CFG Update: PwC's Consumer Finance Group

Complaints have historically been viewed as bad news, costly, and inconvenient. However, if used in the right way, complaint handling can provide an avenue for competitive differentiation. Customers who speak up when they have a complaint provide companies the opportunity to apologize, turn possible vigilantes into advocates, and transform a complaint into a customer success story.

Regulators of the consumer finance industry have begun to approach their oversight from a customer experience perspective and they view consumer complaints as a window into potentially larger issues in a company’s operations. The regulatory agency that has received the most attention, and has perhaps the most reach and power when it comes to customer complaints, is the Consumer Financial Protection Bureau commonly referred to as the CFPB (for a broader discussion of the impact and requirements of the CFPB please read the associated article on consumer financial protection in this edition of the CFG Update). The recently launched CFPB has been clear that one of the agency’s top priorities is to monitor the customer complaints handling process. One of the main parts of the CFPB Supervision and Examination Manual focuses on common elements of an effective consumer compliance management system. Consumer Complaint Response is one of those elements with the following objectivesConsumer Financial Protection Bureau Supervision and Examination Manual, CMR 10, October 2011.:

• Record and categorize consumer complaints and inquiries, regardless of where submitted.
• Promptly address and resolve complaints and inquiries, whether regarding the entity or its third-party service providers.
• Appropriately escalate complaints that raise legal issues involving potential consumer harm from unfair treatment or discrimination, or other regulatory compliance issues.
• Make adjustments to business practices, as appropriate, based on complaint data and individual cases.
• Perform retrospective corrective action as a result of consumer complaints to correct the effects of the supervised entity’s actions, when appropriate.
• Identify where weaknesses in the compliance management system exist, based on the nature or number of substantive complaints from consumers.

Additionally, the CFPB Supervision and Examination Manual highlights the role of complaints in identifying unfair, deceptive, or abusive acts or practices (UDAAPs)http://www.consumerfinance.gov/guidance/supervision/manual/udaap-narrative.. Under the Dodd-Frank Act, it is unlawful for any provider of consumer financial products or services to engage in unfair, deceptive, or abusive acts or practices Dodd-Frank Wall Street Reform and Consumer Protection Act, Section 1036(a)(1)(B), 12 U.S.C. Section 5536(a)(1)(B).; and the CFPB views complaints as possible evidence of UDAAPs. In fact, the CFPB indicates that even a single substantive complaint may raise serious concerns that would warrant further review. 

When reviewing complaints against an institution, the CFPB will also consider complaints lodged against subsidiaries, affiliates, and third parties regarding the products and services offered through the institution or using the institution’s name. In particular, the CFPB will examine whether an institution receives, monitors, and responds to complaints filed against subsidiaries, affiliates, and third parties.

As the CFPB continues to develop its operating model, companies seeking best practices in the regulatory space can look to countries that already have imposed tighter regulations on consumer finance institutions. For example, the Financial Services Authority, the leading regulator in the United Kingdom, requires financial institutions to adhere to a strictly mandated Treating Customers Fairly principles-based regulation, which identifies six desired outcomes for consumers“Treating customers fairly – towards fair outcomes for consumers,” Financial Services Authority, July 2006.

Particularly important to complaint handling is Outcome 6, “Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim, or make a complaint.” Companies seeking to adopt this mentality and streamline the complaint process for the consumer come to understand that these barriers can take many forms, such as tight time limits, long notice periods, onerous information demands, difficulties in communicating, or even administrative delays.

Organizations that are looking to achieve a differentiated customer experience through effective complaint handling should consider incorporating the following into their complaints handling process:

Build a solid foundation of resources for complaint resolution – Start by educating employees about complaint handling policies and procedures and creating a policy to satisfy unhappy customers quickly. Create a feedback loop for complaint follow-up, and communicate the findings across the organization. Begin to anticipate complaints and create effective channels to respond in a timely manner.

Develop a new complaint-handling culture in the organization – Successful companies reap the benefits of effective complaint handling by making sure customers know their feedback is welcome. Companies can accomplish this by maintaining a strong culture of welcoming complaints and requiring that all employees understand how and why complaints can be positives. In addition, remove obstacles that prevent customers from complaining and then thank customers for lodging complaints.

Seize opportunities presented by customer complaints – Leading companies document all customer complaints and leverage feedback from multiple points of contact to identify dissatisfaction issues. By following this practice, companies can transform customer complaints into process improvements by understanding the wants and needs of their customers and learning how to prevent dissatisfaction.

Transform customer vigilantes into company advocates – Once disgruntled customers have been identified leading companies proactively connect with them to address their problems and try to win back their loyalty or, at a minimum, defuse the customers’ negative opinions and potential actions. Leading companies also track and prioritize clusters of similar complaints because they could indicate a problem that could affect multiple customers, and the company on a much larger scale. By making the effort to understand the root cause of incidents involving vengeful or angry customers, companies may reduce or eliminate the problem causing the customer dissatisfaction; this may protect them from future costly customer compensation and damage to their reputations.

Be empathetic to unhappy customers – To help customer service representatives interact with customers appropriately, and with an awareness of customer feelings, study the most likely and common complaint issues. Provide employees with training to help them understand what triggers dissatisfaction. Companies should also seek to recognize when apologies or explanations about the cause of a problem are not sufficient to satisfy a complaining customer. For example, when a customer has suffered a monetary loss, learning the reasons behind the loss and that the company regrets the problem may not be sufficient to retain the customer. Such circumstances may call for compensation.

Anticipate and prepare for new regulatory pressures – As regulations continue to evolve for the consumer finance industry, consider creating a single complaint team approach that increases transparency to external regulators and improves accountability within the organization. In addition, using a common workflow tool to receive, track, monitor, and resolve complaints across all product lines may help to easily identify trends and switch focus as regulations become defined. Finally, creating a single resource for policies and procedures and determining that it accurately reflects current operations across all communication channels with customers will provide a common starting point when new regulations are issued.

Set the tone from the top – Consider using complaint handling as a way for executives and business leaders to engage with the customer. Several leading organizations have done this and achieved considerable success. Not only does this provide business leaders a sense of how their business is perceived through their customer’s eyes, but it can also indicate that there is appropriate organizational focus on fixing the problem. Customers themselves are often surprised and indeed delighted that senior leaders are taking their feedback so seriously. Obviously this type of process needs to be carefully structured and supported by the complaints team. However, if done in the right way, how can any business leader who claims to be passionate about the customer, object to dealing with one complaint a month? Rolled out across the full leadership team, this can act as a significant catalyst for cultural change and really help to put the customer “at the heart of the business.”

As the consumer finance industry continues to work through the issues that have led to recent negative customer experiences, companies can utilize the associated customer complaints as a starting point to address and improve the customer experience. These complaints also provide a unique insight into where process improvements may be made in operations, potentially resulting in increases in customer satisfaction and the identification of customer-friendly cost reductions.

Companies that can deliver a better customer experience during this difficult time for the industry, particularly through utilizing customer complaints to competitive advantage, may be poised to attract new business as the economy recovers. Leading companies in other industries have demonstrated how it is possible to build profitable business models while also significantly exceeding customers’ expectations. It is time for the consumer finance industry to embrace this approach.

Since early 2006, mortgage banks have seen operational costs grow as result of the need to respond to increased regulation. In addition unprecedented delinquency and default volumes have increased expenses in these areas and seen holding costs and advances rise. Even organizations that are benefiting from an increase in refinance activity are starting to consider taking steps to reduce expenses to make sure that they are fit for the future and ready to capitalize on the new normal once it emerges.

For many the immediate instinct will be to adopt a slash and burn approach to operating budgets. While this approach may deliver results in the short term, it will normally end up being divisive and can ultimately cause lasting damage to the business. There is however another way—more proactive organizations are addressing the cost burden with a more positive outlook, one based on really transforming their business model and strategy—through strategic cost management.

Establishing this type of cost management program that focuses on aligning resources with corporate strategy will enable an organization to not only reduce its costs, but also to keep its expenditures down over the long run.
By following six principles of strategic cost management, organizations can develop a unique strategic advantage and position themselves ahead of the curve as the economy eventually returns to normal.

Clearly set out the context for managing costs

In our experience, the most successful and dramatic cost reductions aren’t those that are simply initiated during troubled economic times. They occur when there is a belief across the executive group that the organization truly needs to change to succeed in the marketplace. Each member of the group needs to understand that unless they transform the cost base, the consequences could be unpalatable.

In practice this means finding time to look at the business from a higher level. First of all the context within which costs need to be reduced must be clearly set out in terms of your strategy. The best way to think about costs is to clearly articulate the strategy, and the capabilities that support it, and use this as the basis for driving decision making during the cost management program. The cost management program then becomes a matter of deciding which capabilities to invest in and at what level, with a preference for investing in those that will help you win in the market place. For example, the key strategy for many mortgage banks at the moment is to focus on loss mitigation until there is a real market recovery beyond refinance. This will require investment in the capabilities related to the development of loss mitigation strategies and REO execution which could be funded by addressing the underlying quality issues and inefficiencies in origination and servicing activities that grew during the boom years. By thinking about cost in this way the organization will be able to deliver transformation cost reductions that represent less risk to the business and minimize the chance of costs creeping back in.

Being clear about strategy and the capabilities that support it is not in itself enough to create traction for the program. Time needs to be invested in building a credible burning platform for action across the business.
A climate needs to be developed where the process isn’t seen as expense reduction as usual—it must create a clear imperative for change and a cost reduction story that highlights the necessity of change. Ultimately it is important to develop a picture of what will happen to the organization if cost isn’t addressed effectively, and linking this picture clearly back to the impact it will have on the organization’s longer term strategy and objectives.

Create a robust and living baseline

One of the key factors for success in cost management programs is the development of a single version of the truth. Once this has been established, the “I don’t agree with the numbers issue” is eliminated, and you can really focus on costs. To be successful, the development of the baseline should be viewed not simply as an exercise in putting numbers on a spreadsheet. It should be about creating a clear transparent view of the cost landscape across the organization, one that defines cost from a number of angles and helps managers understand the drivers of those costs.

Making this work in practice means that the control and validation of costs needs to be a budget holder responsibility, with support in doing so coming from the Central program team—it is far more difficult to argue with the numbers when you have had input into developing and checking them.
A common mistake is to wait until a complete set of data is available which can take 4-5 months to achieve. In practice it is better to get started on the numbers early and firm them up as you go than to delay decision making until a complete set of numbers that everyone agrees on is available.

Look at the system as a whole

To keep the focus on targeted goals and to avoid a narrow focus on across the board cost reductions it is best to adopt a broad based search for opportunities. Firstly, a combined top-down and bottom-up approach to opportunity identification will help ensure that no stone is left unturned. This should be supported by an analysis of vertical accountabilities in business unit and functional areas like origination and servicing as well as in central functions. Horizontal themes like procurement, facilities, organization design, travel policy and technology rationalization should also be considered—this will ensure that broader cross organization opportunities are not missed. Finally, companies should consider specific mortgage banking value opportunities like reduced acquisition costs, value management of third party channels, white labelling, insurance, escrow analysis improvement, corporate advance recovery and customer/channel profitability analysis. It is also worth considering re-investment of some savings to increase/ improve overall value. For example efficiency savings made in collections could be re-invested more effectively in a targeted way to further reduce loan losses—in this case every dollar re-invested wisely will normally produce several dollars worth of return.

Looking at cost using this multi-lens approach will increase the scale of potential benefits and provide an exhaustive view of all the opportunities on offer. Requiring that the assessment, selection and prioritization of these opportunities is linked back to strategic priorities will result in an accelerated definition of and movement to a transformed future organization.

Eliminate ambiguity about “what” costs will be addressed and “how”

One of the biggest problems experienced by those implementing a cost management campaign is uncertainty. The first thing that individuals in an organization think when they hear that a new cost management campaign has been initiated is how it will affect them personally. The Executive team and program leaders need to use clear and regular communication to reduce uncertainty and help to build consensus. It is this type of communication that will create the drum beat of success required to sustain the program in the long term.

By eliminating uncertainty, the organization can improve morale. When people see the organization start to move in a positive direction, they will think about how they can make it better rather than focusing on their own interests. In organizations where this aspect has been managed carefully, we have actually seen staff engagement scores increase despite the challenging circumstances.

Create breathing space

A key determinant of success on cost reduction programs is the ability to create the belief across the organization that goals can actually be achieved. To catalyse belief early on, you need to engineer and demonstrate some early measurable successes through the implementation of quick win opportunities. These might include vacancy elimination, increasing the governance process to sign-off any recruitment, a review of sub-contract spend (e.g. REO broker and other 3rd party vendor fees), procurement efficiencies and the elimination of under spent budgets.

These quick wins, which in general can be implemented with limited organizational effort, create breathing space in the program. Without early runs on the board a sense of panic can set into the program that can result in pressure to introduce arbitrary cost cutting to get back on track. The result of this air being sucked out of the program can ultimately cause long term damage to the organization.

Quick wins help avoid this issue by creating the in year benefit necessary to allow full and proper consideration of the more complex longer term/strategic opportunities that will provide lasting benefit and strategic advantage

Embed a cost-conscious culture

Many organizations feel a sense of déjà-vu when they approach cost management. It’s not unusual to hear Executives saying “didn’t we take these costs out 2 years ago?” There’s a good reason for why this happens. It is normally the result of a failure to focus on three key factors that support a cost-conscious culture: clear direction, improving business management techniques and focus on behavioral change.

Three factors critical to the development of a cost-conscious culture

We have already highlighted the importance of clear direction from senior management at the start of the cost management program. This direction must be re-enforced and re-iterated by senior management not just throughout the life of the formal program but become part of ongoing communication during day-to-day operations. Consistency in this communication will also be important—the wider business must see that cost performance is a collective issue and priority of the entire Executive team to ensure that it starts to permeate the bedrock of the organization.

Communication of cost management priorities and issues is sufficient but not enough to ensure that cost becomes an area of day-to-day focus for everyone. Success will be influenced by the degree to which strategic cost goals in the short term and continuous improvement targets in the long term can be made explicit at Executive, business unit and functional levels. These should not just be one off targets but an integral part of the organization’s objectives on a yearly basis.

In our experience tighter business management in terms of cost is normally the result of a focus on three principles. Firstly, to ensure that the cost tide does not start to creep in again, organizations need to continue to evaluate costs from a strategic perspective as a regular part of the business planning and review cycle. The environment is constantly changing and so as a result are business objectives—even as the good times start coming back in and there’s less pressure it is important to maintain a sense of urgency that cost is still an important issue to address. The second area that will help tighten the system is to incorporate the benefits achieved into the budget. Often we see organization’s defining next year’s budget based on the financial out turn of this year and while this may move the overall cost curve in the right direction it ignores the full impact of initiatives delivered later in the year and may be distorted by one offs. Focusing budgeting on the underlying costs going into next year is a better indicator of what will be with no further effort.

Thirdly, unless there is a feeling amongst cost managers that there will be meaningful consequences for failure to comply with and deliver on cost management disciplines and objectives, there will little incentive for them to make it a priority—especially in the early days of the development. To make it clear that things are going to be different going forward there needs to be meaningful and escalating measures for failures to comply with the cost management disciplines and practices and recognition/reward for those who embrace it.

Behavioral change is the final component in the cost conscious culture and the factor which has the greatest impact on the development of cost awareness as a strategic asset. In the cost conscious organization managers need to have absolute clarity about their responsibility for cost control. For many this will represent a significant change in focus and will require them to develop new skills that take them outside their comfort zone—for some organizations this will mean investing in the financial management capabilities of their managers and in training them in areas like Lean thinking and business process re-engineering. It is therefore important to address the skill development requirements that will support them in the delivery of ongoing reductions and continuous improvement. Any skill development program should also recognize that it is not just about cost—it should be about developing managers and staff to understand the value as well as the cost of what they do.

To fully square the circle and align strategic cost objectives with behavior on the ground you need to link these objectives with performance management. Managers and staff must see a positive link between good cost management performance and their own performance assessment and believe that doing well in this area will improve their career progression prospects. These 3 components of the cost conscious culture should not be left until the initial cost management program has been delivered. They should not be a seen as a bolt on but as part of the program itself.

Summary

At first glance putting in place these six critical elements may seem logical and simple. However, establishing these elements successfully needs very careful planning and orchestration. Also don’t forget that the emphasis on any single element and the blend between elements needs to be specific to your own challenges and level of cost management maturity. The focus throughout should not be just on meeting the initial cost reduction imperative—it must also focus on making cost management a core characteristic of how the business is run in the future. 

By approaching the cost issue in this way, by highlighting that it is about repositioning your organization for the future, organizations can help make the pain of cost reduction a bit more palatable. This can have a significant impact on the people involved and give them confidence that this exercise is different than the others they’ve seen in the past. By putting cost management at the heart of the company, a typical short-term cost initiative can be transformed into real change. It can put an organization on a more solid footing for the future and position it at the head of the pack as the economy recovers.

It’s not just enrolment levels that are rising - during the 10 year period from 2001-02 to 2011-12, the average annual percentage increases in inflation-adjusted tuition and fee prices rose 2.4% for private non-profit four-year schools and 4.1% for public four-year schools.

Despite the increase in student loan demand caused by these two factors, many of the larger lenders withdrew from the market place during 2010 when Congress passed the Student Aid and Fiscal Responsibility Act (July 10, 2010), placing all new government educational loans under the Federal Direct Loan Program, thus eliminating the role of private lenders in providing federally backed education loans to students. While private education loans, which do not involve subsidies, grew from $5.1 billion to $22.1 billion from 2000-01 to 2007-08, since those years, student loan volume from banks, credit unions and other private lenders has declined to $6 billion in 2010-11. (Source: College Board - Trends in Student Aid 2011)

Increased volume and competition

However, as the college population continues to increase and the costs of education rise, credit unions and community banks have seen an opportunity to grow their presence in this space.

• 3Q 2011 data from Callahan & Associates FirstLook report indicates that 6,215 credit unions are reporting slightly more than $1.25 billion in outstanding student loans (balances have increased $298 million since 1Q,2011, an annual growth rate of 58.0%). 
• Private student loan volume is growing more rapidly than federal student loan volume; 25% per year versus 8% per year, according to FinAid.org. If that trend continues, annual private education loan volume will surpass federal student loan volume by 2025. 

Clearly, private student lending provides these institutions with the opportunity to develop relationships with a new and important customer demographic; the millennial consumer, those born between 1982 and 2000. 

Rising debt burdens and default rates 
But despite these impressive enrollment and loan growth figures, risks are increasing in the student lending space. Many are alarmed at the rising debt burden on students and their parents. Data collected by CollegeBoard indicates that in each year from 1999–2000 to 2008-09, 52% to 55% of public college bachelor’s degree recipients graduated with student loan debt and 63% to 66% of private nonprofit bachelor’s degree recipients graduated with student loan debt. Loans made to parents under the government PLUS program increased from 483,000 in 2000-01 to 884,000 in 2010-11. Last year, outstanding education debt surpassed credit-card debt for the first time, according FinAid.org and an estimated $1 trillion in total student loans is outstanding. Recent college graduates carry an average debt load of $25,250 each, up 5% from the previous year, in a job in a market with an unemployment rate of 9 percent for 25 to 34-year-olds.

Mortgage lenders are facing numerous business challenges that require a renewed focus on origination quality. These challenges include increased regulatory focus, increased investor expectations, pressure caused by investors demanding repurchase of loans not meeting the required guidelines, and customers demanding a better overall experience from their lenders. In short, the need to assess the effectiveness of your quality assurance (QA) program has never been more pressing. A strong quality assurance program can be a competitive advantage for a mortgage company and leading organizations have come to view their quality assurance programs as a strategic asset rather than a cost burden.

Lenders have traditionally reviewed loan quality post-closing through quality control departments that re-underwrite sample selections of loans. However, leading industry practices are now compelling lenders to bolster pre-closing quality assurance reviews and make corrections early in the process to mitigate regulatory and repurchase risks. In the current environment, regulators are looking to see that quality assurance programs are risk based, include real time checks where appropriate, in which loan defects are not only reported, but also used to correct loan deficiencies if identified prior to closing, and findings receive the required attention from management.

At the same time, primary investors in mortgage loans are implementing their own, more stringent, guidelines to enhance the quality of loans purchased. The government sponsored entities (GSEs) have recently launched efforts focused on loan quality that incorporate policy updates to require more loan data, additional validations, and a series of new quality control measures throughout the delivery process.

This type of initiative has been aided by the Federal Housing Finance Agency (FHFA), which has, concurrently with the GSEs, facilitated the implementation of the Uniform Mortgage Data Program for establishing a standardized approach to data collection. By insisting on the adoption of these new standards, the FHFA is ensuring that the GSEs promote more accurate loan data and reduce the delivery of ineligible loans by placing more responsibility on originators to provide accurate loan data early in the loan origination process.

All of these factors mean that lenders are placing the role and performance of QA departments under far greater scrutiny than in the past. Based on discussions with our clients in the industry as well as recent engagement experience, we have identified a number of recurring challenges that need to be addressed in improving QA performance. These include:

• The underlying policies and procedures are not focused on “doing it right the first time” and are designed with basic controls to speed up the loan processing rather than the more substantial controls required to prioritize accuracy.
• QA metrics often contain a significant time lag which prevents timely remediation and results in the types of major defect that create unnecessary loan repurchase risks that in turn perpetuate a reactive rather than preventative cycle.
• Metrics and reporting from interrelated quality functions are often not linked or aligned to specific business processes, making underlying control weaknesses difficult to identify.
• QA reports are often produced and circulated with no clear response procedures to address the defect trends displayed.
• Loan defect impacts are not properly quantified to understand the potential repurchase liabilities. This means that there is no cost-benefit analysis around whether a loan should be prevented from closing during the QA process if a particular defect is discovered.
• An embedded culture of “getting it mostly right” with the QA function is seen as a built-in safety net to catch defects.
• Contractual obligations such as representations and warranties are not fully aligned with QC or QA initiatives.

The combined impact of these weaknesses results in a reactive culture in which spikes in particular defects are addressed on an ad hoc basis with little consideration to the underlying weakness in a process, control, system, or individual. As such, the quality assurance function fails in its primary objective, which is to provide a sustained increase in loan quality over time.

Based on engagement experience, PwC has developed the Quality Assurance Management Review Framework (shown below) to achieve greater quality in loan delivery into the secondary market, and ultimately a lower defect and repurchase rate.

Quality assurance management review framework

The framework is defined around the key characteristics that a successful QA department needs to display:

• Thorough documentation of processes and controls, including related inputs and outputs, systems, and performance measures. This provides a reference for employees to address day-to-day queries, a basis for developing training, and accountability where defects are discovered and the “correct,” documented procedures have not been followed.
• Clearly defined roles, responsibilities, and escalation procedures within the governance framework. This provides clear visibility around who is responsible for identifying, reporting, and remediating defects, as well as who is responsible for preventing a loan from closing if particular defects are discovered.
• An active governance process that oversees activities and requires cross-functional communication. This is particularly important where organization structures mean that departments responsible for loan quality are not ultimately the responsibility of one individual.
• Training programs to keep employees informed about changing requirements and expectations. This applies both to the QA functions and the other departments contributing to loan quality, such as sales, underwriting, processing, and closing.
• Standardized quality control processes across departments and product types that have required documentation and control points and include testing programs that are embedded within operations and are focused on specific areas of risk.
• Reporting and tracking of key metrics such as overall defect and defective rates, criticality of defects, department responsible, individual responsible, and other regulator-specific metrics. Although there is often an unavoidable delay in the production of such metrics, particularly where external providers are used, the more timely the metrics are produced, the more effectively the root cause of defects can be addressed.
• Reporting customer quality scorecards as a method to align quality activities with representations and warranties.

By focusing on the development of these characteristics, a culture that focuses on getting things right the first time can be developed. It will also help focus on “closing the loop” on recurring defects by tracing them to their root cause and identifying the relevant control that needs to improved or the individual responsible. In some cases, organizations are taking this a step further by linking employee compensation to both individual and overall defect rates — an incentive for a culture of quality lending practices.

Obviously, making improvements will carry costs. But many of these costs are predominantly one-off in nature, such as writing a training program or redesigning reporting metrics. After the changes have been implemented, the new steps in the QA process will become part of business as usual with minimal impact on run-rate costs. In addition, a more successful QA function may lead to substantial longer-term savings in the form of reduced loan repurchases and less time spent in remediating defects after a loan has closed.

One area that regulators have been studying with particular focus in all QA departments is the detection and escalation of potentially fraudulent loan applications. While this has always been a focus for lenders, it is especially relevant in the current economic and regulatory environment. The implementation of the above Quality Assurance Management Review Framework may have a positive impact on fraud prevention and detection as a result of increased employee awareness and more robust controls.

However, there are a number of additional measures that regulators either demand or encourage to combat fraud. These include specific fraud-related guidance and training for employees. They also include separately documented and applied emergency escalation procedures for loan cases suspected of fraud to establish that the appropriate levels of management are informed in a timely fashion, and the appropriate external authorities contacted where appropriate.

Finally, as with all lending functions, consideration should be given throughout the QA process to the impact on the end customer. Lenders that make the suggested improvements may help to decrease their overall defect rate over time, thereby reducing the number of loans that are delayed from closing because of missing or incorrect information. In addition, they may achieve greater consistency in deciding which loans to delay because of potential fraud and encounter fewer instances where the customer has to be contacted and required to provide further information.

Introduction

Foreclosure timeline guidelines have been present within the Fannie Mae and Freddie Mac (collectively “the Agencies”) Servicing and Seller/Servicer Guides for years. Despite the existence of these guidelines, historically there has been limited enforcement activity for breaches, presumably due to the considerable complexity of unwinding chronologies and determining which periods of delay were servicer controllable and therefore appropriate for penalty assessment. However, with the significant increase in foreclosures in recent years this position has changed. Announcements released in 2010FNMA released SVC-2010-12 Foreclosure Time Frames and Compensatory Fees for Breach of Servicing Obligations on August 31, 2010 and FHLMC released seller-servicer guide Section 66.33: Foreclosure time line performance assessment on November 1, 2010 reflected a change in direction and set the stage for recurring assessment of fees related to the servicers’ inability to complete foreclosure actions within the timeframe guidelines. The calculation of these assessments was clarified within further announcements (including those related to the Servicing Alignment Initiative) and is a factor of the unpaid principal balance and pass-through rate on the underlying loan:

Assessment of fees to large and mid-sized servicers began in mid-2011 based on foreclosure time lapses in excess of the published guidelines. The assessment process has included a rebuttal period, where the servicer is given the opportunity to provide supporting documentation for delays, which they feel were beyond their control and therefore should not have been considered in the calculation of the initial fee. Guidance allowing up to thirty days for the rebuttal response to be prepared and submitted was defined, at which point documentation is reviewed before communicating the ultimate assessment to the servicer. Based upon discussions held with servicers, there continues to be a considerable level of dispute related to fee assessments that is requiring further negotiation even after conclusion of the rebuttal process.

In addition, as a result of conceptual questions about the assessment methodology and requests for relief from operational challenges related to the rebuttal process, the Mortgage Bankers Association (“MBA”) became the formal negotiating body for the mortgage servicing industry for this issue. In the fourth quarter of 2011, a number of discussions were held between the Federal Housing Finance Authority (“FHFA”) and MBA related to servicer queries including, but not limited to, the appropriateness of the assessment formula, the level of documentation required to complete a successful rebuttal, and the rebuttal timeframe. While discussions are expected to continue into 2012, the FHFA’s formal response letter issued on January 31, 2012 largely supported the existing activities and guidelines.

Coming storm

Despite the announcement and initiation of billing activities, operational impacts resulting from foreclosure compensatory assessments were relatively limited in 2011. We do not expect this to be the case as the industry transitions into 2012. The largest expected catalyst for foreclosure compensatory activity is potential increases in foreclosure processing in the wake of the Mortgage Servicing Settlement. Assessments are issued on completed foreclosure actions so, despite significant backlogs; activity was relatively muted in 2011 as there was limited foreclosure sale activity. As the industry continues to work through the current foreclosure pipeline, a significant volume of foreclosures will be executed with complex chronologies impacted by judicial moratoriums, counseling and arbitration requirements, and affidavit remediation activities. As such, it is expected that in 2012 and 2013 servicers will have to increase the level of focus and sophistication of their rebuttal processes to ensure that a clear supportable chronology is produced. These improvements in the rebuttal process likely will help mitigate assessment actions in cases of events beyond the servicers’ control.

Further challenging servicers is the fact that the Agencies are clearly increasing their level of sophistication in the assessment process. Most notably, both have now transitioned to a recurring monthly billing cycle from somewhat less structured assessment activities in 2011. This cycle-based process suggests closer and stronger management of foreclosure timelines by the Agencies. In summary, the expectation is for larger and more encompassing assessments prospectively.

Finally, the potential exists for penalties on private loan sales or securitization activities which are not currently being widely assessed. Pooling and Servicing Agreements (“PSAs”) do not typically reflect the same level of detail on foreclosure timeframes as Agency guidelines and also do not dictate an explicit penalty for servicer non-performance. However, the proposed Countrywide RMBS Settlementhttp://www.cwrmbssettlement.com/docs/Exh%20B.pdf, pg 22-24 defined a framework for assessment of servicer penalties for breaches of foreclosure timelines within private deals covered by the settlement. At this point, it is uncertain how the disposition of this potential exposure will progress on a broader spectrum of private deals.

Servicer areas of focus

Given the evolution of this topic and potential catalyst events discussed above, servicers should consider opportunities to incorporate timeline management and monitoring into overall governance of the foreclosure process to meet evolving expectations of regulators, investors, and other incented parties. Enhancements made today may limit financial exposure and operational disruptions related to compensatory fee assessments in the future. Appropriate consideration and upper management involvement are critical in making required strategic investments to best position the organization to respond to elevated assessment volumes. Specifically, examples of these areas of focus include:

1. Improving Foreclosure Processing Timeliness – While the requirement to research and review chronologies is operationally onerous, it also provides a unique opportunity for servicers to develop and apply lessons learned from previous operational lapses. Servicers should track the root cause of fee assessments and implement operational improvements to help prevent future recurrence with a goal of limiting future billings and improving foreclosure processes. Examples of areas of focus include the use of process stop coding and maintaining regular analyst communication with foreclosure attorneys.
2. Accuracy of Delinquency Status Reporting – Announcements and releases have disclosed that the primary mitigation available for foreclosure compensatory assessments will be uncontrollable status coding reported during the monthly delinquency reporting process. Therefore, in order to obtain full credit for the uncontrollable delays experienced, servicers should ensure that their servicing system is updated timely and that the reporting to the Agencies accurately interprets servicing system coding. Historically, this has not been an area of tremendous focus within the servicing industry; however, coding accuracy will help reduce assessments and strengthen the servicer’s negotiating position on assessments received.
3. Operational Implications of Responding – In consideration of expected increases in volumes, servicers should be actively considering their operational ability to issue rebuttal responses within the thirty day timeframe guidance. Specifically, consideration should be given to MIS solutions, resource allocations, capacity planning, and formal protocols for developing rebuttal responses. Executing on these operational considerations will be critical in limiting financial exposures and maximizing negotiation success.
4. Proactive Support Collection – In many instances, the required rebuttal support will not be obtainable from the servicer or the servicer resources. In these instances, consideration should be given to proactively collecting the required documentation upon foreclosure sale as opposed to waiting for an assessment to be received and starting the response timeframe. A notable example of this is attorney chronologies and a potential solution of requiring attorneys to post chronologies on all loans upon foreclosure sale execution.
5. Financial Reporting Estimation and Exposure Calculation – The measurement of foreclosure compensatory assessments is a complex consideration which requires the development of a formalized framework to periodically produce well-controlled, consistent, and reliable estimations for use in financial filings and management reporting materials. A number of large consumer finance organizations disclosed that they recorded costs related to foreclosure assessments in their 2011 financial results. Based upon publically available 10K disclosures and management call transcripts, it appears that many of these amounts included costs recorded for incurred foreclosure compensatory assessments which had not yet been billed. Further, there is a need for various management reporting calculation scenarios to inform executive level resources of potential short- and long-term exposure levels for financial planning.

Conclusion

The topic of foreclosure compensatory assessments was not immediately significant to the servicing industry due to limited foreclosure sale activity and a period where the Agencies developed their tools and processes. It is anticipated that as foreclosure sale volumes increase in 2012 and 2013 the topic will be of increased significance from both an operational and financial perspective. Developing scalable infrastructure and reporting will be critical considerations in managing and responding to increased billing activities as well as helping to mitigate and understand exposure in this area.

Although the growth of real estate owned (REO) inventory has subsided over the last 12 to 16 months, the number and severity of challenges facing REO servicers have not. The end products of a lagging residential real estate market are increases in servicing and disposition costs, fraud risk, and regulatory scrutiny. To defend against these challenges, organizations should consider using this period of reduced volume as an opportunity to further refine their control infrastructures, develop mature and intuitive reporting and analytical tools, and evaluate their current framework against their goals.

Specifically, organizations should look to improve their property and initial “go to market” valuation processes, develop robust controls and analytics for fraud detection, and take a fresh look at disposition strategies and processes. In addition, organizations should review their current operations against guidance contained in the Office of the Comptroller of the Currency (OCC) 2011-49 bulletin. Leveraging capacity resulting from today’s reduced REO inventory levels to properly develop these key competencies can better prepare organizations for the challenges that lie ahead.

Property valuation

The continued downward trend in home prices, coupled with the increase in distressed real estate transactions, has caused considerable difficulty around the processes for establishing a fair market value and, subsequently, a “go to market” strategy for REO properties. However, the answer is not necessarily purchasing more valuations. Organizations with REO portfolios need to weigh the financial risks and exposure associated with each property and develop valuation frameworks to handle applying the appropriate time and resources to specific transactions to maximize recoveries. For example, servicers should focus more time and resources on properties where extra repair and valuation costs will help yield a higher return. On the same token, however, lower-yielding properties where reputational or legal risk exposure may be high also have to be weighed.

Consistent with improving property valuation resources, servicers can consider taking a “greener” approach to their valuations data by developing in-house models that capture valuation processes as well as origination and back-end transaction data. Organizations should consider aggregating origination appraisals, REO appraisals, BPO, and comparable property data in a central location that’s accessible to desk reviewers.

Utilizing existing “in-house” valuations data may serve to do more than save a few bucks on valuation product ordering; there is an opportunity to benchmark performance on active listings and sales. This performance analysis can help identify patterns such as quality issues with valuation products, potential third-party vendor due diligence and execution errors, and interim or outsourced asset management practices.

Fraud identification and prevention

Recent industry pressures and crises have taken a toll on the capacity of many organizations’ quality and risk programs. They have now become more vulnerable to various types of fraud. Fraud risk is an area of focus in the industry as a result of the shrinking buyer pool, reduced home values, and the increase in defaulted properties as a portion of total properties on the market. REO fraud risk can occur along several key points of the REO servicing process. For example, collusion between realtors, valuation vendors and internal staff (or any combination of at least two of these parties) can result in equity stripping or “flopping” (where someone else subsequent to your organization sells the property at a large gain with little or no changes to the property in a very short period of time. This risk can also manifest itself by one of these parties acting alone. Realtors, for example, can misrepresent value opinions (i.e., BPOs) to list the property below market value, resulting in potentially a quick-sale (obtain commission faster) or sell to an outside party at a significant discount for a kickback. Additionally, realtors can potentially conceal offers from buyers represented by other realtors in order to obtain a higher percentage of the commission.

The organization may mitigate REO-related fraud risk by strengthening key controls in the REO servicing process and investing in REO risk-mitigating data tools. Organizations should perform detailed background checks prior to on boarding vendors, including real estate agents listing properties. In addition, detailed reporting to track potential fraud triggers such as identifying parties involved (i.e., internal asset manager, valuation provider and realtor) when properties are quickly resold after the REO disposition (may indicate potential fraud if a trend appears over time). Another example of intuitive reporting acting as a control over fraud would be to track trends as to how quickly properties are sold as well as what agents are represented on each side of the transaction. These reviews are designed to help the organization identify questionable transactions and assess which parties potentially could be acting in a fraudulent manner.

Additionally, advanced data analytics may strengthen key controls and risk management processes in REO servicing institutions. For example, implementing a post-REO sale back-testing process to analyze activity on specific properties after they have been dispositioned by your organization can help identify potentially fraudulent activity by realtors, internal staff and valuation providers. Institutions can use the analytics to prepare for the expected influx of REO properties and seek greater returns in the liquidation of excess inventory.

OCC Bulletin 2011-49

In December 2011, the OCC issued guidance to banks related to foreclosed properties regarding the obligations and risks for which owners, servicers, and trustees are responsible. Although it may seem that the requirements outlined in this bulletin are fundamental to the ownership and servicing of foreclosure and REO portfolios, now is the time to take a closer look at the effectiveness of these processes.

The bulletin stresses the need for organizations to have safe and sound risk management practices associated with foreclosed properties. As the regulatory focus intensifies on the back end of the mortgage servicing life cycle it is important that servicers prepare for the additional oversight and scrutiny that will be placed on ensuring they have the required infrastructure and resources to effectively manage foreclosure and REO inventories, as well as sufficient controls in place to mitigate the risks with owned properties.

As organizations step back and analyze their current framework for handling REO, they can ask the following questions:

Are our third-party vendor management reporting, controls, and oversight processes not only going to keep vendor performance in check, but also detect fraud or critical errors in a proactive manner?

Are property preservation and eviction processes always operated within the most current federal, state, and local ordinances and guidelines?

Does our capacity management process understand not only when we need additional staff, but also how key performance metrics indicate potential needs/gaps on the caseload expectation side?

Are investor guidelines and rules followed closely and tied back to control reporting for adherence throughout the REO life cycle?

Will our marketing and disposition processes improve net proceeds and identify historical instances where we did not do so to make quick and required adjustments?

REO disposition alternatives

Because of the decrease in real estate prices and recent sales activity, there is a need for creative solutions for disposing of REO and foreclosure properties. Today’s residential real estate market is not providing good returns on distressed property sales. Therefore, it is important that organizations don’t look at disposition simply as a repeatable, simplistic process that is not receptive or flexible to the market. Instead, a more holistic view of strategies for disposition will involve helping to improve recoveries long before properties come to REO.

Target the first strategy: prevention
The most effective way to limit portfolio losses is to prevent properties in your delinquent portfolio from becoming REOs, especially if they’re projected to yield a very low or negative net realizable value (NRV) at the REO stage. NRV comprises the total proceeds from an REO disposition less all costs and unpaid balances.

Early disposition solutions for NRV-negative properties include adjusting your foreclosure bidding process to increase third-party sales or providing more incentives for short sales. In addition, creative disposition strategies such as forgiving principal balances on loans collateralized by properties in low-income neighbourhoods that would cost significantly more to carry as an REO than to sell (or donate) may save your organization money and provide reputational benefits.

In the figure below, there is a visual example of an NRV model run for 5 loans which projects the REO disposition outcome if those subject properties were to be liquidated through the REO process.

Segment REO properties to determine a cost-effective liquidation channel
It’s not possible to prevent all properties from becoming REO. So your strategy should also include a plan to liquidate each REO property through the channel that provides the greatest return based on the condition of the property, location, occupancy status, and other factors.

Properties valued on par with comparables, in good condition, and not in a foreclosure-heavy area may realize the highest returns when sold through a real estate agent. In contrast, a property in an area with numerous foreclosure listings (and with little room to increase its market appeal or value) may see greater returns if sold at auction.

Consider liquidation alternatives
In response to concerns about liquidating properties in a market with depressed prices as well as trying to work with displaced borrowers, regulators are calling for programs that would rent out post-foreclosure-sale properties to displaced borrowers.

REO rental strategies have been conceptual and not widely adopted in the marketplace. As the potential for rental programs mandated by government-sponsored entities or investors gathers more steam, servicers can prepare themselves by gaining a deeper understanding of the concepts and developing tools that can assist their decision making.

While today’s market poses several challenges for REO servicers, it is also an opportune time to either start or continue planning for what lies ahead. Having effective decision tools with quality inputs and assumptions, along with robust capacity planning capabilities are key cornerstones for success. In addition, risk and quality management must be paramount in all parts of the operations and culture to successfully navigate the new market environment. Organizations should focus on ensuring that they strike a healthy balance that allows for rigorous adherence to regulatory requirements, proactive analytics to determine recovery maximization opportunities as well as detecting potential fraud. Focussing on these items can provide a competitive advantage and help deliver a quality operation.