Digital Risk In The News

Sleuthing for Problems in Credit, Compliance and Collateral Value

November 27, 2007
National Mortgage News
Jeffrey Taylor

Forensic underwriting only begins the process by identifying shortcomings. When we tell clients what process changes are needed, it then enables them to be proactive with improvements to the front-end of the process. Forensic reviews of loan portfolios producing answers to what went wrong with many loans.

From abrasions to the zygomatic arch, investigators on the hit television show “CSI: Crime Scene Investigations” regularly sort out, in reverse, details of who did what to whom – and perhaps why – as they sleuth through each CBS episode.

Using experience and technology, show characters Gil Grissom and Marg Helgenberger (along with others) explore a crime scene, attempting to uncover what is typically invisible to the unpracticed eye. They piece together clues not only to determine what has happened but also to help identify perpetrators - ostensibly to prevent a recurrence.

There are similarities in what we’re doing today in the mortgage business, where past underwriting transgressions have significantly slowed liquidity and lending, especially outside the most pristine, prime circles.

Just as forensics – from the Latin “forens,” meaning part of a public forum – plays a key role in unraveling critical details of an incident, it can also tell us a great deal about how a loan or pool performed – or fell short.

Forensic reviews of existing loan portfolios at large banks and in secondary market shops are producing answers to what went wrong with many loans, securitization pools and valuations in the past year – all of which led to corporate failures, securities downgrades, billions of dollars in losses and the specter of far-reaching litigation.

While the surface aim is to assign responsibility, smarter firms realize – like real crime fighters – that the best analysis is the one that prevents the transgression from happening again. Call it preventive maintenance; this is the approach the mortgage market must take to recover and avoid the vast troubles it is currently experiencing.

I say “must” because companies like United Bank of Switzerland and its investors cannot simply shrug off the $623 million loss sustained by UBS in the third quarter of this year. That trouble is traced by the company to deterioration in the subprime market, which produced negative revenues of $3.6 billion in their fixed-income division (partly comprised of mortgage trading). UBS has been a major warehouse provider to non-depository subprime firms.

Others share a similar plight, populating a docket of bad news stories filling industry trade reports all year.

For example, the latest default rate statistics on subprime mortgage loans show another increase of nearly 150 basis points (August), to a record high of 16.1%. The foreclosure rate jumped 82 bps to 6.8%, a reflection of declining house prices affecting credit performance. The default rate on alternative-A loans jumped 62 bps to 3.96% in August and the foreclosure rate rose 41 bps to 1.96%.

These negative numbers come as little surprise to us. Time-after-time, in re-underwriting loans, our version of “CSI,” let’s call it “Collateral and Securitization Investigations,” uncovers serious discrepancies, like data tapes that don’t match files (loans).

It’s not unusual to see inaccuracies running as high as 50% in these reviews of credit, compliance and collateral value. Often up to 80% of the loans in a pool were not actually checked by anyone, eluding inspection because they were not part of the sample test. That is plain, sloppy underwriting, which in retrospect, is mind-boggling.

Forensic underwriting only begins the process by identifying shortcomings. When we tell clients what process changes are needed, it then enables them to be proactive with improvements to the front-end of the process and assure investors that the same mistakes won’t be repeated.

Then, asset monitoring services provide continuous surveillance of loan pools in securitizations to ensure that expected performance continues.

Of course, there is no one, single cure. Once a business model stops working, it usually means there has been a chain of deficiencies throughout the system, in this case from origination to servicing to securitization. Borrowers who hoped to get something for nothing, brokers who felt no fiduciary responsibility, lenders eager to get loan files off their balance sheets, ratings agencies believing what they were told and, yes, investors willing to bankroll the whole party – all must re-evaluate their prior shortcomings.

In the big picture we see that problems in one sector like mortgages can resonate throughout the entire financial services world.

The American Enterprise Institute recently noted in a formal response to a U.S. Treasury Department invitation to comment on changes to the regulatory structure for financial services, that: “Turmoil in the credit markets worldwide demonstrates that there is only one worldwide financial services market, one in which the collective actions of the smallest mortgage originators can affect the financial prospects of the largest financial institutions.

Needless to say the housing finance sector cannot conduct “business-as-usual” anymore. The old saying about being twice burned applies and the new metric is reputation. Loan aggregators face a hard sell if they fail to provide necessary transparency that demonstrates solid safeguards of promised performance.

Of course, there are still those few who do not want to accept the truth that changes have to be made. Perhaps its denial or maybe just a belief that they can “wait out” the current storm, in hopes that things will go back to the way they were before. But looking around the mortgage landscape littered with defunct businesses, there is little likelihood of that.

What’s required is a return of market confidence. Consumers will continue to request more loan options. To meet that expectation, confidence in the markets must return.

Jeffrey Taylor is co-founder of Digital Risk, Orlando, a risk mitigation firm that provides special data authentication tools, which limit financial services firms’ exposure to fraud. Prior to founding Digital Risk, he spent several years in financial services risk mitigation, where he created a successful identity theft authentication initiative for mortgage loan originators.