QUESTION
My problem is that I have a CEO who does not want to do pre-funding quality control. When I insist on it, then we do it for a while. But he cuts it off again and again. He says our investors only care about post-closing quality control.
Last month, one of our investors wanted to see our pre-funding quality control reports and checklists. Well, we had the checklists, but we only had a few pre-funding QC reports. Somehow, the word got out, and other investors are now asking for these things.
Yesterday, we got a letter from Fannie Mae that singled out that we did not do pre-funding QC. The CEO called us into his office, showed us the letter, and admitted he was wrong. In the meantime, he's telling us to put pre-funding QC into action immediately.
I am so frustrated I could scream! This was all avoidable. I want you to write something that I can show the CEO so that he understands what has happened and I don't have to deal with him again on this issue.
Why is pre-funding quality control important, useful, and required?
ANSWER
You deserve a badge of honor for warning your management all along. Sometimes, management thinks it is smarter and wiser than those handling the departments and functions. Good managers listen, learn, and are open to staff suggestions; bad managers pontificate and dictate. So, I am going to respond as if I were talking to your CEO.
Mr. CEO, listen up!
I have no skin in the game, but you do – and you have put your enterprise at risk. When you start to cut corners with investors, they will cut you out. Trust me, I've seen it happen many times. First, it's a letter. Then it's a per-file audit. Then it's a warning to restrict loan originations, putting you on a tight leash. The repurchase threats will accumulate. Keep it up and you're out. If Fannie gets burned, expect other investors to drop you. Game over!
So let me give you some guidance. I suggest you give it your undivided attention.
Think of pre-funding QC as a process, a tool to obtain real-time loan quality information about the loan you want to sell to investors. Without pre-funding reviews, you cannot proactively gauge the risk in advance while the loan is being originated. Post-closing and investor audits are "look-backs;" pre-funding QC reviews are "look-forwards."
Read your Reps and Warrants – are you really sure you meet them without a pre-funding check? The fact is, an ineligible loan can lead to repurchase risk and impact your bottom line due to the time and effort needed to remediate defects. Get it right in the pre-funding stage, given that eligible loans are ostensibly eligible because they pass positively through pre-funding, notwithstanding that you have some confidence that the borrowers are in a sustainable home loan.
And there are derivative benefits to your company. For instance, From point of sale to closing, insights are gained into the loan flow process – the very process in which specific risk elements, such as income calculation opportunities, appraisal quality, and fraud – can be identified early. Furthermore, pre-funding reviews allow management to implement initiatives to prevent recurring systemic or incidental errors.
You need to keep pre-funding quality control separate from operations. Obviously, the purpose of pre-funding can be thwarted if the underwriters are evaluating their own decision process. How will a good understanding of loan quality be obtained if the pre-funding review does not provide independently derived information?
Perhaps your organization's reporting structure doesn't have the capacity to separate these duties. That means you are exposed to increased risk, leading to potential conflict of interest, which can cause a failure to maintain an impartial view of your loan origination performance. If you can't provide internally independent personnel, you should use externally independent resources. Many audit firms, including mine, provide this service. Our LCG Quality Control pre-funding reviews are reasonably priced and cost-effective. You can contact us HERE. And visit our pre-funding QC audit overview HERE. We are very hands-on, as that is the only effective way of conducting pre-funding QC reviews.
Whatever the case, you should deploy guardrails. For example, adverse pre-funding QC findings should not be overridden without conclusive and appropriate documentation. The Quality Control Plan needs to reflect an audit process that includes the pre-funding reviews, whether conducted internally or externally, to ensure that quality control procedures are performed correctly and independent from undue influence.
As a CEO, you must ask the right questions if you are going to get useful answers. Here are four questions that I want you to discuss with your QC staff.
1. Does the pre-funding QC process lead to
decisions that drive organizational change?
2. Does our Quality Control Plan detail
the pre-funding process, setting expectations for all relevant stakeholders, departments,
functions, and investors?
3. How confident are you that your pre-funding
department operates independently from outside influence?
4. Is your QC plan compliant with Fannie
Mae guidelines, such as:
·
Timing of the review,
·
Loan selection process,
·
Verification of data and documents, and
· Reporting.
These are the
actions you should take in concert with your staff:
· Review your Quality Control Plan to ensure all
required pre-funding elements are included.
· Determine if an audit process is in place to
confirm that pre-funding QC is fully independent.
· Review your pre-funding reporting to confirm it
complies with investor guidelines regarding timing, process flow, and content.
· Review your pre-funding QC reporting to improve
the information provided to management.
A good suggestion is for you to use our QC Tune-up, which will let you know if your QC department and plan are properly interfaced internally and externally. For more information, contact us HERE.
Finally, I will share with you some of the recurring findings that occur in our pre-funding QC reports. If you haven't been doing pre-funding reviews continually, you may have only a sparse understanding of these risks (and other risks) to which you have needlessly exposed your company.
Untimely Selection of the Loan. This is a weak link because the timing of the pre-funding QC significantly affects the amount of information in the file. You should choose loans early enough in the origination process to complete all review steps but also at a point when sufficient information validates a correct credit decision. Your threshold metric must be a process that meets both the criteria for timing and validation. Ensuring the proper evaluation (i.e., timing and validation) is the basis for implementing a detailed remediation process. And, without exception, if the loan is acquired from a Third Party Originator (TPO), the pre-funding review should be performed pre-purchase.
Defective Loan
Selection Process and Quality Control Plan. You must document the pre-funding
loan selection process and set forth the selection criteria in the Quality
Control Plan, meaning you should:
· Establish a process for loan selection,
· Determine how often the selection criteria are revisited, and
· Determine who is responsible for changing the selection criteria.
Loans with a greater chance of errors, misrepresentation, or fraud should be selected in the pre-funding sample. Essentially, experience has shown that by tracking errors, the lender can select high risk loans and loans with a greater chance of having a defect. This is the reason behind discretionary sampling. A word about discretionary sampling is in order. The pre-funding sample method based on certain selection criteria includes emerging risks, testing of action plans, validation of employee, TPO performance, or targeting a specific component, such as complex income calculations. The discretionary pre-funding QC, therefore, leads to improved loan quality.
Quality Control Plan fails to elucidate Pre-Funding Details. It is essential that lenders precisely document what loan evaluation criteria are to be applied in pre-funding reviews. Do not consider the loan production process complete without determining the review elements in the pre-funding selection. The Quality Control Plan should intrinsically identify those review elements not only in the pre-funding review but also in re-underwriting or re-validation procedures. Be sure that all pre-funding reviewers are trained on and understand the required elements of a full file review.
Defective Pre-Funding Reports. The critical value of the pre-funding QC report is it empowers the lender to take immediate action. But that can't happen if it is received belatedly or is missing all the required elements. Unfortunately, pre-funding reviews are often incomplete and frequently not generated on time. It is also important to develop a monthly report of pre-funding QC findings. Management can then review a monthly summary that includes a description of the review sample. Our clients may provide pre-funding samples that are completely discretionary or have targeted component reviews that can change based on business needs. Defect trending over time (i.e., three, six, or even twelve months) assist in identifying opportunities for improvement because it includes (or should include) enough granularity to allow action planning to target and correct specific defects. Identifying and trending gross and net defects provides a more comprehensive view of initial quality (gross) and your remediation efforts (net) effectiveness. The monthly summary identifies trends, promotes action planning, and drives policy and procedural changes.
Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director
Lenders Compliance Group
