In Newtonian physics, the third law of motion states that for every action there is an equal and opposite reaction. In politics, the response to a disaster is often a flood of new regulations that, in an attempt to prevent said disaster from reoccurring, is an over-reaction that may or may not solve the original problem but certainly creates unanticipated new problems.
The Dodd-Frank Wall Street Reform and Consumer Protection Act is only the most recent example of congressional physics. After the near-collapse of the financial markets, legislators determined that the systemic risk posed by large institutions needed to be tamed. In its 2,300 pages of dense and often confusing legalese, Dodd-Frank, among other things, rewrote the supervision of financial institutions, increased capital requirements, changed the regulation of over-the-counter trading in derivatives and credit swaps, mandated changes in corporate governance, executive and loan officer compensation and credit rating agency practices. Perhaps most significantly, Dodd-Frank created the Consumer Financial Protection Bureau and granted it sweeping and unprecedented regulatory powers.
I like to think of Dodd-Frank as the “Lawyers’ Full Employment Act” because in the two years since it was enacted, and in the one year since the CFPB became operational, a flood of new—and sometimes conflicting—regulations has spewed forth at an alarming rate. While it is difficult to keep up with all the changes, a couple of things are clear:
1. Compliance—which used to be only about high cost/predatory loans, fees and disclosures—now includes standards governing the types of loans that can be safely made as well as the down-in-the-weeds details on how to manufacture them, and
2. Data integrity is the key to compliance.
While many of the details are still being worked out, “safe” loans will include “Qualified Residential Mortgages”—plain-vanilla 30-year fixed rate loans that are exempt from the 5% risk retention rule for mortgage securitizations—and “Qualified Mortgages,” which will provide lenders with some protection in the event of default if, and only if, they follow the QM rule’s detailed instructions concerning how to confirm, during the pre-funding process, that the borrower can afford to repay the loan.
To comply with these new rules lenders must, among other things, be sure that the borrower’s income, employment and assets are accurately depicted on the application and sufficient to repay the loan, that the appraised value of the collateral property is accurate, and that loan-to-value, debt-to-income and total-debt-to-income ratios conform to the rules’ (as yet to be finalized) standards.
Sixteen years in the fraud prevention space has taught me how ridiculously easy it is for someone with mal intent to fabricate loan documentation that presents a false, but apparently perfect, picture of a borrower and the value of the property securing the loan. There is no reason to believe that fraudsters will change their ways and since it is logical to expect these “safe” loans are likely to be less expensive for the consumer, we can be sure that these loans will be targeted by the ethically and morally challenged. This is because we haven’t engineered dishonesty out of the human genome, and because there are still a multitude of websites that, for a small fee, will provide a consumer with fake ID, employment, income and asset documentation, “credit boosting” through authorized user accounts and piggybacked trade lines, and everything else one needs to successfully apply for a loan.
In order to fight back, and to achieve compliance, lenders will need to leverage automated technology that efficiently checks the veracity of what has been represented on the application by comparing it to independent data sources, and that includes borrowers’ and participants’ past behavior. Without such tools, it will be impossible to ensure that the DTI, LTV and TDTI ratios are correct, and it will be impossible to achieve compliance. The best-of-breed fraud detection systems already in use in many shops can do all this, but lenders will need to perform these checks on all loans, not just a sampling.
Failure to fully employ automated technology in combination with the skills of experienced mortgage professionals will surely result in an equal and opposite reaction that none of us is anxious to see. We’ve all had enough good intentions to pave the road to a very warm place.