How to Prepare for a Global Recession

YOUR COMPLIANCE QUESTION 

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I am the CFO of a Mortgage REIT, a residential mortgage lender, and a mortgage servicer. Our board met to discuss what could happen to our mortgage originations in the event of a global recession. Our secondary and capital markets department is already gearing up for a recession. Our loan originations were affected by rising rates – and not in a good way. Our margins have been compressed, and hedging is difficult. 

Your name came up in the meeting, as one of the board members knows you. The thought was that you have many clients and probably have a good idea about the overall condition of the mortgage banking industry and how it can prepare for a recession. Because of your place in compliance and risk management, she feels that you could shed light on how we can prepare for a recession. Thank you for considering our question! 

How can a mortgage lender protect itself in a global recession? 

OUR COMPLIANCE SOLUTION

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RESPONSE TO YOUR QUESTION 

Our clients often discuss how their compliance failures result in direct financial losses. During a period of financial stress, a lender scrambling to address compliance deficiencies while also managing credit losses and liquidity pressures faces a compounded crisis that can accelerate failure. In this article, I want to address your specific question about what happens in mortgage banking in a global recession and how to prepare for it. 

Compliance Amplifies Everything 

Let me state at the outset that compliance during a recession amplifies everything! Specifically, in a recession, the compliance-stability connection intensifies because: 

• Regulators increase examination frequency and scrutiny, 
• GSEs conduct more aggressive post-purchase file reviews, 
• Borrower complaints rise sharply, triggering CFPB investigations, 
• Desperate borrowers and originators increase fraud risk, making compliance controls more critical, 
• Investors have less tolerance for defects and push repurchases more aggressively, and 
• State attorneys general become more active in mortgage enforcement. 

A lender entering a recession with a strong compliance foundation is dramatically better positioned than one carrying hidden violations that regulators and investors are about to discover. 

Fundamental Rule 

Here's the fundamental rule to planning for a recession: 

Lenders who prepare during good times survive recessions;

lenders who assume good times last forever do not. 

The 2008 crisis wiped out hundreds of mortgage companies that were profitable just 18 months earlier. The ones that survived – and thrived afterward – had built conservative balance sheets, diversified channels, and operational flexibility long before the storm arrived. 

Let's zoom out to the implications of a worldwide recession on mortgage banking. Understanding its impact on the banking ecosystem will give us a perspective on how a lender can protect itself in a recession.

Quality Control Challenges – Defect Rates and Trendlines

QUESTION 

During a MORA review, Fannie determined that several areas were problematic. We thought we were mostly ready until we got the MORA results. Fannie required us to revise a list of issues. 

It was too late for us to use your Fannie Tune-up. So we mustered through as best as we could. One area that the MORA team criticized us for was that we did not establish a "methodology for identifying, categorizing, and measuring defects and trends against an established target defect rate." 

They found our Quality Control Plan was defective, and we could not show that we followed a methodology to uncover defects and trends. Our QC Manager discussed this with our QC auditor, but they became defensive. They did not want to update their Quality Control Plan or provide their procedures for Fannie to evaluate. So, on top of everything else, we need to get another QC auditor. 

We need your help in understanding some basics about defects and trendlines. 

What methodology is used for "identifying, categorizing, and measuring defects and trends against an established target defect rate?" 

ANSWER 

It's unfortunate that you did not contact us soon enough for the Fannie Tune-up. It takes 60 days to complete, and it is inexpensive. Most clients use the Fannie Tune-up to comply with Fannie guidelines and stay ready or get ready for a Mortgage Origination Risk Assessment (MORA) visit. 

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Anyone interested in the Fannie Tune-up can request information here. 

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I thought it would be a good idea for you to get some feedback from Brandy George, the Executive Director of LCG Quality Control. 

There are few professionals in mortgage banking with Brandy's credentials and depth of experience. Her group audits small and large loan production into the thousands of units. Importantly, Brandy works hands-on with clients to ensure their quality control meets Fannie's guidelines. So, I asked her to join me in answering your question. 

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 Brandy also offers a free Quality Control Plan (terms apply)

that meets GSE and regulatory scrutiny. 

If anyone wants to talk to Brandy about their Quality Control needs,

you can contact her here. 

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I asked Brandy to give a brief but useful answer to your question. The following outline is reflective of my notes from my conversation with her. 

Brandy confirmed that a financial institution must have a set of policies and procedures documented in its Quality Control Plan, establishing a target defect rate and the methodology for "identifying, categorizing, and measuring defects and trends" against that rate. 

According to Brandy, 

the target defect rate is the final net defect rate your firm has established as an acceptable percentage rate of open defects in any given audit period and the year-to-date percentage rate of open defects. 

That led to our discussion about calculating the defect rate. I like Brandy's response: 

Calculating and tracking the actual defect rate against your target defect rate is how you assess your credit and financial risk performance and measure progress in meeting your quality control goals. Managing gross and net defect rates is critical to understanding the financial exposure revealed during the QC process. 

The gross defect rate is calculated by dividing the number of all defects noted by the number of loans reviewed in the audit period, and the final net defect rate is calculated by dividing the number of open defects by the number of loans reviewed in the audit period. 

To provide a granular description that brings in threat levels, having a target defect rate is required for the top severity level – which, by the way, is ineligible for delivery to Fannie Mae – and enables the lender to regularly evaluate and measure progress in meeting its loan quality standards. 

The lender must define lower severity levels as appropriate for its organization, and different target defect rates may be established for different severity levels (if applicable). Note that the target defect rate is a Fannie Mae requirement!

With respect to calculating the target defect rate, I would like to add my observation to Brandy's guidance. Calculating a defect rate is how you measure against your target defect rate. Some lenders use only a gross or a net calculation when determining their monthly defect rate, while others use both. 

• The gross defect rate is the defect rate based on the initial findings prior to any rebuttal activity. 

• The net defect rate is the defect rate based on the final findings after the rebuttal activity. 

Understanding the root cause of the issues resolved during the rebuttal process may provide insight into how the defects can be prevented. 

Concerning the severity level, if a loan has both the highest-severity level defect and a lower-severity level defect, Fannie directs that the lender should only count the loan once – in the highest-severity category – in a defect rate calculation. Calculations should be done for your two most severe defect types (i.e., Significant and Moderate). 

My conversation with Brandy concluded with discussing the methodology for identifying defects and trendlines. Her insight here is helpful. She said: 

The methodology for identifying defects and trends lies within the audit process. How loan defects are identified and categorized leads to the final reporting results. Meaning, exceptions and defects need to be categorized in such a way that puts the defects in risk rating categories, such as Minor, Moderate, and Significant, compliance and regulatory, or by area of responsibility, such as Loan Officer, Processor, Underwriter, or Closer.  

Categorizing into risk rating categories is essential to the mission of the quality control project. Once initial (gross) defects are cured, it is important to determine root causes, analyze issues, and reconcile the difference between your gross and net defects and action plan accordingly. Be sure to analyze the cause between the gross and net defect rates! The goal is to identify and remediate the issues to narrow the gap between gross and net defect rates. 

A final word about targets and defect rates. An effective way to establish loan quality targets is to model the financial exposure created at a certain defect level. The concept of "zero defects" generally will be considered challenging to achieve. And, in any event, Fannie Mae does not evaluate lenders by a zero-defect-rate standard. 

Fannie Mae expects lenders to set defect rate targets as reasonably low as possible based on a formal cost-benefit analysis of meeting that target. The MORA team expects lenders to demonstrate to Fannie how they manage loan quality to meet their established target. 

_____________________________________________ 

Brandy also offers a free Quality Control Plan (terms apply)

that meets GSE and regulatory scrutiny. 

If anyone wants to talk to Brandy about their Quality Control needs,

you can contact her here. 

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Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group