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   ARTICLE   |   From Scotsman Guide Residential Edition   |   July 2009

Where Due-Diligence Underwriters Go Wrong

Brokers should know the six main areas mistakes occur and how to handle repurchase demands

Due-diligence underwriters' roles have changed in the past three years. They were once employed primarily by large investment banks and firms looking to purchase residential mortgages on the secondary market. Loan-default and foreclosure increases, however, have caused private-mortgage-insurance companies to hire these firms. r_2009-07_Hippensteel_spotAdditionally, holders of recently defaulted loans now rely on due-diligence underwriters to support repurchase actions against mortgage originators.

At the same time, many due-diligence underwriters now work for mortgage brokers. Who better to help brokers defend against repurchase demands and potential denials of mortgage-insurance claims than the people who work for the other side?

The increase in demand has caused the advent of many new due-diligence-underwriting firms. It has not, however, put an end to all mistakes. Due-diligence underwriters -- new and old -- continue to make serious errors when re-underwriting closed mortgages. These blunders often result in poorly supported repurchase demands and mortgage-insurance-claim denials.

Brokers who learn to spot due-diligence underwriters' missteps can better fight for their and their clients' rights. They also can better oversee any due-diligence underwriters they might choose to employ. Here are six common areas where due-diligence underwriters go wrong.

1. Overtime and bonus calculations

Standard underwriting requirements for using overtime or bonus income in debt-to-income (DTI) calculations call for proof that the additional income has been received for the past two years and that it likely will continue in the future. Underwriters often take the latter half of this requirement for granted.

Often, overtime and bonus income is annualized improperly. One way this can happen is when only the borrowers' overtime or bonus income -- and not their entire income -- is averaged over two years. This mistake results in dramatically lower gross monthly income and higher DTI figures.

2. Automated underwriting

Too often, due-diligence underwriters recommend repurchases based on the claim that the original automated-underwriting findings were invalid because of errors in input data. This, however, does not matter if the data improved the loan submission's quality.

Fannie Mae and Freddie Mac have specific guidelines for when their automated-underwriting reports must be run again because of changed input data. If changed data such as increased income or assets, a lower DTI ratio, or a lower loan-to-value ratio (LTV) decrease a borrower's risk level, automated-underwriting systems would still produce an approve or accept finding.

If a file was approved at 85-percent LTV and the true LTV is 80 percent, resubmission wouldn't matter.

3. Incorrect dates

It is important to pay attention to dates, particularly when dealing with once-popular pay-option ARMs. These loans' low introductory rates resulted in negative amortization for a few years before the loan reset to a fully indexed rate. They often used an index that changed daily, and underwriting guidelines required the borrower to be qualified at the fully indexed rate.

While the margin for the qualifying rate would remain the same as set forth in the note, the timing of when to pick the index was critical. In the past five years, indexes for ARMs changed rapidly in the course of any given month. When these ARMs went to an underwriter for evaluation, the underwriter generally picked the given index amount on the day the loan was reviewed.

Oddly, many due-diligence underwriters look at the note to see when the rate change was set to occur, use that date to pick the index to calculate the qualifying rate and then apply the rounding limit from the note.

The loan-approval process must include a specific day to establish the index used for calculating the qualifying rate.

4. Shopping salary databases

The debate surrounding stated-income loans and reasonable stated incomes for specific jobs continues. It's easy to pick a common job title and search different online salary databases for information about how much a person employed in the chosen profession makes. The problem is determining which database is the most accurate.

For a given batch of loans, due-diligence underwriters should pick one online database and stick to it. Surfing from one database to another to find the lowest income so that a loan can be failed for "unreasonable stated income" is unacceptable.

5. Questioning original appraisals

The use of automated valuation models (AVMs) to question appraisal values has grown dramatically in the past year. AVMs serve a valuable purpose, but the data behind them warrants careful review. Using post-closing AVMs to question original appraised values is common among due-diligence underwriters.

The critical error with AVMs involves the dates of the comparables used. Many AVMs use the date of request to pick potential comparables. This often results in an AVM value based partially on comparables that were available only after the original appraisal date. The results from AVMs also can include foreclosure properties, which aren't reliable comparables.

Regardless of what some people say, AVM comparables should be held to the same standards as original appraisal comparables.

6. Not reading front-end guides

Many new due-diligence-underwriting firms believe that all front-end underwriting guides follow standard Fannie Mae and Freddie Mac guidelines. Not so. Wholesale lenders were free to make their own guidelines. Those loans' purchasers should have read the guides before agreeing to purchase them.

Some wholesale lenders allowed borrowers to use cash-out proceeds as reserves. Also, not all lenders required seasoning for assets. Too many new due-diligence-underwriting firms are so eager to make their clients happy that they don't realize or investigate what the front-end underwriting guides really were.

•  •  •

Because of the opportunity for errors in due-diligence underwriting conducted by those looking to pin the blame on brokers, more brokers now realize the value of having their own due-diligence underwriters. It might sound like a complicated circle, but it's one that can keep brokers from losing money and face.


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