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   ARTICLE   |   From Scotsman Guide Residential Edition   |   November 2013

Investing in a Compliant Future

The cost of compliance may be high, but spending today could mean savings down the road

Regulators and the influence they wield have long been an aspect of financial institutions’ everyday business. From the Office of the Comptroller of the Currency (OCC) to the Federal Deposit Insurance Corp., most financial institutions deal with more than one regulator, and in previous years, each entity’s regulations were well known and fairly standard. As long as a financial organization followed the right regulations, maintained good procedures and made sure that its key personnel understood how to deal with an audit, that organization’s operations and compliance were generally fine.

Over the past 15 years, however, the regulatory burden has increased tremendously in the wake of two major industry meltdowns. The first was the result of the accounting scandals at WorldCom Inc., Enron Corp. and Tyco International Ltd., to name a few. The second was the more recent mortgage-backed security crisis. The first saw corrections in the form of the Sarbanes­­­-Oxley Act, and the latter resulted in the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Sarbanes-Oxley has resulted in billions of dollars spent on documentation that aims to assist management in understanding the risks involved in their operations. The act’s intent was noble. Surely, the thinking went, if organizations’ management have transparency into their operations and accounting, then they will be better prepared to attest to the validity of their numbers. Some within the financial services industry may argue that the expenses incurred by companies to comply with Sarbanes-Oxley have outpaced any catastrophic event, but regardless, companies must comply. By now, most organizations have built Sarbanes-Oxley into their processes and their operations are progressing steadily.

Dodd-Frank, however, is a totally different animal, as this legislation and the Consumer Financial Protection Bureau (CFPB) continue to impact companies that may have never had to worry about regulators before. It isn’t good enough simply to show procedures and have personnel trained on best practices; the CFPB and other regulatory entities want proof of compliance. They want an audit trail. They want consistency. They want to see things woven into the fabric of a company’s practices.

It may not be obvious to some, but companies such as mortgage servicers may not have had to deal with a litany of regulators in the past. After all, some servicers aren’t banks, credit unions or mortgage companies. They deal with a lot of money and work with consumers, but they may have not been regulated until Dodd-Frank. Even so, mortgage companies of all sizes and functions should be familiar with some examples of institutions that are — or are not — being proactive when it comes to regulations, and they should be equally familiar with some of the possible ramifications of their decisions and actions.

The wrong approach

To remain compliant with all pertinent regulations, a lending institution must build proper controls — and conduct regular maintenance of those controls, as well — if it hopes to keep up with industry standards. If you don’t maintain your operations and controls, that lack of effort may cost you significantly later. The bottom line is that compliance isn’t free. In fact, it can be an enormous expense if you don’t take the long view.

It can be helpful to consider a few examples of institutional approaches to compliance and the effects that those approaches may have. Let’s consider, for instance, the large nationally recognized institutions that purchased many mortgage and consumer loans between 2004 and 2007. These companies often spent a lot of time and effort on marketing their brands, but many didn’t invest much in their operations-and-controls framework. Many of the loans that these organizations purchased were unusual or nonstandard loans that carried potentially high yields, and because of the nature of the loans, it was difficult to standardize operational processes and technology. In light of this, companies like these frequently decided to hire lots of staff to perform manual processes, sometimes even hiring this staff as hourly labor.

You can guess what happened to companies like these. When the crisis began, their portfolios were hit with huge losses based on defaulted loans, and because of the lack of controls and automation, these organizations couldn’t answer simple questions like, “How many loans of ours are in default?” or “What type of loan modifications already have occurred?”

Naturally, regulators paid companies like these a visit, and for many, the findings were huge and the time to remediate was short. To compound problems, many of these companies already had begun laying off many of the personnel who bought the loans in the first place, resulting in important domain knowledge no longer being available. Because of this, these organizations were forced to hire consulting companies that had experience in “fixing” this type of problem — the rates for which often were in excess of $500 per hour. Millions of dollars later, the issues were remediated by implementing mostly manual controls.

Following all of this, where did companies like this stand? The OCC may have left them alone, but after millions of dollars spent, these organizations still had the same manual processes and limited technology as they had before. In other words, they put a bandage on the wound, but they never fixed the injury.

The right approach

Now let’s consider a different hypothetical — a company that has done business in the mortgage space for years, mostly as a servicer and sub-servicer. Let’s say that this organization has a small lending business, as well, one that’s generally cost-conscious and conservative. In the boom years, companies like this stayed centered on what they were good at, and they didn’t stray outside of the lines, even though originating loans was easy money.

When the crisis hit, these companies did well in the sub-servicing space and had money to spend when the dust cleared. Over the past two years, they’ve begun preparing for business with the Federal Housing Administration, Freddie Mac and Fannie Mae. The first thing that most of these organizations did was assess their own operations and knowledge base. Knowing that they had limited knowledge of doing business with the agencies, they hired consulting companies to come in and review their operations, policies and procedures to provide a gap analysis.

In these cases, the gaps discovered offer a clear plan of attack, and the total cost for consultancy often is less than $100,000 over a six-week period.

Because companies like this then have solid processes and robust control frameworks in place, they can be prepared to do business with the agencies. These companies also gain valuable expertise for any CFPB audits that may be waiting around the corner.

•  •  •

What’s the difference between these two types of companies? The first tried to make easy money but failed to tend to the basics of its operations and controls, while the second stuck to its core competencies in the boom times and now is getting into new business lines. The second type of company is spending money wisely, investing in internal processes and controls, and when necessary, asking for expert assistance. They’re well-positioned now and well-positioned for the future, too.

Going forward, companies must understand the true cost of compliance. Organizations that centralize a compliance function and give that role the authority to drive change will spend money wisely in the short term and move into a maintenance mode over time. They can adapt to changes in regulations and weather storms in the marketplace.

Keys to success in this regard include staying involved with the industry and staying on top of changes. Find expertise outside of your company either by hiring the appropriate personnel or consulting services. Whatever your approach, don’t ignore the situation. If you do, you most certainly will have an unpleasant audit experience at some point, and when you do, be prepared to pay much more money than you bargained for.


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