This piece originally appeared in the March 2022 edition of DS News magazine, online now.
Nelson Mandela once said, “Everyone can rise above their circumstances and achieve success if they are dedicated and passionate about what they do.” Who can argue with someone who went from spending 28 years in prison to becoming president of South Africa? And yet, mortgage industry leaders would be wise to heed such advice in 2022, as the potential for risk lurks in all directions.
With a historic refinance wave fading in the rear-view mirror, lenders are now focusing on selling purchase loans, including non-QM products, which require stronger underwriting. Servicers still need to help hundreds of thousands of homeowners who haven’t fully recovered financially from the pandemic and require loss mitigation options. And everyone is under the increasing glare of federal regulators as Washington sharpens its focus on the housing industry.
In other words, 2022 may go down as one of the most complex and risk-intensive housing markets in history. There will be plenty of winners, of course, assuming they can avoid the many obstacles in their path. But that won’t be easy.
Risk Is Everywhere
By far the biggest source of risk facing the market is the ending of the extended refi party and the increasing focus on purchase loans, which are inherently costlier to manufacture.
While rising rates will reduce the number of refi opportunities, the Mortgage Bankers Association in December predicted lenders would originate a record $1.61 trillion in purchase loans in 2022. Purchase originations will obviously require higher scrutiny, but the types of loans lenders are increasingly gravitating toward will require even more.
Spiking home prices and cash investors have pushed housing affordability out of the reach of many first-time buyers. In fact, according to Fannie Mae’s most recent Home Purchase Sentiment Index, only one in four people believe it’s a good time to buy a home. As a result, more lenders will be looking toward non-QM and jumbo products to drive growth. They’ll be aided by Wall Street trading firms and banks who are eager to expand investments in the housing market through bank statement loans and other products. However, non-QM products also make underwriting and due diligence reviews more complex and expensive.
Servicers, of course, have their own unique set of challenges. Regulatory enforcement on servicing activity is widely expected to grow this year as forbearance plans expire and more borrowers enter permanent loss mitigation plans or wind up in default. In fact, Fitch Ratings warned investors in January that foreclosures could rise this year as forbearance options draw to a close and rising interest rates restrict refinancing opportunities for troubled homeowners.
Because so many borrowers have been refinancing, servicers as a whole haven’t been very diligent with quality control over the past couple of years. To be fair, the CFPB gave servicers a bit of a break so they could help homeowners with forbearance plans. However, during President Biden’s first year in office, we’ve seen the CFPB take greater effort to scrutinize servicing practices, which is fueling the need for servicing QC (quality control)—especially given timeline and communication requirements associated with foreclosures. The problem with the CFPB is that they regulate by enforcement, not by publishing new rules.
Loan boarding is another high-risk area, especially in an increasingly active market for MSR trades. Servicers will need to pay greater attention to detail while onboarding loans, as they will risk legal action or bad publicity for failing to provide borrowers with accurate information. Each MSR trade carries an impact for homeowners, and inadvertently sending mortgage statements to the wrong address could result in a late payment ending up on a customer’s credit report.
In other words, there is more than enough risk for everybody. But there are ways mortgage organizations can avoid trouble.
Choosing Preventative Medicine
There should be little doubt at this point that quality control and risk management must take center stage this year. Fortunately, most lenders are aware and servicers are handling quality and compliance issues fairly well. But without a more thorough strategy, even the most conscientious organization may see minor issues blossom into major headaches.
For lenders, this means post-closing QC alone is no longer sufficient, nor is performing only the minimal reporting that regulatory agencies require. In order to reduce compliance and repurchase risk—especially as riskier products enter the market—originators will need to learn to manufacture quality from the very beginning of the origination process, as well as focus on in-line QC, pre-funding QC, and targeted discretionary reviews.
It bears keeping in mind that most loan manufacturing errors are the result of staff juggling too many tasks at one time, which is likely to happen a lot in the coming year.
We call these “errors of convenience,” and while they traditionally accounted for only about 20% of loan defects, they now make up approximately 85% because originators have been overwhelmed with volume.
For servicers, there will be a growing need for strategies that improve borrower retention rates and shift consumers to digital channels for more cost-effective operations and a better borrower experience. A sound risk management plan might include investing in technology or a partner that is equipped with AI and machine learning tools, which can be used for multiple purposes when servicing loans.
These technologies are increasingly being leveraged to streamline the loan boarding process and improve document classification, indexing, and auditing when ingesting portfolios. As a result, servicers are able to reduce the amount of manual tasks associated with MSR trades and allow their staff to focus more attention on quality assurance and compliant borrower communications.
Speaking of which, AI and machine learning technologies are also being used to improve the borrower experience by providing servicing agents greater insight into customers who call for help. They also enable agents to more easily identify opportunities to transition borrowers who need assistance to digital channels based on their specific needs and communication preferences. And for both lenders and servicers, these tools are even being applied to post-closing platforms to create client-specific checklists that more lenders and servicers are using to lower repurchase risk and improve loan file integrity.
All this being said, AI and machine learning generally carry their own unique set of risks. Increasingly, federal regulators are looking at these tools as having the potential to unintentionally create discrimination in lending and servicing operations. Which is why organizations need more than the tools to manage risk—they need to make risk management part of their culture.
Preventing Risk Is Cultural
The clients we work with that do the best job at managing risk are those that create a full-circle ecosystem of risk management. They create a plan, follow it, have everybody review each other’s work, and then adjust the plan based on what was found. We call this concept part of building a “culture of correction,” and it’s based on the concept of constant improvement.
To be honest, however, most companies don’t spend enough time or thought on risk, and fewer spend much time preparing for it. Problems are bound to happen, of course, but you don’t see companies putting line items in their budget for them. On the other hand, it’s not that bad of an idea. In fact, we find it useful to put a dollar amount to your risk, which does two things—it focuses your attention on what the risks to your business actually are, and it gives you the opportunity to implement a plan for reducing risk and measuring results.
Either way you look at it, there are costs involved with errors, repurchases, and enforcement, and costs involved with managing risk and compliance. Most companies have figured out what level of risks and costs they’re able to live with. However, wise organizations don’t look at the costs of managing risk as an expense, but rather as investments.
For this reason, more lenders and servicers are choosing to outsource their risk management needs for several reasons. For one, buying risk management expertise is typically more cost-effective than recruiting or developing it in house. Secondly, it allows organizations to put a dollar figure on their risk management costs, so they’re easier to measure.
Usually, they’ll find that the cost is significantly lower than the costs associated with buybacks, fines, and reputational losses.
Either way you slice it, the industry has already shifted into a new gear this year. The lenders and servicers who come out ahead by 2023 will almost certainly be those that have built a risk management ecosystem that looks at compliance as an investment and likely involves third-party expertise and AI and machine learning technologies to keep that investment as low as possible. The bottom line is that risk is rising, and the only way to not let it drag your organization down is to rise above it.