A Multi-Billion Dollar Quality Problem Still Prevalent
The popular belief may be that manufacturing risk is no longer a concern with the current mortgage manufacturing process, which is assumed to generate substantially less manufacturing risk. Is the industry really seeing a reduction in risk?
While the level of credit risk may have declined, as well as the risk of default, with the tightening of credit standards and down payment requirements, manufacturing risk has not experienced the same level of risk reduction. Manufacturing risk occurs when the data surrounding the loan (e.g. appraised value, loan amount, income, assets, etc.) lose their information value becoming corrupt and unreliable. All who handle a loan infected with manufacturing risk are experiencing elevated, but unknown levels of risk.
We have discovered that the levels of manufacturing risk are far higher than most believe. Let’s examine the case of property valuation (aka – appraisal).
We have conducted multiple studies across numerous clients involving over 200,000 loans originated between 2011 and 2014, with a dominant emphasis on the 2012 – 2013 time periods. . This population was dominated by high FICO (750+), low LTV (< 75) loans; at least that is what the client’s data suggested. (LTV stands for Loan to Value Ratio – it is calculated by taking the loan amount and dividing by the property’s appraised value.) Using data, analytics and expertise available within Digital Risk, we were able to get a more accurate understanding of “true” property value and the “true” LTV.
The results were alarming.
Exhibit 1: Analysis of Weighted Average Loan To Value (WALTV)
As shown in Exhibit 1, Analysis of Weighted Average Loan To Value the WALTV there is a substantial difference in WALTV between the Client Reported LTV and the Digital Risk Adjusted LTV, based upon an analysis of the 200,000+ loan sample. The Client Reported LTV of 68 is 9 points lower than the Digital Risk Adjusted LTV (77). This means that for every $200,000 property in the sample, there is $18,000 less equity than the loan data represent. And, given default, there is an additional $18,000 of unexpected losses.
We discovered that a substantial portion of loans being originated today have an LTV that is highly under-stated. The proportion of loans with LTV 75 or less is often 10 – 15 percentage points less than the lender believed. For example, let’s take a look at a typical portfolio of newly originated loans, which ostensibly has an excellent LTV profile, with 65% of the loans having an LTV of less than 75. However, in reality, fewer than 50% of the loans had an LTV of 75 or less, making the portfolio far riskier than presented.
Further, as we discovered, the portion of negative equity loans being generated is not hovering around 0% as the typical lender believes; the actual negative equity rate is in excess of 10% and in some cases it approaches 20%. (We controlled for HARP loans, analyzing only Non-HARP).
Finally, across these client portfolios the valuation error rate is very high. A valuation error occurs when the appraised value is 20+% higher than the “true” value. In our research, clients had drastically underestimated the valuation error rate. Although clients consistently thought their rate was less than 2% - and some thought their rate was as low as 0.3%; the actual rates ranged from a low of 12% to in excess of 20%.
Clearly, those who are concerned about valuation error and appraisal quality have good reason. This is not a trivial, nor an infrequent problem; it is an ever-present and very expensive problem. When appraised values are overstated, the resulting LTV is spuriously low. As a result, all parties lose: the lender, the investor, the issuer and the borrower.
For example, let’s assume that the borrower is purchasing a property appraised at $200,000; but there is valuation error (manufacturing risk) and the property’s true market value is only $150,000. Assuming the borrower makes a 20% down payment, the borrower must present $40,000 at closing and shoulder a $160,000 mortgage; a mortgage that is already more than the true value of the property. Further, the lender presents this as an 80 LTV loan, supposedly a low risk loan and the investor buys it under this premise.
All parties have an elevated and unknown level of risk:
The true LTV is 106 (not 80), putting the lender at risk; the lender is at risk of putback from the secondary market forcing him/her to buy the loan back.
If the loan containing collateral such as this were securitized there are additional issues. One, if the security comes with a government guarantee, the tax payer has additional, unintended exposure. Further, whether the security is government backed or private label, the issuer has reputation risk, once it becomes known that it will issue and securitize low quality loans. Moreover, the issuer is still liable for rep and warrant violations, even if it did not know of the quality issues before securitization. There are also pricing issues, with issuers over-pricing infected loans.
The investor is at far more risk than presented; the investor has purchased a loan that is over-valued and highly likely to underperform; should the loan default (which is now more likely), the investor will lose far more than expected.
The borrower has issues too: the necessary down payment would have been $30,000 (not $40,000) and the mortgage required to purchase this property at its “true” value would have been $120,000 (not $160,000), assuming an 80 LTV. Going forward the borrower has to support expenses that are far greater than they should have been, if the property’s true value had been known at closing.
Sadly, there is another very serious borrower issue: the borrower in the above would have lost his entire down payment and would soon be in a state of negative equity, increasing the likelihood of default and also generating another consumer who is disgruntled with the mortgage industry. These consumers (borrowers) now have a voice with the Consumer Financial Protection Bureau (CFPB); multi-million dollar fines are not unusual for violations such as these; nor are personal as well as corporate liability. Proceed with caution.