By Ryan Schuette
Digital Risk wants to change the way mortgage risk due diligence works—for the better. Is there enough consensus for it to work?
Task forces are popular these days. Last fall the Troubled Asset Relief Program and Consumer Financial Protection Bureau (CFPB) stood up a task force to prevent mortgage fraud. The federal government carries on with the Financial Fraud Enforcement Task Force, the primogenitor of several other task forces, including the much-hyped Residential Mortgage-Backed Securities Task Force. And now there is the due diligence task force or so Digital Risk LLC would have it.
Appearing at a Mortgage Bankers Association (MBA) conference in May, the risk analytics company called for the creation of an all-inclusive task force to develop a uniform set of standards for mortgage risk due diligence.
Their premise: The real estate boom-and-bust—and all that fed into the Great Recession—unwound so much of the trust investors placed in residential mortgage-backed securities. Chain links came apart up and down a chain-link fence of high-risk originations, casting doubt on the roles of ratings agencies, small-time mortgage brokers, and investors alike.
Their solution: Bring everyone—including ratings agencies, issuers, investors, underwriters, even competitor companies—back to the table to find a solution.
“While there is market pressure to loosen lending standards, without a true understanding of risk elements, the certainty lenders require cannot be achieved and mortgage capital will remain limited,” Peter Kassabov, CEO with Digital Risk, said in a statement announcing the task force.
He described the force as one that “would not only restore confidence in underwriting procedures,” but also “help the mortgage lending industry feel more confident that it has actionable, reliable data to make quality lending decisions.”
But the solution sidesteps an issue at the center of a storm over due diligence practices—namely ratings agencies. In 2011, the Financial Crisis Inquiry Commission released a report that described the agencies including Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s—as “key enablers of the financial meltdown.”
And that’s where a problem may lie for the task force. Ratings agencies dismiss transparency problems today, citing important reforms to their controversial issuer-pays model. Ed Sweeney, a spokesman for S&P, credited the agency with “many changes” in a past interview, including “significant enhancements to the criteria” deployed to qualify residential mortgage-backed securities.
“Overall, the changes make it more difficult for these securities to receive high ratings,” he told us.
Can the task force succeed in recruiting willing players to set new due diligence standards? Or—with the likes of agencies interested in reform for laws like the Real Estate Settlement Procedures Act (RESPA)—will the heavy hand of federal regulation step in to police the industry?
‘Not a Panacea’
Is a task force on due diligence needed? It’s hard to say, and everyone seems to have an opinion about what’s needed to prevent the next mortgage crisis and still preserve today’s homeownership market.
There’s not even a real consensus about how the crisis started. Four years forward, the mortgage industry, policymakers, and government officials veer left and right over the source of the problems. Peter J. Wallison, co-director of financial policy studies at the conservative-leaning American Enterprise Institute, chalked up the crisis in a white paper in 2011 to government-sponsored homeownership initiatives at Fannie Mae and Freddie Mac to keep credit requirements low for borrowers.
He took issue with a narrative parleyed by the commission, which nodded in the direction of systemically important financial institutions and ratings agencies. The commission laid claim to the notion that “these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding.”
The claims center around a familiar narrative. The ratings agencies inflated ratings for junk mortgage-backed securities, rating many of these at AAA and duping investors, who funneled their cash into the mortgage finance system and pulled out when values plummeted for these securities.
Rick Sharga, EVP of Carrington Mortgage Holdings, says that “the ratings agencies proved to be horribly inefficient and often incorrect, and in many cases appeared to be issuing ratings on many products that they didn’t understand.”
He tallies up “disastrous results” to a lack of skin in the game for these agencies, which fell under intense public scrutiny afterward for allegations of sell-to-the-best-client business models.
Apart from a string of lawsuits, owing in no small measure to the Securities and Exchange Commission (SEC), reforms largely steamed forward under the Federal Reserve, which proposed amendments to Regulation Z under RESPA last year. The rule modification aimed to implement an ability-to-repay model required under the Dodd-Frank Act.
For its part, the private sector stepped up to address wide-spread deficiencies outside the ratings agencies, in the mortgage brokerage and origination communities. Companies like Lender Processing Services proffered technology solutions built on risk management and forensic analysis to mitigate instances of fraud and, more specifically, a failure to check one’s own homework on mortgage loans.
Sharga differs when it comes to technology for mortgage risk due diligence. “While technology presents the opportunity to solve problems, it’s not a panacea,” he tells us. “So throwing technology into the mix if it’s not well developed tends to make the mess more efficient.”
‘Search For Consensus’
Listening to Alex Santos, president of Digital Risk, the entire effort is to build consensus from within for a future without unnecessary risk—or at least the kind that blew up the housing bubble.
“In the past [investors] relied on ratings, but in the future, while there may be reliance on ratings, they’re also going to do a strong consensus that investors will do a lot of homework themselves,” he says. “And that homework involves crunching data. And the task force is to bring everyone together to make standards around how we’re going to check that data.”
He positions such a task force as a feasible alternative to government-imposed regulations, citing the 1933 Securities Act as a law that hanged the name of the game for mortgage risk due diligence.
“In the old days, you could hire your neighbor to do due diligence on these loans,” he says. “And your neighbors might not know anything about mortgages, except that they have one. Congress’ solution was to force the diligence companies to be named as experts in the prospectus.” He says that set up accounting firms and other market players for enormous liability in instances of “material misstatements or lies.”
Fraud certainly remains a staple of the government’s efforts to clean up the mortgage industry. According to recent statements, the Residential Mortgage-Backed Securities Working Group continues to bulk up on personnel and funds to collar alleged crooks from the crisis—not excluding mortgage lenders and accounting firms that bore the blame for faulty numbers.
Santos likens his hopes for the task force to the facilitation of an independent private-sector organization like the Financial Accounting Standards Board, which has the go-ahead from Uncle Sam to name the rules of the game without necessarily functioning like a federal rule making agency. No single such body currently exists for mortgage risk due diligence.
Just how will the task force work, once it assembles? Santos says that the committee will build an initial agenda that sets out how members will vote on due diligence standards and when committee members exit. Digital Risk plans to unveil results at the MBA conference next year.
Although he demurs from naming names when it comes to companies and entities that accepted invitations, the chief executive admits that Digital Risk recently called on representatives from the SEC and CFPB to participate on the panel.
“We haven’t had the right person yet and it’s hard to navigate those organizations,” he adds.
Forced Tasks?
And if the industry agrees to new due diligence standards on paper? Whither the future of mortgage risk due diligence if the marketplace doesn’t self-regulate? The alternative may well lay with the leviathan so many lobbyists, trade groups, and political committees fear: the federal government.
Market players don’t need to wait for the Fed to wrap up RESPA reform; other government agencies already appear to be on the move in other areas of the industry. Experts say the CFPB is poised to deliver the first draft of what may look like national servicing standards this summer, with goals to make rules of the draft standards by January next year. Joseph A. Smith Jr., the court-approved monitor of the landmark $25 billion servicer settlement, told us in a recent interview that the industry should subscribe to a national game plan. (See our exclusive interview with Smith in “Take 5″ this issue.)
That alternative may be more palpable if the task force fails to gain traction with consensus, Sharga says.
“If you asked 30 CEOs to define what that meant, you’d get 30 different answers,” he tells us. “If you go all the way up the ladder—from appraisers to underwriters to originators to the people who write securities and run retirement trusts to invest in the securities-there is absolutely a lack of transparency. … People aren’t sure what they can believe.”
He goes back to a lack of faith in everyone, maybe especially the investor. “Every investment portfolio is different, and not everyone has faith that what is being presented is accurate,” he says.
Asked how Digital Risk plans to benchmark for results, Santos says that the goal is to create “a set of standards that are conceptual so they can be flexible and applied [to] … shrink diligence times … so this obstacle holding back the market can be removed.”
He gives the ratings agencies some leeway. “Let’s assume that ratings agencies models are correct,” he tells us. Solid results from the task force “would help their models and help the agencies because, assuming [it] comes to the conclusion that diligence needs to be robust, then the ratings agencies’ positions become stronger since their rating information is more accurate and reliable.”
Uncle Sam may rate the task force differently—and force tasks onto the industry if the absence of change hints at a repeat of sins from the crisis.
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