualified investor reporting personnel to work in organizations facing uncertain futures. MDI has found true disaster areas in investor reporting in some RTC shops it reviewed. Correcting these problems prior to transfer is imperative to minimize the damage to the acquiring organization.

Focusing ahead

In order to maximize earnings on servicing, senior management must change its focus. The American automobile industry was faced with a similar challenge and has been struggling with this issue for the past 10 years. Top management in mortgage servicing must focus now on modernizing their manufacturing plant so the "car" not only looks great on paper, but also "performs."

In the automobile industry, the trend has been towards upgrading staff in critical areas of the manufacturing process, recognizing the need to move to higher technical skill levels, instilling pride in workmanship and placing greater responsibility on such workers to make decisions.

Similarly, the most successful servicing operations of the 1990s will reflect dramatic change in their corporate culture, with emphasis on knowledgeable, trained technicians and further labor-saving technology.

Mary Bruce Batte is a managing director of Mortgage Dynamics. Inc., a McLean. Virginia-based management consulting firm.
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Title Annotation:reviews of 80 servicing operations
Author:Batte, Mary Bruce
Publication:Mortgage Banking
Date:Mar 1, 1991
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