“It’s the little details that are vital. Little things make big things happen” - a quote by John Wooden that seems tailor made for “loan asset quality”.
Atleast, that’s what we picked up from the panel discussion on “Optimizing your loan quality” at IMB Conference 2023.
To begin with, discussion was anchored by Ronald Feigles (Vice President, Single Family Quality Control and Fraud, Freddie Mac) and Duane Gilkison (Senior Director, Credit Risk Management, Fannie Mae). Both the panelists are subject matter experts and lead the post purchase QC practice at their respective organizations.
However, it was not just the quality of panelists that piqued our interest but also the data backed discussion that really drove the point home.
With high interest rates and dipping origination volumes, every loan counts.
The last thing a lender should have to deal with is repurchase risk.
Every loan asset sold to GSEs goes through a rigorous post purchase QC process during which the sampled loans are reviewed against strict data integrity and compliance requirements.
This is where it gets tricky.
According to STRATMOR’s data, nearly 20% to 30% of the loans offered to an aggregator are not immediately purchased due to ”issues” or areas that need further clarification.
Hence, optimizing loan quality for mitigating repurchase risk is an overlooked area that can unlock a new lever for profitability in the current market conditions.
Loan quality trends: What does data tell us ?
As part of its loan QC process, Fannie Mae performs Random Post Purchase Review (RPPR) on loan assets. Defects emerging from this review are classified into different severity levels - Findings, Price Adjusted Loans and Significant defects.
In case of significant defects, Fannie Mae may request for core critical documents or in the worst case, calls for a repurchase.
As shown above - from 2019 onwards significant defects in RPPR have been rising at a consistent pace.
The same is corroborated by Freddie Mac’s trend data on statistical defect rates - which grew consistently between 2020 Q3 and 2022 Q2.
So what has been the impact of rising defect rates ?
Simple. Repurchase has gone up.
Overall the repurchase volumes grew in tandem with origination volumes between 2020 & 2021.
As per Fannie Mae data, with rising origination volumes in 2020 & 2021, repurchase volumes also increased correspondingly, reaching a high of $426 Bn UPB in Q4, 2020.
What’s driving up loan defects ?
Knowing is just half the battle. While we see that repurchase is tied at the hip with origination volumes, the question is - how do we decouple them and in fact reduce our repurchase risk.
In order to solve that, we need to solve for loan quality.
Hence we must understand what’s driving loan defects in the first place.
During the IMB panel discussion, Duane Gilkison from Fannie Mae, did a deep dive into the top 10 contributing factors for significant defect trend between June 2022 and Sept 2022.
As we can see from the above image - while appraisal related issues such as failure to adjust comparables & inadequate comparables were top drivers, income calculation and documentation omission related defects had an overall larger share.
On similar lines, Freddie Mac’s data also shows that income calculation related factors were the single largest contributor of performing loan defects between Q3 2020 and Q2 2022.
In a nutshell - appraisal, income calculation and documentation are three areas that have been responsible for affecting loan asset quality over the last two years.
Hence, a quick win in improving loan quality could come from building the right infrastructure for efficient document verification, income validation and post funding QC processes.
Optimizing loan quality to reduce defects & repurchase risks
Having looked at the impact of critical defects in loan assets, the next logical question is - what are some of the actionable steps towards optimizing loan quality?
According to Duane, some of the strategic measures for lenders to begin with, are:
First, focus on gross defect rates as much as on net defects.
The gross (initial) defect rate is the defect rate based on any initial findings prior to any rebuttal activity, whereas net (final) defect rate is the defect rate based on the final findings after the rebuttal activity.
This is because gross defect rate measurements are important - Gross defect rate is the true measure of a lender’s manufacturing quality for its overall book of business.
Hence focusing only on correcting net defect rates means a lender is not actually correcting every loan with a defect in the overall book of business — rather, only the loans in the random sample. This in turn fails to solve for repurchase risk.
Second, strengthen their muscles in prefunding QC. Fannie has a detailed advisory on pre-funding QC for lenders.
Some of the immediate steps in optimizing pre funding QC could be:
- Initiating QC early in the origination process, but only when enough information is available for correct credit decisioning.
- Documenting the pre-funding loan selection process.
- Preparing actionable prefund reportings that are complete in all respects for GSE’s review
These would not only help lenders spot significant defects early on but also minimize clarifications from Fannie Mae’s QC team.
Third, lenders should strengthen processes around improving appraisal quality and valuation.
On similar lines as Duane, Ron (VP, Single Family Quality Control, Freddie Mac) suggested that lenders must focus on improving their initial file quality.
As per Ron, solving for missing core documents during post purchase review is a huge waste of time & resources for lenders.
It also delays the purchase review process by months. Hence, it is a win-win to ensure that loan files are complete at delivery. This again, points us back to the importance of having a robust prefunding QC process.
But it should not just stop there. Lenders should also have a well oiled root cause analysis mechanism to prevent future defects and drive an eventual improvement in loan production quality with time.
Lastly, lenders should invest in internal capability building & training of QC teams with the objective of improving initial file quality. Alongside this, lenders should also invest strategically in tools & platforms that improve the efficiency of document handling and income calculation.
However, this should not come at the expense of human interaction.
There should be an active feedback loop between QC & origination team, so that we eventually move the needle on loan quality improvement.
While much of the narrative in 2020 & 2021 centered around loan volumes, it’s time to recalibrate our focus. From the IMB conference, we got a sense that lenders are better placed to navigate the current market conditions, if they focus on improving process efficiency & productivity. The session on “Optimizing your loan quality” in particular was an eye-opener. It put the spotlight on an overlooked aspect of loan production - keeping high quality assets on one’s books. It not only reduces repurchase risk but also opens new revenue streams through capital market trades. In a nutshell, the session drove home a simple point -“It’s the little details that are vital. Little things make big things happen.”