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   ARTICLE   |   From Scotsman Guide Residential Edition   |   January 2013

Taming the Four C’s

Ride the waves of success by knowing underwriting and risk-mitigation standards

Taming the Four C’s

The aftermath of the mortgage crisis has created an explosion in demand for cautious underwriting, with banks and lenders requiring more efficient and effective document review and management. Although the guidelines and risk tolerances have changed since the meltdown in 2008, the so-called four Cs of underwriting remain in place: capacity, credit, cash and collateral.

That doesn’t mean that the underwriting process is as simple and straightforward as it used to be, however. What must mortgage brokers and originators know about today’s underwriting standards and processes — and what should they do to streamline their loan processing and rein in success?

Although the four C’s continue to comprise the heart of underwriting, they also have materially different interpretations than they did a decade ago. In other words, although the general concepts of the four C’s may remain unchanged, their specific definitions are shifting constantly.

That’s one of the reasons why it’s crucial for the underwriting process to be something more than just a simple game of check the box. For their part, mortgage brokers and originators can play a central role in ensuring the documentation of the four C’s in their individual loans, and help ensure that their production is as steady and efficient as possible. To do that, mortgage professionals must begin with a solid understanding of basic underwriting procedures and considerations, as well as some of what brought the industry to where it is today.

Background

In the business of loan origination and servicing, it’s sometimes easy to forget that a mortgage is merely a contract with a security provision. A mortgage is, at its heart, a secured loan. The security is expected to be a high-value asset, which supplements the borrower’s own credit. What happens, however, if a lender doesn’t value that asset very highly? It’s at that point that the qualification of the borrower’s credit comes under the microscope.

The credit aspect of the four C’s rose in importance as housing prices collapsed. The history of the average home price in the U.S. from 1975 through 2011 demonstrates that, before the crash, home prices were rising more or less steadily. Although everyone in the industry is familiar with the subsequent collapse of the market, why it drove a surge in the demand for documentation is not always fully understood. In short, as lenders became increasingly concerned about the value of their collateral, the credit and intentions of the borrower became essential to determining the investment quality of mortgages.

Matters were further complicated by the legacy of lenders that simply assumed that the real estate backing their loans always would continue to appreciate. No-documentation loans and low-documentation loans seemed like an easy way to gain exposure to an appreciating asset. This, as the industry now knows, introduced an enhanced element of moral hazard in the mortgage lending business, in part because lenders were sometimes disregarding certain borrowers’ overall qualifications in favor of the appreciation of their housing collateral.

Intensified standards

From this recent history came today’s more stringent underwriting standards. Mortgage brokers and originators should never underestimate the scrutiny with which their clients’ documents will be analyzed from origination to recording. And, ultimately, the central focus of any document review is risk mitigation. This encompasses the idea that lenders are entirely risk averse, although that isn’t completely true. In a way, fraud is a type of risk that — for a price and at a certain level — can be tolerated. The challenge for the lender is risk mitigation, not total risk avoidance; otherwise, lenders would only buy treasury bills, and the government would have to go beyond its current level of guarantees. In this sense, risk management involves certain broad questions, the answers to which are inferred from a multitude of data derived from the documentation that supports and defines the four C’s.

Brokers and originators should know that almost any lender will start with one simple question: Is the buyer really the buyer? Identity fraud, identity theft, personal misrepresentations (i.e., straw buyers) are essential tools of the mortgage criminal, and every bank and lender knows that well enough. Even with a real buyer, however, an equally important question remains: Does the buyer intend to actually live in the house or simply flip the property? In this respect, the value and marketability of the property is a key factor. In other words, lenders will be interested in whether or not the property has adequate collateral for the transaction and whether or not the appraised value is supported.

When it comes to verifiably real buyers, capacity likely will be the next issue that lenders and underwriters consider, in addition to the matter of the borrower’s cash position. Can the borrower afford the property in question? Does the borrower have cash on hand to manage a short-term crisis? Of course, all of this revolves around certain questions regarding the valuation of the collateral. Even with good collateral, valuations can be inaccurate, which in turn may give the lender a higher level of risk and the borrower a lower capacity to pay off the loan.

When dealing with these issues, mortgage brokers and originators must direct questions that extend far beyond a myopic inspection of a borrower’s balance sheet. Such a level of communication and transparency can go beyond mere customer service; it also can help to assure borrowers that they’re not setting themselves up to be victims of a scheme. Justified or not, many homeowners are aware of the wide array of mortgage professionals who have been involved in fraud cases, from builders to correspondent lenders, loan officers, brokers and attorneys.

This, of course, relates back to the mortgage industry’s increasingly strict underwriting standards, as many lenders’ response to growing instances of fraud has been to check off more and more boxes. Lenders are digging deeper into the financial and personal lives of their borrowers and scrutinizing every person involved in the process all the more.

Nonetheless, it takes more than the simple act of data gathering for underwriting standards to be effective; mortgage brokers and originators also must strive to truly understand the data that they receive. For example, if a borrower barely meets a lender’s criteria and the sources of the borrower’s income remain unclear, originators must take it upon themselves to investigate that scenario more thoroughly. Filling in all those boxes only helps to solve the documentation and fraud problem if the data is closely analyzed for red flags.

Intensified reviews

Mortgage professionals also should know that, at the direction of the Federal Housing Finance Administration (FHFA), Fannie Mae and Freddie Mac recently changed their representations and warranties. The purpose of these changes is to provide more clarity for lenders regarding their repurchase risk and to acknowledge that the risk of default because of qualification and fraud issues generally will be revealed in the early years of a loan.

With these changes, Fannie and Freddie essentially are enhancing their quality control (QC) practices. Mortgage professionals should know that the number of loans selected for QC review will increase in the future but may fluctuate based on the quality of a lender’s performance. A random sample of loans will be selected between 30 days and 120 days after acquisition by Fannie or Freddie, and a discretionary sample using data analytics to identify high-risk factors will be selected within 150 days of acquisition. Early payment default loans also will be selected.

Further, if a seasoned loan is no longer performing, it may be subject to a QC review if Fannie or Freddie becomes aware that the loan violates a life of loan representation and warranty. This includes data integrity, first-lien enforceability and regulatory compliance, as well as entailing that a loan must be free of misrepresentation or omissions at the time of origination.

Mitigating risk

Once you’re familiar with the general state of underwriting and all its various considerations, one key question remains: What can mortgage brokers, originators, loan officers and anyone else who touches loans in the pipeline do to mitigate origination risk for the banks and lenders with whom they work? Mortgage lending will never be risk free, but there are certainly some excellent ways in which mortgage professionals can help to allay risk. Consider the following.

  • Prepare the borrower for the application and take a complete initial application. An incomplete application often leads to omissions and potential misrepresentations of information. There is also an increased risk that the underwriter may overlook something critical when a loan is submitted.
  • Don’t just check boxes; analyze the data. Take advantage of the various tools available in the industry today to improve loan quality and mitigate risk. When possible, use service providers’ products that streamline the collection of information and monitor applicants’ credit activities.
  • Place an emphasis on effective pre-closing quality assurance. Select loans on a random and discretionary basis to review after a loan has been underwritten but before closing. This discretionary sample must focus on high-risk factors. These factors include but are not limited to new loan officers, new third-party originators, new underwriters, non-owner- occupied properties, loans in areas with high rates of fraud and default, and loans associated with parties that have high QC defect rates. Don’t allow defective loans to close until they are cured.
  • Consolidate and trend risk-related data from multiple sources. This will help you find patterns of potential fraud, lack of operational controls and employee knowledge gaps. Loan quality and loan deficiency data and the participants associated with mortgage transactions may come from many places. These include internal and external audit reports, investors’ quality reviews, repurchase or indemnification requests, consumer complaint logs, outstanding final document reports, and early payment delinquency reports.
  • Create a learning culture within your company that reinforces your business objective to originate investment-quality loans. If you’re a manager, work to ensure that all of your employees have an optimized learning path that starts when they’re first hired and continues throughout their careers with the company. This means setting expected knowledge requirements. You may, for instance, require all loan officers to be able to accurately calculate income for a salaried borrower.
  • Have an independent operations risk assessment performed annually. If your organization does not have an internal audit department with enough mortgage experience, engage a qualified third party. Be sure to follow through with acting on the recommendations given, which may include updating policies and procedures, improving data integrity, enhancing loan quality and compliance controls, and closing employee knowledge gaps. 

• • •

Evaluating the four C’s of underwriting — capacity, credit, cash and collateral — is not solely the responsibility of the underwriter. Remember, underwriting begins when a loan officer or broker first communicates with applicants. The loan officer sets the expectations with borrowers regarding the required documentation to support their application.

Following that, as a loan makes its way through the pipeline process and each employee checks off their boxes, invest the time to closely analyze the documents and the data. Are there inconsistencies? Does the transaction make sense given the borrower and property profile? Investing time close to the point of sale to identify and address red flags and performing a double check before closing will enhance customers’ experiences and reduce your lenders’ risks.  


 
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