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Automated underwriting systems helped the GSEs gain efficiency and save money, but it also created risks. Image: Fotolia
Automated underwriting systems helped the GSEs gain efficiency and save money, but it also created risks. Image: Fotolia

Need for Speed Played Big Role in Mortgage Crisis

AUG 28, 2012 12:42pm ET
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The mortgage industry is undergoing unprecedented transformation as a result of heightened regulation along most parts of the business, owing in large measure to a self-inflicted wound sustained during the housing boom.

Signs of how far the industry strayed from prudent underwriting include the Consumer Financial Protection Bureau's efforts to set the standard for underwriting quality through its qualified mortgage rules; the recent notice of proposed rulemaking on appraisal requirements for riskier mortgages; and the aggressive putback campaign waged by Fannie Mae and Freddie Mac.

The roots of the crisis stretch back to 1996 with the introduction of Freddie's Loan Prospector automated underwriting system followed shortly by Fannie Mae's Desktop Underwriter. (Disclosure: I worked for Freddie Mac during this period and Fannie Mae a little earlier). This new technology in the hands of both government-sponsored enterprises ushered in a remarkable evolution of the traditional mortgage business, which up to that point had relied on humans to underwrite the borrower, verify her income and assets and fully appraise the property.

Innovation in the form of statistical modeling enabled the GSEs to construct an algorithm that could distill the 3 C's of underwriting (creditworthiness, collateral, and capacity) into a single score reflecting the borrower's probability of default, allowing an originator to communicate an almost instant loan decision to the applicant. Such tools were designed in part to control credit risk upfront and also to provide significant efficiency in the mortgage process. As more AUS scores passed the GSE-designated threshold of acceptable quality, fewer loans had to be reviewed by the more time-consuming human underwriting process.

It may seem surprising now, but a major consumer issue back then was the time and effort it took a borrower to secure a mortgage. Paperwork requirements were onerous and costly in addition to the delay in processing all of this information. The game was now afoot.

AUS technology could effectively order risk along a continuum and had advantages in the area of fair lending by providing an objective and consistent means of evaluating borrowers. Over time, as the industry became increasingly comfortable with the results of these tools, companies kept tinkering with the acceptable risk profile. More loans were deemed acceptable and to no surprise that also meant more loans that could be processed more quickly. Even the Federal Housing Administration got in the AUS business and continues to extensively use this technology today.

Remember that in a highly commoditized business as the conventional conforming mortgage market was, there was little product differentiation. Thus originators increasingly looked to compete on service.

Next came appraisals, where the ability to apply statistical modeling to property valuation led to automated valuation models. The combination of AUS and AVMs eventually led to a tiered application of appraisal alternatives. Full appraisals were reserved for the riskier-scoring loans while higher-quality AUS loans could receive streamlined appraisals of various types.

With credit and collateral streamlining addressed, the last bastion of the underwriting process, capacity to repay the obligation, came under scrutiny. With sufficient credit and collateral (referred to as "compensating factors"), a borrower could enjoy further streamlined processing by undergoing a more limited assessment of their income, assets and employment status. These programs started off innocently enough, with low documentation requirements reserved for refinancings where the lender had previous experience with the borrower's payment pattern.

Over time, the application of these new underwriting techniques had two effects on the market that presaged its demise. First, and most importantly, it allowed the industry to distance itself from the basic blocking and tackling of mortgage underwriting. Processes and controls that had worked for decades relying on humans gave way to statistical models that are only as good as the last several years of data on which they are built.

Second, the new technology allowed a blurring of market segments that traditionally had been largely walled off from one another. Prime, alternative-A, and subprime loans could be scored along the risk continuum, and if they passed the risk threshold, were deemed acceptable.

Many court cases today hinge in part on the definition of "subprime." With an AUS tool, the characteristics of the loan are evaluated comprehensively. In theory, this gives a better representation of the borrower's risk profile than a simple bright line such as "a FICO score less than 620." But it makes categorization difficult.

At the outset, the vision of AUS and related technologies held great promise for the industry to control risk while reducing the pain of the mortgage experience for the borrower. Increasing competition and a service-oriented model over time completely distorted this vision.

The industry's lack of discipline, unfortunately, has ushered in an environment where simple rules decide who obtains credit and who does not. Innovation in mortgage markets is a victim of the industry's poor self-restraint. Borrowers will feel the loss for years to come.

Comments (4)
Having lived and worked thru the period describe by the author I can understand his "pain". Not only has the industry suffered in the last 5 years but more importantly the mortgage customer. It was not the failure of AUS and AVM applications but the lack of good judgment in the use of the tools. So an industry that galloped toward greed has fallen off the cliff into the free fall of fear. The return of good judgment and the proper use of technology can help revive the industry and provide mortgage customers with the options they need to turn this economy around.
Posted by | Thursday, August 30 2012 at 1:48PM ET
Nice article but I find it a little hard to blame the mortgage industry alone when in reality lenders were reacting to the constant(governmental) pressure to cast a wider net to include more borrowers. Companies that were demonized for lax guidelines were previously lauded for those same lenient guidelines. Also it is simplistic to say that the crises was caused by the greed of mortgage industry alone. There is blood on the hands of the borrowers as well. Are not borrowers that took on obligations that they could not afford as least as complicit as the lender? (As an aside, it is my opinion that mortgage brokers are probably the least at fault in all of this. Who can blame them for selling the products that were available)
Posted by | Thursday, August 30 2012 at 2:19PM ET
I agree with Rob, we shouldn't shun the technology innovation, specifically AUS platforms. They may have helped push us over the edge faster, the guidelines supporting the engines were to blame. I am a big advocate towards AUS platforms, as we have integrated a new version of an AUS for the current loss mitigation industry we face today. If it was the AUS platforms that propelled us off the edge, maybe we we should be using the same style platform but in reverse! Lenders and servicers are already using AUS platforms in house to decision loans for detailed loan modification work outs or short sale, but these systems are NOT available to outside 3rd parties working to help homeowners get out of their underwater/distressed mortgage situation. Those interested to learn more can see it in action here: theloanpost .com
Posted by | Thursday, August 30 2012 at 2:20PM ET
Good article Mr. Rossi! I would observe however, that the strategic insertion of technology and models to create speed and efficiency, when applied appropriately and with the proper controls is a good thing. The evaporation of prudent judgment across the loan creation continuum was a bigger factor I think. Also, regarding one of the comments you've received, having been on both sides, primary and secondary, of the industry for the past 27 years, and having lived and breathed the industry cycles and outcomes, I always find it troubling to read/hear comments stating that "government pressure to cast a wider net to include more borrowers" caused this crises. The numbers disprove such statements. In fact, pure CRA and Affordable Housing loans, as determined by MSA or ratio to median income, are primarily fully documented, have and continue to perform well (see the reports from the regulators on-line) . The private label subprime loans, NINAs and SISAs, produced and environment for fraudulent behavior NOT the AH population or the "wider net". Layer on mortgage products that were created to be curative for borrowers who had prior credit impairment, i.e. 2/28, 7/23 etc., were taken out of that intend purpose/niche and sold to the general public because folks thought they could "price for the risk" and the borrowers who actually knew what they were getting, thought they could turn the property over before the huge balloon payments came due at the end of the very short fixed period. These weren't primarily AH borrowers. The median income test had to be met to meet the govt imposed AH / Fair lending targets. Where's the income documentation on a NINA or SISA 2/28 or 7/23? Add to this the creative features to provide "personal customization"...can anyone say "pick-a pay" or "not". Not to mention the one fun option that created negative amortization by allowing the borrower the "option" of paying interest only when they wanted, but watch out, had a neg-am cap of 115%, at which point the borrower had to cough up the excess upb, refi the excess to a new mortgage, or face loan acceleration i.e. foreclosure, if they weren't able to refi....I could illustratively go on & on. Niche products should stay in their niche and not be mass-produced. At a high point of reported dlqs, 2009-2010, while the GSE portfolios had about 62% of the MDO, they contributed between 14 - 21% of of the SD population (90+). While the PLS, holding about 26% of the MDO, contributed about 43% to the SD population for the same periods. Unbalanced a bit? (GSEs used to publish this publicly available data in pie chart format). The application of prudent judgement & the layering of unacceptable risks on both the origination and capital markets sides evaporated and the house of cards collapsed. But let's not fool ourselves, and our readers, by blaming it on pressure to "cast a wider net to include more borrowers".
Posted by ingrid b | Thursday, August 30 2012 at 9:54PM ET
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