Major Trends in Quality Control

by Hakki Etem & Marta McCall

1. Cost control pressures.  Many mortgage lenders, particularly those that are subsidiaries of banks, are under severe cost-cutting pressure now.  (Because the losses at the bank are more than offsetting the profitability of the mortgage business.)  This may be manifested by lay-offs and/or reorganizations that consolidate multiple review teams (QC, Compliance, Underwriting, Post-closing) into one or two review teams with broader responsibilities.  Certainly we have seen both, either put in effect or being seriously considered currently.
2. Volume growth and product expansion.  To compete, many small to mid-sized lenders have had to rapidly diversify.  This can mean the expansion of operations into new geographic areas (new states – regulatory implications, accuracy and training),  the development of new origination/funding sources (Wholesale, Net Branching, Correspondent or Concurrent funding hybrids) and/or the expansion of a product menu (sub-prime, government, no- or lo-docs and HELOCS in addition to traditional conforming conventional).  Without proper controls these can be very high risk.
3. Quality improvement initiatives.  A number of lenders have bought into the GE concept of quality improvement, often accompanied by a high-level consultancy promoting Six Sigma initiatives.  QC managers (or their bosses) are being required to demonstrate unprecedented statistical sophistication — at least their reports must reflect that.  For lenders who have not embraced Six Sigma or other quality improvement concepts, they can get QA focused on the types of things that can actually undermine process or quality improvement. Many lenders focus on identifying, communicating and fixing each defect regardless of pattern or severity.  Failure to address systemic issues can be costly (too busy fixing or responding to minor issues to analyze the cause and fix it); the big issues can get buried in the details or volume and ultimately production loses focus on the really important items.  Another area where efforts can be wasted is in post-funding fraud detection and resolution. Unless this is performed in conjunction with a pre-funding detection review or tools, it creates tremendous exposure.
4. Tying Compensation to Quality.  A very common situation now, perhaps a part of a quality improvement initiative, is a new QC reporting requirement:  quality metrics of the loans originated by commissioned loan originators.  The goal is to adjust volume-driven compensation to reward high-quality (and punish low quality).  This requires more sophisticated reporting.
5. Technological Innovation.  A number of origination processes have been automated, or supplemented by new technological tools, in recent years.  Slowly these are impacting more and more loans and lenders.  They include:
   1. Automated Underwriting Systems (replacing entirely, for many loan originations, the role of the traditional (breathing) loan underwriter).  This has had significant impacts.  For example, many loans are approved without human review, essentially because the borrower has a high credit score and/or the loan’s risk characteristics are ordinary (small dollar amount, low loan-to-value ratio, etc.).  But this means that the quality of the data input into the AU system (beginning with the borrower’s name and SS#) now becomes paramount.  A second impact involves loans that are not approved by an AU system, because these applications are not really turned down, but rather “referred” to a human underwriter, who can approve the loan.  The lender’s remaining underwriters (and they now need fewer) accordingly work routinely with the more complex and risky loans:  if they make an error, the potential for loss is greater and the recourse is more limited in manual underwriting.  Many of the people involved in AU decisions were recently processors, lacking depth of underwriting experience or lacking familiarity or training with the various AU systems.
   2. Automated Appraisals.   Not as ubiquitous as AU systems, and less heavily relied on (because of data limitations and inaccuracies), online appraisals of property are growing — they are cheaper than traditional appraisals and well-suited to the refinance market.  But a flawed property valuation is highly-correlated with loss magnitude for those loans that go into default.  Deciding how best to use automated appraisals, and when to invest in a traditional appraisal, is a new required skill, for both underwriters and QC auditors.
   3. Fraud Databases.   Loan losses due to outright “fraud for profit” are significant and, importantly, very high profile.  To a QC manager, they are also a sexy target lurking in the production.  The growth of AU systems and other technologies has spawned a new fraud opportunity — identity theft — but there remains the more familiar ones:  corrupt appraisers, brokers, loan officers and title companies. Many lenders, certainly all of the larger ones, have dedicated QC resources — fraud investigators — that focus only on this risk and employ national databases and scoring algorithms to flag loans with elevated risk characteristics. Volume pressure, especially in bad times, makes fraud more prevalent.  At the same time, peaking value markets make fraud an increased risk.  As loans default, more losses will be pushed back to the lenders from investors due to misrepresented qualifying information or relaxed underwriting standards (reflecting the heavy refinance share of total volume).All of these technological innovations, but especially the fraud prevention aspects, shift the QC emphasis from the back-end (traditional post-closing QC:   reviewing loans that have already closed in a thorough manner and with some leisure) to the front-end (pre-funding QC:  reviews done before a loan closes, while they are in a position to impose new loan requirements or simply deny a loan application).  Monitoring a loan pipeline presents more significant software demands and puts a premium on review speed and communicating new loan conditions quickly.
6. Reliable Quality Control Findings.  One of the most difficult tasks in the QC process is developing consistency and accuracy among several auditors. (Controlling for non-sampling error.)  If the reviews are not consistent they do not provide reliable inferential results.  If the reviews are not accurate not only is the reliability in question but so is the integrity of the entire QC process.   Additionally, the current business environment makes it difficult to find and hire experienced personnel.  If QC has to train auditors, there can be a significant impact on productivity due to the extended training cycles.  Many lenders implement an “audit the auditor” program to facilitate feedback and on-going evaluation of consistency and accuracy.
7. A Boom in Outsourcing.  Replacing full-time employees with contract workers is a growing trend in the mortgage industry.  For example, most loans today are originated wholesale, using independent loan brokers, rather than retail.  (The days of walking into your local bank branch and sitting down at the loan officer’s desk are largely over.)  This presents unique quality challenges, because a lender may have relationships with thousands of brokers, 80% of which submit 0 to 3 loans per month, creating a monitoring nightmare.  It also changes the feedback dynamic:  the QC manager cannot really contribute to improving process quality within the brokerage company;  the real option is basically whether to cut off the broker or not.Within a lending organization, entire department functions may be outsourced in whole or part.  Independent brokers, for example, can be granted “designated underwriting” authority, meaning they not only originate the loan but also approve it, too.  (Other brokers would still need to submit the application to the lender’s underwriters for their approval.)  Appraisals are generally performed by independent contractors, and the lender may or may not have the skilled resources for reviewing these appraisals.  There has also been a growing trend in the use of MI contract underwriters, while the MI companies provide reps and warrants (may be significantly limited) with these underwriters, many of the underwriters are inexperienced (limited labor pool), succumb to production pressures (no longer in the more protected MI environment), can be transitory and very expensive. Finally, the QC function itself can be outsourced — to contract auditors or contract firms.  The risk with this approach is that QC is reduced to a pure cost function with little or no contribution, because the contractors cannot be as familiar with the lender’s origination process and probably are unsophisticated in sampling strategies (they prefer large random samples) and reporting (which tend to be focused on individual findings and ignore trend analysis).  Often the lender selects a QC outsourcing firm because they have bid the lowest $ cost per loan review — a situation that can easily lead to poor or inconsistent review quality.
8. Increasing Regulatory Compliance Requirements.  The governments’ (federal, state, local) rules and penalties governing loan origination and servicing continues to grow.  Although this has been the case since the 1960s, one major new trend in loan originations has placed more lenders at compliance risk than ever before:  the charge of predatory lending in a lender’s “sub-prime” originations.  These are loans made to borrowers with less than perfect credit — sometimes dismal credit — at very high prices.  Before, these borrowers could not get financing anywhere — now they can, if they are willing to pay the price.  Since many are minorities, the charge of predatory lending has collided with charges of racism, and the result has been punitive regulations, steep fines for stepping out of line, and class action lawsuits.  All large lenders now originate subprime loans, and many smaller lenders originate only subprime loans, so compliance is a major new issue for the industry.
9. Hire Cautiously.  The mortgage industry has enjoyed unprecedented prosperity in recent years, because of extraordinary loan volumes and equally extraordinary home price appreciation and easy credit.  A lot of critical quality errors have been irrelevant because the value of the collateral keeps rising — putting a floor on loan losses– and there is no shortage of lenders willing to take out an unhappy lender with a new loan of their own.  But these two fortuitous circumstances will end, probably sooner than later, and the wise lender will start strengthening quality control now, with pre-funding QC, post-funding QC, and also in the area of servicing QC.  It will be the people who service loans in the eventual crunch who will need to manage today’s (hidden) poor quality loans, not to mention the good loans that go south because mom and dad have lost their job in a weak economy.  Significantly, the monitoring of the quality of the many loan servicing functions is probably the weakest of all mortgage QC operations — many lenders don’t do it all.