When it comes to used cars, there are several important steps both the buyer and the seller must take to ensure the transaction goes smoothly. If you’re a seller, you make sure the vehicle is in the best shape possible by fixing anything that might prevent the sale, be it mechanical or physical. You clean it inside and out. And, you research the fair market value and price it accordingly.
If you’re a buyer, you do your homework by researching the model’s reliability record online. You run a Carfax report to get the history of the vehicle, such as if it has been in an accident or might have any other potentially worrisome issues. You take the car for a drive to test it in a variety of situations to see how it handles. And, you also get the vehicle thoroughly inspected by a mechanic to ensure there are no “hidden” surprises.
All of these steps are taken to improve the chances of a successful transaction by making sure the used car is in good condition and is a good value.
Buying and selling a loan portfolio in the secondary market isn’t all that different. When you’re evaluating a loan portfolio for purchase or sale in the secondary market, there are several audit components that must be included in a thorough quality control (QC) assessment to reduce risk by validating its value and predicting its future performance.
It’s worth noting, though, that these are the same components loan originators require outside of the secondary market when performing a QC assessment on their loan portfolios. The difference lies in what secondary market lenders and investors are looking for and why.
The four components of a QC review from a secondary standpoint include the following:
- Credit qualification analysis: In the secondary market, the specific credit guidelines of the investor are known. One prospective investor may require a certain credit score, while another might bundle jumbos or have different minimums.
The sample pool, in turn, is dependent on these requirements, with some forcing a review of the entire file and others requiring a 50% or just a 10% sample. The size of the sample pool just depends on the investor’s guidelines.
- Regulatory compliance: Regulations are regulations, and complying with them is required, regardless of the market – be it secondary or origination. However, when it comes to a QC assessment post-closing, the goal is to make sure all of the regulations were followed because if they weren’t, the loan portfolio would not be sellable.
And here again, regulatory compliance QC reviews can be tailored to the investor’s regulatory preferences or requirements, and sample sizes will then vary by lender or investor, as well.
- Collateral analysis: As in the loan origination market, collateral analysis in the secondary market involves looking closely at the properties within the loan portfolio to ensure their values are properly and adequately supported. Did the appraisers use appropriate adjustments when they were evaluating the properties? Do the appraisals look accurate compared with the photos?
The purpose here is to make sure the same values that appear on the appraisal documents line up with the information that was submitted and that those values are accurate.
- Data validation: On the post-closing side, this data validation is not as important, though more attention should probably be paid to it. On the secondary side, a lender or investor might look at a spreadsheet with data on 5,000 loans and use that data to conduct a quantitative review – the goal being to ensure the data is accurate within the loan file to avoid future default.
The typical spreadsheet components that are reviewed include whether the property is a primary residence, a credit report, a debt-to-income ratio, a loan-to-value ratio, an interest rate, the loan amount, and the property value.
And, just as with the previous components, when it comes to private investors, each has a different way of analyzing the data to predict the possibility of default.
How is the secondary side different?
The main difference between a QC review that is conducted on the loan origination side and one that is conducted on the secondary side is that in the secondary market, the loan portfolios are being bought and/or sold. Therefore, they are being evaluated to determine whether the portfolios are worthy of purchasing and valued appropriately. The QC review is essentially an audit that lets the investor rate the portfolio – and assists in the proper prediction of how those assets will perform in the future. The investor then uses items found in the audit that create deficiencies to offer to purchase the portfolio for a reduced fee or a reduction in basis points, or it might negotiate to buy X number of loans from the lender over a certain period of time. A QC review is both an evaluating and a negotiating tool.
Alternatively, loan originators conduct QC reviews to identify loan manufacturer defects so they can change and improve their processes in order to deliver sellable loans. That’s the main reason why post-close reviews are conducted.
Many, both inside and outside of the industry, are following the future of Fannie Mae and Freddie Mac. There’s widespread agreement across the industry that Fannie and Freddie shouldn’t go on forever. But at this point in time, no one really knows what is going to happen with the government-sponsored enterprises (GSEs) relative to the intended reforms the new administration has put forth.
Ninety percent of the secondary market is currently with the GSEs, and many processes and procedures have been put in place, designed to improve loan quality. That quality still needs to be there should reforms take hold and these portfolios begin shifting to private funds. Safeguards must remain in place to ensure the secondary market doesn’t begin to experience pre-2007 quality issues again.
Hopefully, QC companies will be nimble enough to continue to customize their QC solutions to private investor specifications and do more analysis on the pre-close side to identify compromising issues up front, such as leveraging fraud tools to protect against undue risk.
For now, however, lenders are only beginning to put their toes into the private market.
Common portfolio errors
Lenders and investors evaluate portfolios based on their deficiencies. And, over the last year, the top five defects/issues relative to loans we have audited for the secondary market were the following:
1. Legal/regulatory compliance: Real Estate Settlement Procedures Act (RESPA) violations – change of circumstance letter was not properly disclosed;
2. Legal/Regulatory Compliance: initial closing disclosure failure;
3. Assets: qualifying funds were not properly documented;
4. Income/employment: income calculations were incorrect or not properly documented; and
5. Income/employment: two-year employment history was not verified.
These are not unusual defects, as historically, income and asset issues have been the biggest drivers of loan quality deficiencies. However, with the implementation of the Truth In Lending/RESPA Integrated Disclosure roughly 18 months ago, there has been a spike in regulatory compliance issues.
Steps to ensure compliance
If you are a lender or an investor on the secondary side, the best way to ensure compliance is to conduct post-close audits. The more due diligence you do, the more you can improve loan quality and the better shape you will be in throughout the process.
In addition, be sure you are making good use of all of the technology tools that are out there: undisclosed debt verifications, verification of employment, fraud identification programs, etc. They will help you catch issues and identify errors up front rather than after the fact.
So, just as it is when you are selling your car or buying one that was previously owned, when buying or selling a loan portfolio in the secondary market, a thorough QC review must be performed to identify any issues that could affect the success of the transaction, thereby decreasing risk for both the lender and the investor.
Michael Crockett is executive vice president of product development at Credit Plus, a provider of third-party verification services and technology for the mortgage industry. He can be reached at firstname.lastname@example.org.