Hundreds of thousands of businesses open their doors each year across all types of industries. These entrepreneurs, including those in specialized professional services — such as mortgage originators — are small-business owners who help push the U.S. economy forward each and every day.
Success in the small-business world, however, is not guaranteed. In fact, according to the U.S. Bureau of Labor Statistics, more than half of all businesses started in 2014 failed within four years. The driving forces behind business failures are varied, but for many, closures take place because of a lack of experience and no plan for success.
When any company — including a mortgage company — fails to meet the needs of a client, surety bonds work as a protection mechanism to make things right. Clients receive payment from a surety agency for a successful claim, and the mortgage company repays the claim amount to the surety agency. When a bond claim arises due to a mortgage company’s financial hardships, several different solutions may be put in place to keep the business from closing its doors for good. For mortgage originators who are just getting started, it is helpful to first understand how surety bonds work.
Surety-bond basics
A surety bond is often a state-mandated requirement to obtain a professional or business license. Several different types of industries use surety bonds as a means of protecting their clients from bad business practices.
When a surety bond is put in place, three parties are involved in the process — the principal, the obligee and the surety agency. The principal is the person who is required to have a bond for a specific project or profession, and they purchase a bond from a surety agency. This bond is meant to safeguard the obligee, or the individual or organization that requires the bond.
If a mortgage originator fails to abide by the rules of his or her profession, or a loan is not closed per the terms of the agreed-upon contract, a claim can be made against the surety bond that is in place. Subsequently, this requires the surety agency to investigate the legitimacy of the claim. If the claim is valid, the surety agency may pay to help offset the financial loss or personal damage incurred by the client. This works differently than insurance, since the payment does not go to the business holding the surety bond, but directly to the client.
The surety agency may then require the principal to repay the bond. When this occurs, it can have a negative impact on the financial health or reputation of a mortgage company. Defaulting on a contract often leads to a surety-bond claim and, subsequently, bond-claim payments, but the reason for a default varies greatly from one business to the next. Let’s take a closer look at the different forms of business default that mortgage professionals may face, and how default is handled as it relates to a surety bond.
Business-default scenarios
Mortgage companies can experience failure for any number of reasons. There are, however, three issues that are more common than others — economic slowdowns, cash-flow constraints or a lack of performance.
During periods of broad economic turmoil, such as the housing-market crisis of a decade ago, mortgage companies may be unable to keep up with expenses. When this takes place, clients may not get what they bargained for and businesses may ultimately have to shut down.
Similarly, if cash flow is an issue for a business — due to nonpaying clients, or mismanaged debts or expenses — default may be on the horizon. Clients may get left behind, leading to surety-bond claims. Unfortunately, a successful bond claim increases the costs of a new bond in the future, as well as any required repayments to the surety agency. An ongoing cycle of bond claims can lead to additional financial issues for a mortgage company.
A failure to perform, due to overextension or unrealistic guarantees for services provided, can cause a mortgage company to default simply because it could not live up to the promises made to a client. This also often results in a costly surety-bond claim.
Claim-process management
Part of the reason surety bonds are required for mortgage professionals is to help offset the risk of default based on bad business practices or other issues that leave clients unhappy. When default takes place, surety agencies step in to manage the claim process and may help a company from closing. This begins with an investigation of the bond claim to ensure it is credible. If it is, the following solutions may be offered to help complete the claim process.
A surety agency might implement a takeover by stepping in to complete the work promised by the mortgage company. This could involve using another licensed mortgage professional to finish the deal. A tender takes place when the surety agency decides to work with the client or clients who filed a claim, in order to find the right solution to the issue. If a remedy cannot be found, a claim for financial losses may be paid by the surety agency to the client.
A surety agency may opt to offer direct assistance to the bondholder — such as providing additional staff or financial help to complete the work as promised. A final solution may be obligee completion: If no other solutions work to resolve an issue with a client, the surety agency will suggest that they move on to a new mortgage company to complete the services they were promised. Often, this results in a claim against the bond, which the bondholder must repay over time.
Business default in any shape or form can lead to serious consequences for the bondholder. Most notably, the added expense of repaying a bond claim can lead to financial circumstances that are difficult to manage. When bond claims are successful, the cost of a new bond in the future is likely to be higher. Additionally, the reputation of the mortgage professional and their company may be damaged, making it harder to attract new clients down the line. For these reasons, surety agencies work closely with bondholders to reduce the impact of bond claims whenever possible.
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For mortgage originators who are new to the business, it helps to have the necessary training and education to do the job, and this includes education about business-security tools like surety bonds. Originators can avoid bond claims altogether by only taking on the work they know they can perform successfully.
