Return on Quality

Ocwen Financial Corporation, which does residential and commercial loan servicing, special servicing and asset management, is reporting significantly better results in its HAMP modifications than the rest of the industry.  And they attribute it to superior technology. 

In congressional testimony, Ocwen’s President Ronald Faris claimed:

• that Ocwen is converting trial modifications to permanent modifications at a rate that is 10 to 20 times greater than industry average;
• a 3-month re-default rate of less than 5% for Ocwen, versus 18.7% to 33.7% for the industry; and
• a total of 100,000 successful modifications since the beginning of the mortgage crisis.

These impressive numbers could use a little clarification.  So could the statement that Ocwen has spent “$100 million in R&D to build loans servicing technology that incorporates behavioral science for effective customer communication and is also scalable for high volumes.”  But Ocwen is an industry leader and when they report these kinds of results, it’s worth listening.

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Likewise, their recommendations for improving the HAMP program carry weight.  Among those:

• Lower the borrower debt-to-income (DTI) ratio for modifications to below 31%; in other words, allow for lower monthly payments on modifications  
• Allow for principal reductions on modified loans  
• Make additional funding available for housing counseling groups
• Require underperforming servicers in HAMP to outsource to servicers that perform 

Also worthy of note: Mr. Faris is one of the few industry voices who believes that HAMP is a “well designed response to the mortgage crisis”.  Maybe he’s on to something.

Mortgage servicers have no choice but to open their kimonos to Freddie Mac’s MHA Compliance (MHA-C) division.  So when MHA-C offers to share its insights, as they did at the Mortgage Bankers Association’s National Servicing Conference last week in San Diego, there’s a rapt audience of servicers, most of whom are struggling to comply with HAMP programs.

Servicing Management magazine was there to capture the main points.  The presenters were quick to acknowledge the difficulty of setting up and complying with the program.  However, citing Sarbanes-Oxley as an appropriate benchmark for packaging HAMP modifications, the panel suggested that a lot of the loan packages they see seemed devoid of any due diligence or quality control. 

So how do you deal with a constantly changing program that is known to be difficult to comply with but that has high documentation standards?

“The biggest takeaway I’d have for a servicer is to really understand the program, which is why I recommend having somebody in the organization who is the ‘internal expert,” says Vic O’Laughlen, vice president of servicer oversight for the division.  This becomes more important as the programs morph and spin off programs are introduced (like Home Affordable Foreclosure Alternatives (HAFA).) 

As we all know, MHA is a work in progress.  The question is, will it ultimately be a successful work?

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For a clear, concise perspective on which parts of HAMP are and aren’t working, and why, take a look at this interview in HousingWire with Gagan Sharma, president and CEO of BSI Financial, “an outsourcing provider specializing in mortgage subservicing, default management, loss mitigation, due diligence, REO and quality control services to over 240 lenders and investors.” 

Among the insights:

• Loan modifications will only work for a subset of distressed borrowers, as the Treasury Department admits.  Of the 7 million or so eligible, only 1.5 million are real candidates and with fewer than 800,000 trials in place, it’s doubtful that we will see 1.5 million permanent modifications.
• Even modified loans are in danger of re-default, for two main reasons: 1) many if not most HAMP borrowers are underwater and 2) unemployment will remain high for some time.
• The willingness to reduce principal may be the single biggest determinant of modification success. But owners of mortgages have different incentives in that regard.   Banks must recognize the loss immediately, which is not appealing.  Investors who bought loans at 40-to-50 cents on the dollar may be more willing.
• Short sales and deeds-in-lieu of foreclosure are good alternatives to HAMP (and non-HAMP) modifications.  Generally faster to process, these alternatives give borrowers an incentive to maintain the property and leave mortgage owners with better collateral.

If we’re going to solve the problems that HAMP was designed to solve - stabilizing the housing market and keeping borrowers in their homes - we need to look at the incentives built into the program.  The reality is that for most servicers, HAMP is not a money-making proposition.  It costs them more to set up and maintain a HAMP infrastructure (people, systems, processes) than the payback they can expect from the program.  There must be a better way.

It’s no secret that the mortgage servicing sector is under severe strain, especially when it comes to loss mitigation and default management.  In response to massive distressed borrower volumes, servicers have hired armies of new, inexperienced servicing reps and asked them to manage loan modifications for a wide variety of complex borrower situations.  This is happening even as fundamental regulatory change is being introduced (e.g., RESPA) and loan modification programs are shifting beneath servicers’ feet.  

Meanwhile, the Treasury Department and the courts are pushing for faster loan modifications while investors who have interests in such loans are balking at the kinds of concessions necessary to make the needle move.  Thus, servicers find themselves between a rock and a hard place as they face the flood of modification requests.

Because this deluge happened suddenly and is still roiling the industry, there has not been time to automate many of the standard tasks involved in the loan modification process.  Indeed, compared to the origination side of the business, servicing automation - or workflow management - is relatively undeveloped .  This is certainly true in mortgage quality control, which is why Cogent can tout that ServicingQC is the only quality control system developed specifically for mortgage servicing. 

But as a recent piece in MortgageOrb confirms, it’s the case in default management workflow systems, too, and no doubt in other servicing sub-processes.

On the positive side, mortgage servicing is finally getting some attention.  With luck, we will see promising technology solutions at the MBA Servicing Conference, which is gathering this week in San Diego.  And given the pressure from inside and outside the industry, we should start to see some adoption of new solutions.

Currently, the biggest enemies of efficient workflow are paper and the telephone, as the MortgageOrb article reiterates.  Both are inefficient, hard to track and prone to error and both are legacies of the traditional workflow of mortgage lending and servicing.  Now that the light of day is shining on the servicing world, we can hope that new technology adoption will lead the way to the Promised Land of eMortgages.

It’s good news that in some quarters, quality control is beginning to matter. But here’s the Economist to remind us that the job of risk manager “is said to have the risk profile of a short option position with unlimited downside and limited upside — something every good risk manager should avoid.”

Small wonder that talent is staying away in droves.  In sales-driven cultures - like mortgage banking - it’s frowned on to discourage transactions, without which money can’t be made.  The bias is to get the deal done.  So risk managers are always swimming against the current. 

However, risk is currently the busiest area for financial recruiters, which means there is a lot of activity.  Chief risk officers are being appointed, risk committees and departments are being formed, and new regulations are announced with frequency. 

But business practices adapt to new structures and find their way around them. (Like fraud, in some ways.)  Once the spotlight is off regulation and compliance, experience suggests that a new innovation will make it seem like “it’s different this time”.  And the Cassandras in risk management will be ignored anew.

So how does a risk manager survive the next bull market?  Hope that new incentives will be put in place to encourage the right behavior.  And show the ROI of risk management - or in the case of mortgage quality control professionals, show the return on quality (ROQ).  In future posts, we’ll try to help formulate that ROQ.

Apparently, in early 2007 - at the peak of the real estate bubble - the Mortgage Bankers Association (MBA) came to the “inescapable conclusion that owning [their]own building was the smartest long-term investment for the association.”  So with $75 million in financing, they purchased a new headquarters building.  Then on February 5, 2010, they announced that they had sold it for a little over $41 million.  Oops.

This is the sort of fiasco that the mortgage industry can dine out on for years.  But it’s just the latest irony that we’ve witnessed recently.  Remember the advocates of unbridled capitalism on Wall St. asking for government assistance so that they could continue to do ”God’s work“?  Then paying out billions in bonuses with taxpayer money?  Irony verging on outrage.

But more ironic to mortgage quality professionals, and likely to have a larger impact, is another major story these days: the recall of millions of cars by Toyota due to quality issues. 

Toyota?  Poor quality?  How could the company that virtually invented the quality revolution in manufacturing over the past 50 years be in this position? 

As one article points out, it was a combination of things: the goal to be Number One in the world driving rapid expansion; increasingly complex products with multiple potential points of risk/failure; uninterrupted success leading to arrogance; a culture that discouraged bad news; and managerial sclerosis. (One might almost be talking about Wall Street).

It might seem like the compeuppance of a world leader in the quality movement would negate the value of a quality culture.  Yet this story may unfold to include other car manufacturers, too.  Everyone is trying to sell as many complex ‘world cars’ as they can, and each car shares components with other cars in manufacturers’ product lines. Will Toyota’s brand be the only one tarnished?  Probably not.  But Toyota will recover, while others may not.  And Toyota at least will re-learn a basic lesson: don’t rest on your laurels. 

Granted, most of the housing and mortgage industry news out there is deflating, perhaps even deflationary.  For example, see the recent announcement by Zillow that as many as one in five markets may be in store for a ‘double-dip’ in housing prices.  This just adds to the gloomy news about foreclosure volumes, unemployment and an anemic economic recovery.

Yet there are bright spots.  As Exhibit A, we cite the remarkable results that Mortgagebot achieved in the 2009 calendar year.  As reported in HousingWire:

“Wisconsin-based Mortgagebot, which develops Web-based software as a service (SAAS) for mortgage lenders, said it added 200 new clients in 2009, bringing its total client base to nearly 950 organizations. With the new clients came a 25% increase in revenue in 2009 compared to 2008; further boosted by a 25% increase in overall contract value for new sales.”

The movement to “eMortgages” (totally digital, paperless origination of loans) is a long term trend that will need to overcome many obstacles.  But the pieces are being built out today.  Mortgagebot provides a solution that automates and streamlines the online mortgage application process.  Other technology innovators are developing solutions for other aspects of the mortgage origination process.  In time, as the technologies are proven to be reliable, secure and compliant with regulations, we will have an end-to-end eMortgage process.

In the meantime, as mortgage technology companies offer solutions that perform cumbersome tasks more efficiently and reliably, lenders who wish to reduce costs and stay competitive will adopt those solutions.  And that will provide the impetus that mortgage technologists need to grow and thrive, in spite of the general pace of economic recovery. 

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Until the subprime crisis, the quality control department had always been something of a Rodney Dangerfield in the world of mortgage lending.  No respect.  After all, who wanted to see cold water thrown on a red-hot origination market?  Not the production department, surely.  In fact, many lenders didn’t think twice about setting the Production foxes to guard the Quality Control hens.

Things have changed, though.  As Jan Wetzel of Wetzel Trott sums it up in her recent interview in MortgageOrb:

“It used to be that lenders just did the quality control to fulfill the agency requirements so they could have the results available in case of an audit. Now, they are actually reading the reports at a senior management level and taking corrective actions in their procedures.”

Part of the reason, of course, is that the agencies are paying more attention, following up on audits, and demanding resolution of infractions.  But there is also an awakening in the upper management of lenders that perhaps the quality control process, including fraud detection, could be more than just a hindrance to maximizing profit.  Could it be that mortgage quality control could actually serve to enhance profitability?

As it happens, this is the very value proposition that Cogent has been offering for almost two decades.  We hope this sea change is permanent.

Statistics is baffling enough without being footloose with terminology.  So let’s clear up what we mean by a statistical sample.

The term “Statistical Sample” has a very specific meaning in the Cogent system.  It refers to a sample that is randomly selected from the entire population of loans eligible for a particular sample type (aka “audit shell”).  The suggested sample size is calculated every period by the system and is designed to yield a 95% confidence and 2% precision over 12 months.  This is the standard originally established by FNMA, FHLMC, and HUD for lenders who qualify to substitute ’statistical sampling’ for the traditional 10% random sample.

The generic term ’statistical sample’ is not very meaningful, in and of itself.  It simply refers to a sample in which some statistical principle has been employed, without defining which principle.  For example, it could refer merely to a randomly drawn sample, without specifying what population is being drawn from or how much precision will be achieved across what period.

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Rick Astley reference 

To illustrate: most Cogent ProductionQC clients have at minimum a “Production” sample type, for which all loans originated in a particular period (typically a month) are eligible.  When a Statistical Sample (in the Cogent definition) is randomly drawn from this population, all loans have the same probability of being selected.  No distinction is made between loan type, loan source or any other loan characteristic.  It is intended  to establish a baseline of overall loan quality across the organization.

In order to achieve a 95% confidence and 2% precision for a particular category of loan, it is necessary to go beyond the “Statistical Sample”.  For example, in the Cogent system, to achieve this standard for all FHA loans originated, define a Targeted Query (Loan Type = FHA) and run the query.  The resulting screen displays all qualifying loans, including qualifying loans  that were randomly drawn previously in the “Statistical Sample” or any other samples in this period.  These count towards the total required.  Use the embedded Cogent Statistical Calculator to calculate the required (”suggested”) sample size for the period.  From the suggested sample size, subtract the number of qualifying loans that have previously been sampled and enter the result in the Sample Size box. The Cogent system will then randomly select the entered number of loans from the qualifying loans.

The Cogent “Stratified Sample” is in effect a pre-defined Targeted Sample.  Most typically, the Cogent system stratifies originations by Source or Channel and automatically tracks and calculates the sample size required for each stratum (Source or Channel), net of qualifying loans randomly drawn in the “Statistical Sample.”  Over 12 months, the Stratified Sample achieves 95% confidence and 2% precision for each stratum.  In Targeted Samples, this automated operation is performed by the user, using Cogent’s embedded tools.

Thus, in order to leverage the Cogent system’s sampling optimization, clients should begin sampling from the broadest category (all loans eligible) to the most narrow category (e.g., individual underwriters).  In this way, all loans selected in previous broad categories are counted towards ever narrower categories, minimizing the number of loans to be sampled and audited.

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Berkery Noyes, “the only middle-market investment bank with research and M&A transaction teams dedicated to the mortgage technology, regulatory and compliance market,” has just published its 2009 Recap and 2010 Predictions For the Mortgage Technology Market. 

Providing a view from 30,000 feet, the report lists a number of high-profile M&A transactions from 2009 and offers up a few trends in the mortgage technology space, including:

• accelerating vendor movement towards becoming a complete end-to-end solution provider
• more stringent lending guidelines and regulations increasing the need for compliance, fraud prevention and risk-mitigating technology solutions
• burden of ensuring proper compliance moves to the point of sale rather than merely at closing, and falls on all mortgage industry participants

In the context of these trends, the report states that market participants no longer see compliance and auditing solutions as “nice to have” - they have become “must have” solutions.

We couldn’t agree more.