Two reports issued this past July by the Federal Housing Finance Agency (FHFA) office of the inspector general expressed material concerns about mortgage purchases from smaller lenders and nonbank specialty servicers by the government-sponsored enterprises (GSEs), Fannie Mae and
Freddie Mac. Increasingly, the secondary market — and GSEs in particular — are focusing on counterparty risk and how seller/servicers can stand behind their warranties and representations for the life of the loan.
Interactive finance expresses solutions to concerns raised in the reports and restores mortgages, the largest, most-broken asset class, by employing behavioral analysis to supplement statistical analysis. Through a patented innovation, a risk-scoring system renders the net present value of
underlying collateral with recurrently refreshed, user-originated, crowdsourced data, as well as comparably updated risk-determination data.
This neutral process supports arbitrage in any direction for all risks by inclusion of any and all participants in a marketplace. Process enablers and due-diligence providers will find interactive finance would improve risk detection throughout the full life cycle of mortgages. Enterprises
in nonconforming markets that originate loans for subsequent sale without implicit government guarantees also would benefit.
Fannie and Freddie are encountering greater counterparty credit risks, more operational risks with higher transaction costs, and increased reputational risk from community banks, as well as nonbank originators that are managing increasing numbers of troubled mortgages. These
lenders generally lack the information-monitoring and processing capabilities found in larger banks.
Community banks, many privately owned, and nonbank specialty servicers, operate with smaller capital requirements and different regulatory scrutiny. Nonbank servicers are subject to Consumer Financial Protection Bureau (CFPB) rules and state regulations, but operate without a federal prudential
soundness and safety regulator.
Big banks and aggregators are exiting whole swaths of mortgage-origination and servicing markets in response to greater repurchasing risks and costs, tighter margins and higher regulatory costs. From first-quarter 2011 to third-quarter 2013, community banks and nonbank
mortgage-company shares grew to 55 percent at Fannie Mae and 56 percent at Freddie Mac, while shares of the five largest sellers fell from 65 percent to 45 percent at Fannie Mae and from 70 percent to 44 percent at Freddie Mac.
In consequence, the GSEs now face greater risks because some community and nonbank mortgage companies may lack capacities to honor representation and warranty commitments. The GSEs may also face higher administrative costs and greater transaction and counterparty risks because of
less-sophisticated systems and expertise managing sales volumes.
Fannie Mae and Freddie Mac may know the scope of trends and character of market developments, these reports observe, but they have yet to implement meaningful controls, policies and procedures to address new, potentially catastrophic risks.
Minimum net-worth requirements are higher, now as much as $2.5 million from $250,000 for community banks and nonbank originators, and these higher net-worth requirements supplement greater scrutiny of borrowers, mortgage pools and revised repurchasing standards.
Monitoring of operational risk is stepping up and slipping by. Fannie Mae mortgage-origination risk assessment and Freddie Mac counterparty operational-risk evaluation teams are conducting operational reviews of some nonbank seller applicants to evaluate back-office capabilities
to adhere to seller/servicer standards. The FHFA division of enterprise regulation review, however, never evaluated existing controls when recommending GSE planning for servicers expanding into origination.
Unfortunately, reputational risk remains reactive. Once there’s litigation or state regulatory action, the GSEs look into the offending entity. The absence of federal oversight and lower barriers to entry compared to bank chartering enable nonbank lenders to enter markets with less capital
and lower regulatory costs.
Crucial work remains outstanding. The FHFA did not specifically test and validate risk controls for direct mortgage sales by small lender and nonbank mortgage servicers in 2013, although it does plan to examine GSE risk management in 2014 to articulate counterparty risk management
Community banks, nonbank originators or specialty service developments represent rational participant action. Big banks are shedding risk and retaining cash by farming out servicing — once a cash cow but now increasingly less lucrative — to enterprises with lower operational and
regulatory costs and less scrutiny.
The FHFA and GSEs are attempting to manage risk by creating practical intelligence and articulating guidance. Smaller banks, originators and servicers implement distinct business models and regulatory obligations within risk tolerances. Should those mortgages sour because of originator or
servicer abuses and GSE lapses, consumers and citizens will emerge as the risk-takers and bear the costs.
This is where interactive finance could help. It would power robust risk-predictive analytics for better loan/security standards and seller/servicer yardsticks.
In interactive finance, participants trade information for cost-saving incentives that create risk transparency throughout the life of an asset. As a result, the asset trades with optimum liquidity and is price-advantaged over similar assets that are less risk-transparent, or opaque.
“ Mortgage holders and servicers can employ transaction credits
to reduce costs and gain a competitive advantage. ”
This process employs transaction credits, direct strategic benefits or monetary benefits to provide upfront credit transparency and update risk data after the origination process is complete. This information generates prospective risk-detailing data that enhances retrospective prudential
valuations generated by statistical analysis. Broadly, this behavioral system rewards any party for risk-detailing revelations, and improves mortgage-data robustness and granularity.
Beneficiaries would include:
- Individual consumers, who accomplish funding goals through use of a system that optionally accepts all necessary and increasingly granular market information using a methodology that rewards ongoing participation.
- Mortgage originators, who ensure that information is properly processed, workflow recorded and financial instruments properly shopped for price and terms.
- Portfolio lenders, such as community, commercial and mortgage banks, which agree to absorb the risk, and whose product menus and individual risk-taking processes are often unique to this transaction platform.
- Servicers and lenders, which watch and report cash flow and work to restore it when it is deficient, foreclose on the asset, or replace one loan with another.
- Risk raters, who look at the original pools and retool or refresh their analytics to track risks on a going-forward basis.
- Securitizers, which assemble and structure the loans into pools that are turned into securities with attributes and risks that can be known going forward and captured for future analysis.
- End-user investors, who mark their investments to market or model, and may also need to measure possible liquidity.
As a mortgage continues through earliest servicing to ultimate disposition, mortgage holders and servicers can employ the patented notion of transaction credits to reduce costs and gain a competitive advantage by exchanging risk-detailing information. Mortgage-industry enterprises achieve
greater internal savings and efficiencies, better pricing in secondary markets, and risk-detailing data and metadata in risk markets.
If transaction credits constitute the foot soldiers of interactive finance, risk-determination scoring, component analysis and real-time contract revaluation are its sentinels and field generals.
Risk determination yields monetary and risk values for a mortgage. An ongoing transparency index calculates risk scoring based on the quality and quantity of risk-data records. The technology creates, stores and enables specific retrieval, analysis and matching of financial product data and
risk data to determine current monetary values of mortgages. These capabilities would refine the latest capital-ratio rules set by banking regulators.
Component analysis and real-time contract revaluation act as continuously refreshed feedback loops connecting a specific risk instrument — like an individual mortgage — with broader risk indices.
In these ways, interactive finance measures information quality and quantity over the life of a mortgage with information that refreshes, verifies and revalues with full market reach from initial purchase through final disposition.
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Interactive finance benefits and lowers costs for all mortgage-market participants, which means Freddie, Fannie and the FHFA would no longer need to play catch-up. Real-time and near-real-time risk scores would illuminate counterparty credit risks, as well as operational and reputational
risks, so future cash flows can be more accurately forecast to support the stability of asset values. Thus, everyone gets paid.
Michael C. Laing, vice president and branch manager of the
East Falls branch of National Penn, commented thoughtfully on drafts of this