Almost three years have passed since the mortgage meltdown and we continue to witness the fallout daily. Lawsuits are emerging against banks and their executives for, among other things, failure to institute effective risk management procedures, failure to implement sound quality control programs and failure to practice good judgment. These are serious allegations that could end up with very serious consequences including, but not limited to, hefty tabs and/or closure, substantial civil and criminal penalties, and treble compensatory and punitive damages.
How these suits will play out is yet to be seen, and it could be several more years before the dust finally settles. However, in the interim, the question we should be asking is, “Are these lawsuits paving the way to banks establishing better practices?” The answer is they should.
In FDIC v. Killinger, filed in May 2011, the FDIC (in its capacity as receiver of Washington Mutual Bank) alleges that WaMu failed because its executives “breached their duties of care and…act[ed] with reckless disregard” by maintaining weak underwriting practices and failing to implement adequate fraud prevention controls. In support of this allegation, the complaint cites a Feb. 14, 2006 memorandum from the chief enterprise risk officer reporting that “[a] major concern” of the internal WaMu Fraud Steering Committee “is the inadequacy of WaMu’s fraud tools compared to the industry.”
Sen. Carl Levin’s May 2011 report, “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse,” presents an elaborate portrayal of the factors that contributed to the economic crisis. Sen. Levin’s report contains a wealth of information and clues as to how a bank can improve its practices, one of which concerns quality incentives—or lack thereof. Subcommittee interviews of WaMu employees revealed that everyone, including quality assurance controllers, received a bonus based on the number of loans they reviewed, and that there was substantial pressure to produce quantity over quality.
Forensic investigations by the industry and regulators into defaulted loans originated during the boom lead to the conclusion that mortgages that go into default within the first six payments of the mortgage origination are generally reliable indicators of mortgage fraud because they reveal that the borrower, whom the lender has certified as creditworthy, could not fulfill immediate, much less long-term financial obligations.
This recognition led FHA to change its requirements regarding third-party originators in March 2011. In addition to routine quality control reviews, sponsoring lenders must now review all early payment defaults originated by their TPOs. EPDs are defined as loans that become 60 or more days past due within the first six payments. Lenders must now also review EPDs within 45 days from the end of the month in which the loans are reported as 60 days past due.
It is pretty safe to say that there is a strong case for banks to, at a minimum, strengthen their quality control and anti-fraud programs, re-align financial incentives to encourage production of quality loans, and pay closer attention to EPDs in order to create a credible environment from which to fund loans. Seemingly, there is nowhere to go but up, and the path is straightforward. However, given where the industry has been, it is clear there is much work to be done.
We are already seeing signs of change but the revamping of antiquated tech systems, the integration of smart data and the creation of robust quality control, quality assurance and compliance environments is only half the battle. The battle will not be won unless banks use that information as feedback for additional process improvements, and educate, empower and encourage those on their front lines to practice good judgment and make sound decisions that will truly restore confidence in the industry. There is no magic solution, but if lenders leverage technology and partner with experienced specialists to establish better practices to scrutinize loans in an effort to ensure quality, the entire mortgage industry will be better for it.
Celine Adams is the vice president of business development at Interthinx.
