QUESTION
I am the manager of our quality control department. We do our own quality control and use an outside auditor. We originate high production and have multiple channels. And we are in 30 states. Our CEO told me that he wants to downsize my department and also pull production audits from the outside auditor. He says our defect ratios show we are doing well and don’t need to maintain quality control to the same extent.
I tried to tell him that he is seeing the positive effect of quality control, and that downsizing it and removing the outside auditor will cause the defect ratio to worsen. If anything, he should be maintaining or even increasing my staff and external auditor because our production is rapidly increasing. Frankly, I couldn’t change his mind.
So, I am appealing to you. Our CEO passes your articles out at almost every management meeting. He uses them as ways to encourage discussion. I want him to read your reply. I have been reading your articles for years, and I am familiar with your stance on maintaining a strong quality control department.
How does mortgage quality control protect the lender?
SOLUTIONS
ANSWER
Your question comes as a surprise to me, since compliance in general and quality control in particular should be the very last departments to be downsized. If there are mitigating circumstances for the cutback, such as a substantial drop in production or a change in the company's configuration, then I suppose reducing quality control may be warranted. But, even then, it must be done carefully, slowly, judiciously, and with full awareness of any impact on investor due diligence and contractual requirements.
Lenders Compliance Group offers quality control auditing. But, unlike most quality control companies that veered into mortgage compliance, morphing into a compliance firm, we began as a compliance firm and subsequently established a fully staffed quality control affiliate, carefully managed by an executive director, experienced personnel, compliance professionals, and attorneys. LCG Quality Control, our quality control auditing group, oversees the entire audit process, from the smallest to the largest production, and delivers reports in accordance with GSE and portfolio guidelines, pursuant to timing requirements. We know whereof we speak when it comes to quality control.
MORE THAN JUST DEFECT RATIOS
Quality Control is far more than just maintaining defect ratios. Wherever you got that impression, get rid of it. You are putting your mortgage company at considerable risk, a risk that is so high that your company will likely implode in a matter of days if you fail to maintain the necessary departmental and auditing staff levels. Cut elsewhere, but do not cut the operational needs of quality control!
Mortgage quality control (“QC”) protects lenders by mitigating financial risk through the identification and correction of process errors, ensuring compliance with regulations, and maintaining the quality of loan portfolios. This, in turn, prevents costly buybacks from investors, such as the GSEs, and reduces the likelihood of loan defaults.
Indeed, QC is a component of the Second Line of Defense; in fact, its exact placement depends on the financial institution's structure, as QC functions can also be embedded within the First Line of Defense. The Second Line of Defense typically comprises risk management and compliance functions that provide oversight, develop policies, and monitor activities to ensure adherence to regulations and internal standards. Therefore, when a QC function is established within or aligned with these oversight departments, it serves as a "second-line control."
QC is crucial for identifying and preventing errors; the specific placement of the QC function determines whether it serves as a First or Second Line of Defense. Regardless of its placement, QC plays a detective role in identifying issues after they occur and provides an early warning mechanism to management, thereby strengthening the overall control structure.
Consider how quality control impacts the following risk categories.
RISK MITIGATION
Let’s start with mitigating risk. Two specific areas that QC impacts are default rates and loan buybacks. QC confirms that loans adhere to federal, state, local, and investor regulations (for instance, Fannie Mae guidelines), thereby avoiding penalties, legal issues, and breaches of contract.
Reduced Default Rates
QC processes ensure thorough underwriting and borrower verification, confirming a borrower's ability to repay the loan, thereby lowering the risk of default. Your CEO seems rather cavalier about defect rates. Through pre-funding and post-closing reviews, QC identifies errors in documentation, underwriting, income verification, and appraisals, allowing lenders to correct them before they become costly problems. It makes no sense to reduce staffing and outside auditors because the company’s defects appear to be currently stable. That is an invitation for disaster!
Loan Buybacks
By catching loan defects and errors early in the process, lenders avoid defects that could lead to investor-initiated demands for loans to be repurchased or bought back, a significant financial risk. QC verifies loan eligibility and accuracy, significantly reducing the likelihood that investors will demand the lender buy back a defective loan, which can lead to substantial financial losses and damage to investor confidence.
Regulatory & Legal Protection
Compliance with Laws
QC programs verify adherence to federal and state laws, such as the Equal Credit Opportunity Act (ECOA) and Real Estate Settlement Procedures Act (RESPA), protecting the lender from legal penalties and sanctions.
Preparation for Audits
Regular QC reviews allow lenders to identify potential compliance issues and take corrective action before regulators conduct official audits, ensuring a clean record and preventing fines.
OPERATIONAL & FINANCIAL BENEFITS
Improved Loan Quality
QC defines standards for loan quality, establishing processes that result in well-originated and serviced loans, which are crucial for selling to the secondary market.
Operational Efficiency
A robust QC program identifies weaknesses in the loan manufacturing process, leading to remediation and improved operational procedures, saving time and resources in the long run. Implementing strong QC processes and leveraging technology can streamline operations, reduce errors, and improve overall productivity within the loan production and servicing cycles.
Secondary Market Requirements
QC ensures loans meet the standards of investors and secondary market entities, enabling lenders to sell their loans with confidence. QC auditing verifies that loans meet the strict eligibility and underwriting criteria set by investors, such as Fannie Mae and Freddie Mac, ensuring marketability and preventing buybacks due to non-compliance.
Loan Quality and Underwriting
Consistent post-closing and pre-funding reviews ensure that underwriting decisions are accurate and well-supported, resulting in higher-quality loans and improved long-term performance. By systematically evaluating the loan pipeline and addressing identified deficiencies, lenders can improve the overall quality and reliability of their mortgage loans.
Fraud Prevention
Regular reviews of loan files can uncover fraudulent activities or material deficiencies, allowing lenders to take immediate action and prevent financial losses. Robust QC processes help detect and deter various forms of fraud, including misrepresentation of income, employment, and assets, or appraisal fraud.
Reputation Risk
A strong QC program demonstrates a lender's commitment to high standards, building trust with prospective and actual borrowers, as well as regulators and investors. These standards help to maintain a positive reputation. The QC program must demonstrate a commitment to quality and compliance, protecting the lender's reputation.
A Word of Caution
In more than forty years of experience in legal and regulatory compliance, I have never encountered a single company that opposes mortgage quality control outright. Instead, several entities have engaged in practices that fail to meet quality standards or have lobbied against the oversight that enforces such standards. I view the unnecessary downsizing of quality control as a high-risk action against quality control.
Regulatory agencies, such as the Consumer Financial Protection Bureau (CFPB), have litigated against certain lenders for misconduct involving mortgage loan originations, yet many industry players and political groups have opposed regulations on consumer financial products. Rather than opposing quality control in principle, many financial firms and trade associations have lobbied against the regulations that empower agencies like the CFPB to enforce consumer protections.
As but one of many such examples, Wells Fargo Bank paid millions in penalties to resolve claims of fraudulent mortgage lending, including certifying loans for FHA mortgage insurance that were not eligible. The CFPB cited the bank for widespread mismanagement and other misconduct across its various financial products. In some of these instances, reliable quality control could have caught some of these violations.
Mortgage
quality control is designed to ensure the reliability and accuracy of mortgage
loans. While no company would explicitly state they are "against"
quality control, some have faced enforcement actions for failing to comply with
related regulations or standards, indicating deficiencies in their processes. Unless
there are overwhelmingly substantive reasons for curtailing quality control,
don’t make the same mistake!
