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Subprime Woes Drive Up Demand for Due Diligence

The mortgage industry today is experiencing something of a dichotomy. For some, it's the best of times; for others, it's the worst.

Just ask subprime mortgage lenders and they'll tell you about the worst of times. But for prime and diversified mortgage servicers, things are looking up, according to a senior executive with Fidelity National Information Services' mortgage servicing division.

Jeff Mouhalis, executive vice president for product delivery and chief information for the mortgage division at FIS, said that with early payment defaults and buyback requests posting such a problem for nonprime lenders, demand for third-party due diligence to ensure that loans meet investors' requirements has increased.

That's a big change from the peak of the subprime lending boom, when originators had to put up with little interference from the investors who ultimately purchased loans. Now, investors and wholesalers are policing their purchases more carefully.

"The amount of due diligence that originators of loans are willing to tolerate now far exceeds anything I've ever known," Mr. Mouhalis said.

That means lenders face more intensive document reviews. Some companies run automated valuation models to double-check on collateral values, and order a full-blown appraisal if a property doesn't appear to be valued correctly. And loan buyers are starting to call borrowers, even asking questions to make sure they understand their loan product. Investors have sometimes found that borrowers with an adjustable-rate mortgage claim not to know that their monthly payments will adjust, Mr. Mouhalis said.

He said the greater emphasis on third-party due diligence is an "astonishing swing in the pendulum." But it reflects the concern about buybacks and early payment defaults that has swept through the market.

In recent months, the market has significantly discounted the value of subprime loans, creating headaches for firms that originate them and putting many companies out of business. Investors are factoring higher servicing costs and higher credit costs into their assumptions about loan performance, he said.

But the depressed prices may mean that today's market ends up being the best of times for firms that have the capital and capacity to buy up distressed subprime assets, he said.

In an age of early payment defaults, it's not just the originator who faces more due diligence scrutiny. Investors are also beefing up post-foreclosure reviews to make sure that servicers comply with servicing requirements. Those reviews are designed also to make sure that the servicer finds out if errors were made at the point of loan origination, Mr. Mouhalis noted.

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