Digital Risk In The News

Lenders, Investors Embed Risk Management Processes

March 20, 2007
Residential Finance News

Mortgage lenders and investment banks are increasing their risk management procedures and due diligence to review loans, mortgage-backed securities (MBS) and processes as a hedge on other investments and company reputations.

“[Investment banks] understand the significance not just on how they are buying these loans and then securitizing them, but how it has an overall impact on their companies and their brand names on every channel of business they do,” said Jeffrey Taylor, managing director of Digital Risk, an Orlando, Fla.-based firm specializing in risk modeling tools. “They are relooking at every aspect of their due diligence and how they acquire these assets to go ahead and bring them up to speed to make sure that these issues they are having right now do not happen again. Ultimately, outside major banks, the Wall Street firms are dictating policy moving forward.”

Rebecca Walzak, president and founder of Walzak Risk Analysis LLC, a Boca Raton, Fla. firm that provides an automated score on risk, similar to a credit score, said risk analysis is necessary on the front-end of the mortgage process to determine whether non-performing loans derive from bad products, mortgage fraud or poor operational procedures. While “lender process risk,” in the origination process will have an impact on loan performance, Walzak said quality control review after loan closing does not necessarily correct process weaknesses.

“There’s no manual way to review files and have it be objective and standardized. In today’s lending environment we continue to see lenders forced into bankruptcy due to repurchase demands on non-performing loans,” Walzak said. “While everyone involved in the secondary market understands the potential for this to happen, the fact that it could not be measured prevented these lenders from preparing for or preventing it.”

“Risk is not a bad thing. The bad thing is actually not pricing the risk properly,” said Peter Kassabov, managing director at Digital Risk. “The insurance industry has been in the risk business for a century, but they figure out how to price the risk properly, and this is what is lacking in the mortgage business. I believe there is no way to really assess the risk and price differently.”

Regulation largely defines risk management for financial institutions rather than “strategic discipline” embedded throughout the business, according to a survey of 400 financial services executives—“Creating Value: Effective Risk Management in Financial Services"—by PricewaterhouseCoopers and Economist Intelligence Unit, both based in New York. Two-thirds of respondents—66 percent—said their companies need to view risk management as a more strategic function to add greater value to their business.

“Even when directors of financial institutions insist on risk managers having their say, too little attention is paid to embedding risk managers in the individual businesses. This often makes it harder to get to grips with the intricacies of the business,” Shyam Venkat, partner at PricewaterhouseCoopers.

Mortgage fraud against lenders, for example, requires diligent reviews in data verification—from Social Security numbers and tax returns provided by the federal government, to employee pay stubs, credit scores and geographic regional trends.

The Mortgage Bankers Association reported a .54 percent foreclosure rate in the fourth quarter last year, but most foreclosures occurred in states with manufacturing job losses, including Michigan and Ohio. Meanwhile, fraud against lenders caused nearly 70 percent of mortgage early-payment defaults (EPDs) last year, according to a study from BasePoint Analytics, Carlsbad, Calif.

Financial services executives said their firms have “high levels of effectiveness” in credit risk and market risk, but confidence levels drop for business risk, people risk and risk to reputation.

However, a greater number of executives in the financial services industry expect risk management to play a more important and strategic role within the next three years as risk managers move toward integrating into individual functions inside the companies.

“The priority is integration,” said Paul Horgan, partner at PricewaterhouseCoopers. “For too long, organizations have had a silo mentality towards risk management.”

As mortgage originators increase their due diligence and risk management toward data verification, Taylor said title industries and closing agents will increase safeguards to prevent risks from mortgage fraud.

“EPDs are obviously at an all-time high right now,” Taylor said. “With a straw buyer or a total made up person orchestrating a scheme with never any intent to pay—absolutely it is going to have an effect on that because the intent is to get the cash and take off. The [fraudster’s] intent is not to actually make any payments on the property.”

“Ensuring that lenders are aware of and correcting process weaknesses that allow these loans to be originated without imposing onerous regulations will go much further in wiping out fraud and predatory lending practices, particularly as Wall Street begins to incorporate this risk into their pricing programs,” Walzak said.