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Loan quality lessons learned from 2020

Q3 2020 saw the highest quarter-over-quarter increase in critical defect rates since 2016

HousingWire recently spoke with Trevor Gauthier, CEO of ACES Quality Management, about the effects of 2020 on loan quality and what lenders should expect regarding loan quality and risk management this year.

HousingWire: What did the mortgage industry learn from the past year from an operational perspective?

Trevor-2020-picture-V2

Trevor Gauthier: 2020 was a wake-up call in terms of building a roadmap to increase your organizational efficiency and how technology needs to be a cornerstone of that plan. Navigating a remote work environment on a never-before-seen scale and maintaining long-distance collaboration while maintaining operational efficiency, compliance and data security was foreign territory for most, requiring the industry to be flexible in a way it hasn’t before.

Furthermore, after lenders tapped the well of available talent dry in the midst of last year’s skyrocketing volumes, many were forced to acknowledge how massively inefficient the “hire-and-fire” strategy for dealing with volume fluctuations is and begin thinking long and hard about how to break that cycle. Overall though, I believe many lenders took last year’s difficult circumstances and used it as fuel to invest for the long-term health of their organizations.

Of course, the pandemic wasn’t the only event in 2020 that had an effect on our industry, as we also experienced a transition of power in both the White House and the Senate this year. Given the seemingly more relaxed attitude towards enforcement from federal regulators under the Trump Administration, it was easy for lenders to let their guard down in terms of compliance.

However, industry oversight can also be cyclical to a certain degree, and rather than following the tides of political transitions and regulatory enforcement, lenders need to focus on maintaining a level of compliance that passes muster regardless of the party in power or how strenuously regulators may or may not be directed to hold lenders accountable.

Fair Lending is a great example of this. Even though the Trump Administration rolled back the disparate impact standard, amongst other changes, the need to comply with Fair Lending regulations and requirements did not change. Now that the Biden Administration has singled out Fair Lending as one of its top enforcement priorities and put disparate impact back into play, lenders are scrambling to ensure that they are in compliance.

Even though last year’s circumstances were extraordinary, the fact that we operate in a cyclical industry did not change, and while the peaks and valleys seem to get more extreme each time they come around, we should be long past the point of being caught off guard by that volatility. If your organization hasn’t already begun laying the groundwork for long-term operational improvement, now is the time so that you’re prepared for the next up-cycle.

HW: What effect did the pandemic have on loan quality in 2020?

TG: While we’ve only seen the data from the first three quarters of 2020, those results tell the story of the pandemic over the first nine months of the year. In Q1, the industry saw the critical defect rate fall 9.5% over Q4 2019 to 1.56%, matching Q3 2019 and representing a multi-year low. With the pandemic not hitting the nation as a whole until the end of the quarter, we only began to see a hint of what was to come, with early payment defaults (EPDs) emerging as the major area of concern.

In Q2, we began to see the number of EPDs rise as the pandemic’s impact on employment grew more pronounced and more Americans took advantage of forbearance options provided by the CARES Act. The critical defect rate also rose to 1.88%, and given the chaos surrounding the swift transition to remote work, it came as no surprise that income/employment defects were largely to blame for the increase.

Because of the potential impact to lenders, we began tracking and reporting EPD numbers for the early months of Q3 in the Q2 report and saw a nearly 200% increase by Q3 over pre-pandemic levels. Thankfully, that number began trending downward in Q4, though it remains to be seen if this trend will continue as borrowers began coming out of forbearance plans in the early months of 2021.

However, Q3 also brought the highest quarter-over-quarter increase in critical defect rates (25%) since ACES began issuing its QC benchmark reporting in 2016, with the overall rate hitting an industry-high of 2.34%. This coincided with the massive spike in volume lenders experienced starting in July.

Adding fuel to the fire was the “adverse market refinance fee” announcement from FHFA, which was shared with the industry in August and originally scheduled to go into effect in September. Because of the short lead time and expensive repercussions of the fee, lenders had a frenetic couple of weeks figuring out what to do with loans that were already locked but not able to be delivered to the agencies prior to Sept. 1st. Of course, the fee was later deferred to December 1st so I think we’ll still see the effects of this in the data from Q4 and the early quarters of 2021.

HW: What adjustments did ACES make to its technology to help lenders maintain loan quality and mitigate risk amidst last year’s skyrocketing volumes?

TG: As a company, we are always looking at what our clients’ areas of concern are and where we can help. By keeping our ear to the ground and being responsive to our clients’ needs in as close to real-time as possible, we were able to roll out several major enhancements last year to help our clients keep their eye on loan quality.

Most immediately, we launched a new question set category within the ACES Managed Questionnaire functionality to house all temporary regulatory provisions issued by state and federal agencies and the GSEs in response to the COVID-19 crisis to ensure our clients were auditing to the most current regulatory standards.  We also created an EPD-specific audit module to bolster lenders’ existing audit programs and maintain a closer eye on this growing area of concern. Other additions to ACES Quality Management & Control software included:

  • The addition of automated managed questionnaires related to the submission of Home Mortgage Disclosure Act (HMDA) data and state-specific compliance requirements
  • Updated the loan defect taxonomies for Fannie Mae and FHA to improve loan defect categorization for a deeper understanding of loan quality
  • The launch of our QC Now web series to educate the industry on the most current regulatory and operational changes related to QC, compliance and risk
  • Upgraded in-app reporting capabilities to increase users’ access to live data
  • Enhancements to the user interface to align with the rebrand from ARMCO to ACES Quality Management to provide users with an intuitive, modernized and easy-to-use experience.

More recently, we’ve added ACES CONNECT, which is an enhanced communication module designed to improve communication and collaboration not only across internal teams but also with third-party providers. This was a direct result of our clients’ sharing their need to provide secure access to audit results and reporting outside of their organization to streamline the QC process. To that end, we’ve also added 30 vendors to our network of integrated providers to give our users greater access and choice in re-verification partners and create a smoother, less error-prone process for ordering and receiving re-verifications as part of the post-closing QC process.

In addition, with regulators increasing their scrutiny of mortgage servicers, we’ve taken a very proactive role not only in helping our servicing customers leverage the ACES platform to ensure their servicing QC audit process includes both EPDs and forbearance procedures, but also serving in an advisory capacity to provide our servicing clients with even more support to help them prepare for this increased level of oversight.

HW: From a loan quality and risk management perspective, what areas should lenders be watching closely in 2021?

TG: Even though the MBA is predicting that 2021’s total volume will be the third-highest on record, lack of affordability and inventory coupled with rising interest rates are forcing lenders to tighten their margins and compete on volume rather than price. Historically, when we see the market transition from a high refinance volume environment to one that’s more purchase-driven, defects in borrower qualification categories tend to increase as lenders attempt to capture every last bit of volume they can.

For those looking for a roadmap on what to expect regarding loan quality and risk this year, I’d point them to Q4 2018, as there are several parallels between that market and the one in which we currently find ourselves. For starters, there was a huge interest rate spike in Q4 2018, driving purchase volume up to 72% of the overall market share. Having already locked in low interest rates in previous quarters, highly qualified borrowers sat out of the market in Q4.

With lenders trying to maintain and grow their lending volumes in the absence of this “low hanging fruit,” they stretched to qualify every borrower, and as a result, the overall defect rate jumped 8% that year over 2017, fueled by a significant increase in income and employment defects.

This largely mirrors what we’re seeing in today’s market. In Q3 2020 refinances and purchases were largely at parity, but we are likely to see that flip by Q1 and Q2. Furthermore, after a sustained period of low interest rates, we’re starting to see those rates creep up now. Despite being relatively low by historical standards, rates today are still higher than they were two quarters ago, and that has an impact on volume and margins.

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