FI’s Tim Lee Published in American Banker
By Tim Lee, FI Consulting
All Federal Mortgage Lenders Should Follow New GSE Quality Controls
In the bad old days of the American auto industry, instead of identifying and addressing problem vehicles as they were assembled, brand-new cars would keep rolling to the end of the line, defective or not. Production quotas were king, quality be damned.
A car was only inspected after assembly. If it had any flaws – or, rather, if existing flaws were found, which anyone old enough to have ridden in a Chevette may recall was not always the case – the car would be set aside for repairs before being fobbed off onto unsuspecting drivers.
For many years, quality control for loans funded by the government-sponsored entities worked much the same way. Seller-servicers transferred their loans straight to Fannie Mae or Freddie Mac under agreements that incorporated a number of representations and warranties. These typically included assertions that the loan package was materially true and complete, that it conformed to underwriting requirements and applicable laws, and that the loan was serviced according to accepted practices, among other things.
But the seller-servicers, of course, had their own production quotas, all too often, quality be damned. And, until recently, the GSEs only verified mortgage loans’ reps-and-warrants compliance by sampling a small proportion well after purchase, the mortgage finance version of post-assembly line repair.
Disgruntled Chevette owners might have predicted the result: rising reps-and- warrants breaches as the housing boom sent ever more loans hurtling down the assembly line without diligent quality checks. Even in the post-crisis rework, the GSEs missed opportunities to recover fully on the loans they had bought, making sampling methodology errors that sometimes missed billions in likely reps-and- warrants breaches.
Happily, the American auto industry has returned to health, helped in large part by quantum strides in quality control. By incorporating ideas like the Kaizen philosophy and Six Sigma manufacturing methodologies that emphasized quality at their heart, the Big Three have transformed themselves into carmakers that can compete and thrive around the globe.
Now, with their revised reps-and-warrants policies, the GSEs have recently begun their own quality control transformation. As reported in American Banker, the two mortgage giants have launched programs to identify flawed loans within weeks, rather than let them languish on the balance sheet for years or go unexamined altogether. Voicing the expectation for defect-free mortgage production, a Fannie Mae spokesman declared, “It’s a whole new world from a loan quality perspective.”
The GSEs set the standard for the mortgage market, but even with the post-crisis shriveling of private-label mortgage funding, they aren’t the only major players. Public-sector mortgage funders, including the Federal Housing Administration, the U.S. Department of Veterans Affairs and the U. S. Department of Agriculture, still comprise a substantial portion of the market. For example, according to the Census Bureau, these agencies financed at least 30% of all new home sales in 2012. Moreover, they deploy taxpayer dollars for this purpose.
As the GSEs step up scrutiny of mortgage loans in the new data-intensive, quality-emphatic business environment and drive down repurchase costs, they will reshape reps-and-warrants standards for the entire market. This represents an enormous opportunity for other federal agencies that fund home loans to protect taxpayers’ funds against undue risks by likewise upgrading their infrastructure and procedures.
Keeping step with the GSEs is an imperative. To do otherwise only increases the risk that lenders may route their weakest mortgages to the government. If that happens, the federal programs providing a major portion of mortgage lending chance being harmed by their defective purchases.
After years of struggle and their own near-death experience, America’s automakers accepted that the Chevettes and Pintos of earlier days were no longer good enough. Industry standards had been reshaped by Hondas and Volkswagens. As the GSEs raise quality standards in the home mortgage industry, their federal government counterparts can also set a consistent tone for the market and protect taxpayer resources by raising their own requirements to match.