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   ARTICLE   |   From Scotsman Guide Residential Edition   |   April 2008

Protect Yourself from Risk

A plan with preventive and restorative measures can help you stay strong

Although risk management has always been a part of the wholesale channel, it was rarely used in retail. Some brokers feared that it might slow or stifle their production, while others believed the benefits did not outweigh the costs.

As with any problem, the further you get from the source, the harder it is to detect and prevent the problem. Although wholesale lenders did their best to detect and manage loan-level risks, they were at a disadvantage because they often were working with second- or even third-hand information.

Brokers and bankers all across the nation felt the pain. Faced with unsalable loans and surmounting early payoffs, early payment defaults and buyback demands, many were forced to dip into their personal reserves, to tap out their warehouse lines of credit and to make staffing cutbacks. Some even lost their warehouse lines and were forced to shut down their lending operations altogether.

Now we must move forward. We must analyze our weak points and find a way to protect our industry’s future. That is why it is paramount for brokers and bankers to reconsider their current risk-management policies, paying special attention to the areas where they sustained the most loss.

Risk management is not a one-size-fits-all solution. What works for some might not work for others.

The best bet is to have a comprehensive plan that is tailored to your particular business model and that factors in historical weak points and overall risk threshold. By creating a risk-management plan that includes preventive and restorative measures, mortgage professionals can cover their bases.

Put a preventive plan in place

When considering loan-level risk, consider some of the most-common issues:

  • Do the borrowers do what they say they do?
  • Is it feasible that they can earn what they say they make?
  • Is it reasonable that they will continue to earn the same level or more in the foreseeable future?
  • Is the property worth the appraised value?
  • Is there a tangible benefit to the borrowers for taking the loan?
  • Are there enough compensating factors to support their ability to repay the debt?

With these questions in mind, there are some basic risk-management and quality-control procedures that should be incorporated into every preventive plan.

First, verify the accuracy of the appraised value. You can do this by pulling additional comparable sales data and using an automated valuation scoring system for lower loan to values (LTVs) and loan amounts.

In instances of higher loan amounts or LTVs, you should get a full, secondary appraisal review. Because the property is the loan’s collateral, you should spare no expense to ensure that it’s accurate. If you were ever forced to buy back the loan, you’d be relying on the accuracy of your value to mitigate additional losses.

In addition, verify employment and asset information using a third party before the loan setup, document and funding stages. Because there may be a conflict of interest, it is not advisable for anyone who is compensated on loan production (e.g., processors, loan officers, sales managers, etc.) to perform this task.

If you can’t afford to hire a third party to perform this function on all your loans, at least consider doing so for the higher-risk loans, such as those with LTVs greater than 80 percent, jumbo loan amounts and limited-income loans.

Further, perform a full, secondary quality-control review before funding. This ensures that all documentation in the loan file is consistent, that all other risk-management controls have been performed properly and that the file still qualifies. This is especially helpful for small mortgage bankers who don’t have the luxury of making forward commitments or large pool sales. It gives them a final insurance against any last-minute investor-guideline changes.

If a loan fails the quality-control risk review, then the file should go to senior management for review and assessment. It should not be accessible to anyone who may have a potential conflict of interest until senior management completes the review. This ensures the integrity of the documents before funds are dispersed.

Create a restorative plan

Because there is no way to eliminate the risks associated with lending completely, even with a comprehensive preventive risk-management plan, you should assume that you will incur losses at some point. Your restorative risk-management plan is one that kicks into action after all your due-diligence efforts have failed and when you are faced with an unsalable loan, a buyback, an early payment default or even litigation.

It’s important to determine an acceptable risk threshold for your business. This should be done along with making your preventive risk-management plan. Because everyone’s approach to risky business is a little different, there is no exact formula for this.

Many firms, however, usually operate with a 3-percent risk threshold, which means they assume that 3 percent of their loan production will become losses and prepare for such.

It should be noted, however, that if your business caters predominantly to a nonprime clientele, then 3 percent may not be enough. You should consider current economic conditions, as well as your clientele, past losses and overall risk-management plan, when determining your threshold.

Having professional-liability insurance with errors-and-omissions coverage and incorporating a loan-loss allowance fund to cover whatever percentage you determine to be your risk threshold are crucial to protecting your firm from future losses.

•  •  •

Though we can’t completely eliminate the risks associated with mortgage lending, a risk-management plan that encompasses preventive and restorative measures will help minimize the risks.

Success lies in consistency. By establishing a plan and sticking to it on every loan, you will minimize your overall exposure. As such, when you are faced with distressed or impaired loans, you can manage through them and move on.

By protecting yourself, you are also doing your part to protect the industry as a whole.


 


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