Q&A w/ Phil McCall of ACES Risk Management Corp.

MBA NewsLink recently posed questions to Phil McCall, COO of ACES Risk Management Corp. (ARMCO), Pompano Beach, Fla.

McCall has more than two decades of executive experience in the mortgage industry, anexpert in quality control, loan origination and underwriting, mortgage fraud, loss and litigation and real estate-based transactions. Previously, Mr. McCall was the COO for IMARC, a forensic loan auditing and loan data verification provider. He also held executive positions with three privately owned mortgage banking firms. In the process, he was an integral liaison between the companies and various Wall Street firms. The company’s website is http://www.armco.us/.

MBA NEWSLINK: ARMCO recently released its first loan defect report, covering the first quarter. What was the most significant finding for this period?

PHIL MCCALL, ARMCO: Without a doubt, the most significant finding was the effect of TRID on Legal/Regulatory/Compliance defects. We saw a fairly significant increase in this category between Q3 and Q4 in 2015, and because most post-closing quality control reviews are conducted anywhere from 90-120 days out, it’s unsurprising that this category of defects continued to trend upward in Q1 2016. To me, this dramatic increase really shines a light on the magnitude of this change. Lenders have worked really hard to get this right, but there are so many unknowns that can’t be uncovered until after implementation.

Take, for example, change of circumstance. Prior to the TRID implementation date, the aspect that lenders were most concerned about was ensuring that they met the rule’s date requirements for proper delivery. What lenders have uncovered, post-implementation, is that it is difficult to document and manage change of circumstance at the speed of origination, and as such, lenders have had to reassess their operations and put some systems in place to better manage this process.

NEWSLINK: Given the results from Q1, what can we expect in the second quarter?

MCCALL: Q2 will be the litmus test on the effectiveness of lenders’ corrective action plans for the defects they uncovered in Q1. As I mentioned earlier, post-closing QC audits typically occur 90 to 120 days out so we’re just now starting to see the results from post-closing audits conducted on Q2 originations, and I, personally, am anxious to see what plans lenders have put in place to address the root causes of the defects they uncovered. Hopefully, lenders were able to make the appropriate changes to their manufacturing processes and ensure the appropriate stop-gaps are in place to catch these issues before the loan gets to closing.

In looking at the Q1 data on a month-by-month basis, you do see an ever-so-slight dip in March over the peak in February so things look promising. However, as we have observed in collecting loan defect data since ACES Analytics was released in Q1 2015, there are periodic dips and spikes across all the categories so going off a one-month “trend” doesn’t typically paint the full picture. You really have to look at the numbers across several months before true trends start to be revealed.

When you dig deeper into the Q1 data and start looking at sub-categories along with the actual loan level defects, you start to see a couple of common themes: 1) Missing/incomplete information; 2) Information that doesn’t match either between the Loan Estimate (LE) and Closing Disclosure (CD) or within sections of the same document; and 3) information being miscalculated and/or incorrectly categorized. These are all issues that can certainly be addressed, and I think we’ll see that supposition born out in the data for Q2.

NEWSLINK: In what other areas did you observe a significant number of defects in Q1?

MCCALL: Loan package documentation defects are a perennial problem for lenders. In fact, this was the highest category of defects in 2015. However, this is also an area where the data continues to trend downward, and I believe there are a couple of key reasons that have facilitated this downward trend.

First and I believe foremost, the GSEs have been very vocal regarding the sheer numbers of defects that are associated with missing documentation. In a panel, which I moderated at the MBA’s National Technology in Mortgage Banking Conference & Expo in April, Freddie Mac provided data that stated 28 percent of all loans it received in 2015 were missing at least one document, and according to a “Missing Documents Checklist” from Fannie Mae (https://www.fanniemae.com/content/tool/missing-documents-checklist.pdf), 40 to 60 percent of the repurchase requests it issues are solved by simply providing a document that was missing from the original loan file.

In addition, as we’ve rolled out our benchmark and allowed lenders to compare their results against the industry, we’ve seen wide variances in where individual lenders are compared to the aggregate, but even then, lenders that were coming in under the benchmark were finding that missing documents still made up a significant portion of their overall defects. Thus, there seems to be an industry-wide acknowledgement of this issue, and lenders are constantly working to shore up this aspect of their operations.

Missing Documentation is a defect that is many times associated with “the rush factor.” The issue isn’t necessarily that the document is outright missing; it’s that it just didn’t make it into the final loan package. Because this is typically a non-critical defect, meaning that it ultimately doesn’t result in an actual buyback and/or a non-performing loan, the most serious consequence lenders’ faced was paying an extension fee here or there when they couldn’t close or deliver the loan on time.

Because missing documentation is largely a curable defect, a lender’s emphasis to proactively address issues within their manufacturing process many times received a lower prioritization to areas of concern that presented a larger overall risk to the organization. Both public and private investors are placing renewed, continuous pressure on lenders to clean up this area of their process and enforcing more serious consequences for incomplete loan files. They want to know what lenders are doing systemically and procedurally to fix the problem, and they want to see evidence of corrective action planning and process documentation to verify that lenders are making a good-faith effort to deliver complete loan files.

NEWSLINK: What does the overall critical defect rate tell us, and what rate should the industry be striving for at any given time?

MCCALL: The critical defect rate is a newly recognized benchmark for the mortgage industry of the quality of your loan production and your loan defect risk exposure. Fannie Mae introduced the concept as part of its Loan Quality Initiative, and because Fannie did not set an industry-wide standard, lenders have struggled to set a target critical defect rate that is both realistic and appropriate for their organization.

When we began collecting loan defect information in mid- to late 2014, the measurement of the critical defect rate was atrocious. Some lenders had critical defect rates as high as 8-10 percent, and a lot of this was attributable to imperfect management and measurement of their actual defects. We saw a dramatic drop in critical defect rates in 2015 because lenders starting using technology to help them better measure their defects, standardize their defect tracking and reporting, and implement a process to be able to track critical defects v. non-critical defects.

As far as what rate the entire industry should strive for, there is no “right answer,” and Fannie Mae chose not to establish an industry benchmark specifically because it wanted lenders to calculate this figure based on each lender’s individual risk tolerance level.

The standard post-closing QC audit reviews a 10 percent sample of funded loans for a given month. For the sake of argument, let’s say you originated 1,000 loans this past month so your sample size would be 100 loans that are actually audited. Within that sample, you find that 2 percent, or 2 loans, are critically defective, which means the loans are non-salable or subject to repurchase. If you extrapolate those findings across your entire volume for that month, you could potentially have 20 loans with critical defects, which still may not sound like a lot until you put some math around the average loss associated with a defective loan.

For comparison sake and some easy math, let’s assume that each of the 20 non-saleable loans costs your organization $50,000 in losses. That’s $1 million in potential losses per month. Can you, as an organization, sustain this kind of loss on a monthly basis? Alternatively, by using a 0.77 percent defect rate (i.e., the Q3 2015 rate), your potential risk (losses) due to critical defects declines to $385,000 per month; still not a trivial number, but a good indicator of how an organization should be setting their target defect rate and striving to reduce critical defects to a number that aligns with the organizations tolerance for risk.

As such, I think we can safely say that a sub-one percent critical defect rate begins to get us to a number that the industry can be proud of and that keeps risk at a manageable level. Some lenders have stated that their target critical defect rate is zero percent, but that simply isn’t a realistic goal because there are always going to be mistakes and errors. However, a sub-one percent defect rate is absolutely achievable, as we saw in Q3 2015, and effectively balances inevitable errors with limiting financial exposure due to those errors.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor does it connote an endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions; articles and/or Q/A inquiries should be sent to Mike Sorohan, editor, at msorohan@mba.org.)