This piece originally appeared in the May 2023 edition of MortgagePoint magazine, online now [1].
Current market sentiment is that repurchase risk is increasing because Fannie Mae and Freddie Mac, for various reasons, are taking a closer look at loan underwriting. This is why mortgage industry participants are concerned about whether their tech is robust enough to reduce buybacks.
However, the issue is more nuanced than this shift in the market, and I will explain why. Repurchase risk is the result of the lack of documented precision when home loans are manufactured. The key to success that independent mortgage banks are searching for is about having a scalable platform that will handle high- and low-volume scenarios with the same effectiveness and efficiency.
A recent 2023 RMBS (residential mortgage-backed securities) outlook from Kroll Bond Ratings Agency shows issuance for this year to be down across the board. “Expectations for FY 2023 are at $61 billion overall (down 40% YoY), with non-prime at approximately $30 billion (down 30% YoY), prime at $14 billion (down 57% YoY), and CRT (credit risk transfer) $18 billion (down 25% YoY),” the analysts write.
In the conforming markets, total originations are forecasted to be $1.8 trillion vs. $2.225 trillion in 2022. Volumes are down but there are a large number of loans being made.
With market volumes so low, from purchase mortgages up to RMBS, independent mortgage banks (IMB) are facing more than repurchase risk, they are facing the following trifecta of risk:
- Increasing market complexity (higher costs + low volume = less profit)
- Investor expectation for greater precision (zero buybacks)
- Macroeconomic volatility that is reflected in the 10-year and its wide movements daily (mortgage rate unpredictability)
My take: without a systems solution, there is no dependable way to manage the strategic challenges of the mortgage business at scale. The fear is not the fear of the GSEs or the scrutiny of correspondent, or the 100% review rates of non-QM investors. It is a fear of the increasing expectations of consistent quality, the demand for uniformity, and the intolerance for error that leaves loans unsalable to non-GSE investors (jumbo, aggregators, non-QM) but subject to repurchase at a later date by GSE investors. Achieving near-zero defects is the key to making this contingent liability dynamic manageable.
We are at an inflection point. The inflection point occurs when there is a greater impetus for the originator to produce with great precision than there is for the investor in the loans originated. The originator can no longer make money producing at the current cost, and one of the leading indicators of high levels of imprecision in production environments is high cost. Concerns about salability that manifest in longer dwell times or longer cycle times indicate ambiguity in the requirements necessary to close the loan.
Increasing market complexity rears its head in the guidelines for manufactured housing loans, the use of down payment assistance varying by investor, and the variance in the way non-QM programs calculate free cash flow, for example. I chose managing underwriting guidelines to acknowledge the need for independent mortgage bankers to have the greatest opportunity to originate nearly any borrower circumstance presented.
Absent an underwriting platform that will manage the guidelines into underwritten loans as the method for reducing defect or error while increasing throughput, the IMB at scale will not harness enough of the efficiencies to become a differentiated competitor.
Managing underwriting guidelines through systems is one of the key ways to manage the volume of loan programs and volume of loans effectively while reducing cost and ensuring quality—the trifecta.
Consideration 2: Increasing investor expectations of greater precision. In effect, no investor besides the GSEs with their rep/warranty recourse construct will accept anything less than 100% compliance with their criteria.
Fannie Mae and Freddie Mac allow for interpretation of their guidelines and affirm the compliance with post-closing reviews of 10% of each month’s volume, where many non-GSE investors in jumbo, correspondent, and non-QM assets require 100% review and compliance prior to sale. The path to higher gain on sale is a function of withstanding higher scrutiny. Whether surviving repurchase reviews in the future or assuring an ability to sell at origination, surviving 100% review is the most reliable path to predictable revenue recognition and margins.
Consideration 3: Macroeconomic volatility—what can I do about rates? We are in a period where the rate of change on very low interest rates is a step change. A 50 basis points (bps) increase on a base rate of 5% is a 10% change in the cost of a loan, and we are digesting those regularly. The scale of increase of rates and the frequency of the rate increases are the sources of unpredictability that roil secondary market execution.
The best hedge is not a fancy Treasury trade where the actual Treasury security is experiencing the same volatility as the securities you are attempting to hedge. Instead, the originator’s best hedge is collapsing the time to originate as the best way to minimize the exposure to rate volatility. It is possible to close loans in 15 days or less now and to sell the loans within 48-72 hours of closing. My advice is to operationalize the macro risk by closing faster and controlling the length of your exposure to the volatility in execution.
The reality is that repurchase risk is growing as the loans are becoming more complex. Loans are also getting more difficult to obtain, and it is becoming harder to get people approved or to calculate the most liberal qualifying income possible without breaking any guidelines. More attributes must be managed more precisely to originate a loan cost-effectively and sell that loan at the forecast price. An example would be what sources of income and what assets are eligible to qualify a borrower for—a loan eligible for sale to the GSEs, a loan eligible for FHA insurance, or a non-QM loan where cashflow may be the basis of a judgment about income or reserves. The inability to document the care and diligence employed by the lender during origination would make a big difference—just one more reason for embracing systems.
Complexity Is Increasing, but Human Tools Are Not Keeping Up
Resolving the problem of eligibility for sale and the best fit for a borrower is a uniquely human task. Humans have the unique ability to engage the borrower to solve for solutions, when supported by tools that organize, present, and validate the data necessary. The challenge is that humans need better systems to support performing this valuable service uniformly, accurately, and inexpensively. The key to managing complexity is organizing humans to perform high-value tasks like pathfinding, organized around systems that support data capture, data validation, and decision-making.
Humans are incredibly flexible and able to perform creative tasks in ways even chatbots can only talk about. When humans are asked to repeatedly perform highly precise tasks or to consistently interpret highly variable data correctly, they do not perform as well as machines.
Leverage the skills of humans to solve creative tasks that drive effectiveness. Organizing your operations in a fashion where the division of labor suits the task is critical. Use the machines to perform what must be precise and consistent to assure uniform interpretation of unique situations. The machines must be better at more complex but repeatable tasks to allow humans to contribute more to achieving a desirable outcome for the borrower and the owners of the originator.
Mitigating Risk
There is a range of responses to having to mitigate risk daily. Most lenders try to spend a tremendous amount of time and investment on processes and workflow tools. Originators can buy tools, organize a process, or invest in trying to train their people, but the real driver here is how to integrate automated tools into what is still a manual process. In manual workplaces—which most workplaces still are today—people are required to have cognition and to make judgments to trigger other processes. There are not a lot of processes that are driven by either automation or some objective measure that is 100% accurate all the time.
This means requiring a human to play a role where their effectiveness will decline throughout the engagement. This is the heart of the repurchase challenge. Successful repurchase defense requires comprehensive documentation and evidence. The problem is that lenders cannot document their workers’ judgments. There are no notes that travel with the file or logic chains that represent the diligence in selecting a method to underwrite income. The lender is resigned to defending a decision without the benefit of the work performed, other than the result.
Repurchases are driven by this inability to organize and document judgments systematically made by humans to rebut a claim of insufficiency or inaccuracy. Many would say loan reviews have subjective elements.
Comprehensive capture, organization and presentation of the data, calculations, and judgments leave less room for something other than a preponderance of the evidence to carry the day. If there is documentation or evidence of due diligence supporting the loan, it is very difficult to arrive at a resolution that requires the ultimate response—a repurchase. It is a difficult dynamic when lenders do not feel that they can manage all of those elements at the speed necessary to cover their costs and make a profit in a difficult market.
Repurchase risk is not driven by review rates but by an inability to document or provide evidence of the thought life and choices made during the loan-making process on every loan.
The Real Challenge of the Mortgage Business: Volatility
The challenge I see over time has been managing volatility. We often do not acknowledge the extent of the influence of market volatility, which cannot be easily quantified. An example would be that everybody knew that a significant interest rate move would affect the market. What is not understood is that the Federal Reserve is also threatening to stop its purchases of mortgage-backed securities, which is having an add-on effect. This creates a tremendous amount of volatility around the 10-year price, which is our pricing benchmark.
Volatility is not related to credit in the mortgage assets or to concerns about the housing markets. There may be some concern about the economic markets in a macro sense, but the challenge is that volatility is being purely expressed financially around the risk of interest rates going up or falling further and the activity around that.
The current expression of volatility is financial. Practices that were profitable in markets with large volumes no longer make sense. Simply reducing headcount to reduce cost is a scalability trap that will not perform when even slightly larger volumes return. Managing operational, financial, and market volatility requires a business strategy and mindset that is designed to virtually eliminate repurchase risk while reducing cost, increasing speed, and delighting the borrowers. Strategists call this a “blue ocean” strategy. A blue ocean strategy is when a company that typically competes on a few attributes like price and service expands the competitive framework to compete on every aspect of the business (cost, speed, risk, product, price, quality, etc.). In doing so, the more robust competitor finds market segments within the narrow definitions of price and service where the more comprehensive competitor can deliver value in more dimensions.
The blue ocean competitor who selects a wild goal like zero repurchases or zero defects has, in effect, chosen a strategy that indicates the ability to compete in every dimension of the business model. Let me explain: curing defects will also expose methods to use machines and people more effectively and efficiently in the pursuit of higher quality.
Higher quality usually results in reviewing and rectifying old assumptions and practices in favor of evidence-based methods focused on measurable and objective outcomes. The winnowing of the practices that no longer contribute to zero defects, and the promotion of the practices that do, is the lever that will alter the competitive profile of the company in multiple dimensions.
This is not creativity but hard work—the hard work of challenging all that you believe in. Why challenge all of the accumulated experience and learning of the entire industry?
Quite simply because those practices no longer create a profitable outcome. Unprofitable businesses in low-margin industries that struggle to differentiate themselves are best positioned to think differently—there is little to lose and huge benefits to gain.