Welcome to the inaugural edition of CFG Update, our Consumer Finance Group’s electronic newsletter. The past few years have without a doubt brought about unprecedented change to the consumer finance industry, and there is more underway as key structural and regulatory elements continue to evolve. In this environment, staying on top of industry risks, issues and opportunities is critical to success.
We will use this regular update to share with you our insights and perspective across consumer finance asset classes, in order to help you identify upcoming challenges and risks you'll want to consider preparing for, as well as highlight market opportunities that may exist. In this edition we bring you our latest thinking on a number of cross-industry topics as well as specific articles relating to the mortgage and student lending industries. In future editions we will share our perspective on auto finance and credit card lending.
Finally, one of our core beliefs is that the winners in the market will be those that think strategically about the emerging environment and adopt a structured and proactive approach. To this end we have developed a survey that aims to help participants understand how peers within the industry are approaching their strategic response to these unprecedented times. Click here for more information about the survey.
We welcome any feedback that you may have on our newsletter and how we can make future editions as relevant and meaningful to you as possible. Please click here to share your feedback or comments.
Principal - 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. 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.
Since early 2006, mortgage banks have seen operational costs grow as result of the need to respond to increased regulation and the impact of unprecedented delinquency and default volumes. For many the immediate instinct has been to adopt a slash and burn approach to operating budgets. 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.
Foreclosure timeline guidelines have been present within the Fannie Mae and Freddie Mac servicing and seller/servicer guides for years. Despite the existence of these guidelines, historically there has been limited enforcement activity for breaches. However, with the significant increase in foreclosures in recent years this position is changing. Given the evolution servicers should be focusing on 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.
We are continuing to see changes in the economy and impacts to the lending environment as medium to long term consequences of the credit crisis play out. The government is pushing forward with new regulation and one area of particular focus is consumer protection. The Consumer Financial Protection Bureau is one of the key ways in which the government is aiming to support fairness to consumers in lending and there are significant implications for all consumer lending organizations.
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 shore up their control infrastructures, develop mature and intuitive reporting and analytics and evaluate their current framework against their goals.
Rising defaults, confused borrowers, allegations of predatory lending practices, increased regulation and the promise of increased government examination - sounds like post-subprime mortgage banking, but these cries are now being heard in the student loan marketplace by lenders, servicers and regulators alike. The student lending market is in a state of transition. Organizations that approach these challenges proactively, by treating them as an opportunity to develop a more solid and long-term strategic advantage, will be the ones that grow market share and profit in this sector over the coming years.
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.:
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.
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.
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.
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.
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.
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.
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
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.
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.
We are continuing to see changes in the economy and impacts to the lending environment as medium to long term consequences of the credit crisis play out. The government is pushing forward with new regulation on a number of fronts and one area of particular focus is consumer protection. The Consumer Financial Protection Bureau (CFPB), mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, is one of the key ways in which the government is aiming to support fairness to consumers in lending for the long term. This article provides an overview of the CFPB, their published expectations of consumer financial lending institutions, their plan to govern those expectations, and what organizations can do to prepare while considering ways to improve the experience of their customers.
The CFPB has been set-up as the advocate of the American consumer with a focus on providing educational resources to consumers for making better financial decisions and putting in place a point of focus for feedback on all financial products and services. Additionally, the CFPB has been mandated to consistently enforce the Federal consumer financial laws, provide an added level of assurance to consumer protection, develop programs to ensure lenders’ compliance, create audit programs, and report on findings from examinations and consumer feedback. This is the point at which the impact to consumer finance companies begins.
The CFPB will supervise both depository and non-depository consumer financial companies and as a result, many organizations who had previously found themselves under a reduced level of regulatory oversight can now expect a significant increase in that oversight and related compliance requirements. Laws such as UDAAP, RESPA, TILA, EFTA, FDCPA, HPA, FCRA, GLBA, ECOA, SAFE, and HMDA1 will help to guide the CFPB as they conduct examinations across financial institutions. They will be seeking to prevent bad behavior (e.g. non-compliance and deceptive acts toward consumers), ensure robust compliance management systems are in place and that financial lending institutions effectively measure and monitor risk. Other CFPB activities include:
The CFPB has been organized by regions – West, Southeast, Midwest and Northeast – operating somewhat independently with an appointed senior regional leader. This means that some of the activities within each region may be prioritized differently based on the needs perceived by regional leadership. However, in the end the goal is the same; protecting the consumer by ensuring compliance with regulations and looking for ways to enhance the customer experience.
The three primary areas companies should consider while they work to understand the goal of the CFPB and how it is likely to impact their operations are:
Unfair, deceptive or abusive acts or practices (UDAAP) – UDAAP is an expansion of the Federal Trade Commission Act’s “UDAP” provisions, adding a new “abusive” standard. Unfair refers to the considerable harm to consumers that is not reasonably avoidable regardless of any benefits presented to the consumer. Deceptive is defined by the Fair Trade Commission as an act or practice considered from the perspective of the customer in which a representation, omission or practice that likely misleads the consumer is material. Abusive is intended to mean that the act or practice materially interferes with the ability of a consumer to understand terms or conditions of a consumer financial product or service and takes advantage of that lack of understanding. It is important to keep in mind that complete and accurate disclosure consistent with legal and regulatory requirements may still raise UDAAP risks. UDAAP risk is still apparent even if the action had no intention of harming the consumer.
Mortgage servicing – Servicing practices are a priority area of the CFPB and the Supervision and Examination Manual that has been created includes a section focused on procedures for this area. These supplemental procedures, highlighting formal internal controls and compliance, generally align with emerging supervisory expectations, many of which have been emphasized in the Interagency Review of Foreclosure Policies and Practices and related Foreclosure Consent Orders (April 2011) and OCC Bulletin 2011-29.
Mortgage origination – The mortgage origination procedures were released January 11, 2012, almost two months after the publication of the Manual. The goal of these origination procedures is 4 fold:
The CFPB’s approach to supervision and examination of consumer financial service providers is outlined in the Supervision and Examination Manual which was issued on October 13, 2011. The Manual contains examination procedures for different substantive and functional areas, including Compliance and Risk Management, UDAAP, Mortgage Servicing, Mortgage Origination and “Payday” Lenders. As mentioned the mortgage origination procedures came out shortly after the initial Manual release, as did the short-term, small-dollar/payday lending procedures (January 19, 2012). In the coming months an additional set of procedures will be released around Private Student Lending as this manual continues to evolve (for more information on potential CFPB impacts in student lending (please see the associated article in this edition of the CFG Update on the challenges facing the Student Lending market).
The Manual includes three sections discussing the purpose, process, activities, instructions, and guides:Part 1: Supervision and examination process
The Manual is intended to be used by both consumer lending organizations and the CFPB examiners. The procedures are generally consistent with the existing Federal Financial Institutions Examination Council compliance examination procedures. However, the CFPB has expressed an intent to overhaul existing procedures, making them product and service-focused, rather than regulation-focused. This represents a key departure from the approach previously taken by regulators. Key differences include the expanded procedures for Compliance Management and UDAAP, which will be applied to all products and services. These new procedures suggest the CFPB will be focusing on the principles of consumer financial protection, which in some cases may extend beyond existing consumer laws.
This means it will be important to take the time to review the manual – organizations must not make the assumption that what they have seen in the past will be the same with the CFPB. It is important to understand the content outlined in part one in order to gain an understanding of the process the CFPB will be executing so that your organization knows what to expect when contacted by them. Part two of the manual details what your organization’s compliance management system/program should include and areas of greater focus. This section will also help you determine which procedures the CFPB will use when they are reviewing your compliance program and provides the details for those procedures giving companies an opportunity to identify gaps in the current operations or practices. Then comes part three which is comprised of the templates and forms that will be used throughout the examination process. The examination procedures are broken up into eight categories covering both enterprise-wide and functional areas helping you understand the potential impact to your business. The diagram below describes the key risk factors and areas of regulatory focus by exam category.
First, be aware of the CFPB’s three main objectives when undertaking an examination in order to understand how to prepare for an examination
The CFPB has developed a detailed process for executing the examination for both depository and non-depository institutions. This is outlined in the table on the following page.
There is a direct focus on consumers and data analysis in this process, focusing on an organization’s ability to detect, prevent, and correct practices that cause harm to consumers. A primary component of the data will be driven by consumer complaints that will include public records from the prudential regulator, from state regulators, from state attorneys general offices and from private or other industry sources.
Additionally, the CFPB has emphasized that a critical element of a sound compliance program is a responsive and effective consumer complaint processes. Accordingly, you should determine that your program has robust consumer complaint handling, response, reporting and analysis processes. Consumer complaints should be used to identify appropriate changes to processes, procedures and products.
For large complex institutions, the CFPB continues to expect programs to meet the guidelines established by the Federal Reserve Board in SR 08-8. You should determine if your Compliance Risk Management program and processes are consistent with the principles established by the Compliance Management section of the CFPB Examination Handbook, Federal Reserve SR 08-8, and Basel Committee’s Compliance and the compliance function in banks.
Knowing the CFPB purpose and goals, reading the manual, identifying the applicable procedures, and understanding the examination process is just the beginning. What you really need to do is prepare your organization to capitalize on the opportunity presented. Set out below is a list of activities that can support your ability to find success in responding to CFPB requirements. Additionally, these activities can be a springboard to your business refocusing to a customer-centric model.
The traditional banking model, structured around internal product groups/silos, is organization-centric. This type of model can prevent you from understanding which products and services your customers have purchased across the enterprise. In this difficult economic environment, lending-product silos are struggling to stay profitable on a standalone basis, and the challenge will only increase. Companies should seek to develop a new, customer-centric model that is integrated around the customer’s needs while meeting the requirements of the CFPB.
To kick off the development of this type of model, and to get ready for CFPB requirements, the following actions should be considered:
Rising defaults, confused borrowers, allegations of predatory lending practices, increased regulation and the promise of increased government scrutiny – sounds like post-subprime mortgage banking, but these cries are now being heard in the student loan marketplace by lenders, servicers and regulators.
Unlike mortgages, instalment loans and auto loans, student loans have continued to grow at a steady rate since the economic crisis of 2007. As the job market has suffered from the recession and unemployment has risen, older workers have joined the traditional student population in seeking college degrees, advanced degrees and technical training. In fact, the National Center for Education Statistics forecasts that enrolments for students under 25 will increase by 9 percent during the period 2010 to 2019, while students over 25 will increase by 23 percent during this same period. These projections continue a trend that saw enrolment of students 25 and over from 2000 to 2009 rise 43 percent, while students under 25 saw an increase of 27 percent during that same period.
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)
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.
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.
With the increase in borrowing one would normally expect the average default rate to decline as the volume of new loans overwhelms past debt, but in fact the opposite is true. The default rate in 2009, the most recent data available, indicates a default rate of 8.8%, which shows a steady increase from 4.6% in 2005. In addition a closer look at the 2009 default rate shows that the default rate for borrowers in public and private schools who fully completed their education is at 5%, while those who complete two or three years is more than twice that rate. However, the figure is even more dramatic for with for-profit colleges, where a February 2011 Department of Education report indicates that a quarter of all federal student loan borrowers at these colleges defaulted on their loans within three years of beginning repayment. The National Association of Consumer Bankruptcy Attorneys (NACBA) issued survey results in February 2012 warning of the effects of rising student debt on recent graduates, parents, and older Americans who have gone back to school for job training. The report stated that the Association found that 81 percent of bankruptcy lawyers said the number of potential clients with student-loan debt has increased “significantly” or “somewhat” in the past three or four years.
This “student-loan debt bomb” as the NACBA named it, is having an effect on other parts of the economy as well. The National Association of Realtors reports that the 25 to 34 age group accounted for 27 percent of all home buyers in 2011 compared to 33 percent in 2001; the 2011 figure was the lowest in the last decade. The same report stated that this age group represented only 37 percent of first time home buyers, the lowest since 2006 when home prices peaked.
A growing regulatory challenge
It is not just default rates that should be a concern for the student lending industry. This sector, which until now has enjoyed the benefit of a comparatively unchallenging set of regulatory requirements, is shortly to be put under the consumer protection microscope. The newly formed Consumer Finance Protection Bureau (CFPB) requested and received information in January 2012 from the student loan market place regarding private student loans (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). This information on the role of schools, underwriting criteria, repayment terms and behaviors, impact on career, loan servicing and modification and default will all be the subject of a report that the CFPB and the Department of Education is due to submit to Congress by July 21, 2012. The information gathered from this report will be used to prioritize its regulatory and education work and will almost certainly result in more stringent consumer protection requirements and stricter oversight.
This is not the only area in which regulation will become more challenging. Just as in other parts of the consumer finance sector, regulators will also put an increased emphasis on making sure that companies within the sector have fully effective third party vendor management protocols in place. With the majority of private and federal loans being serviced by third party servicers, this is likely to be a key area of focus for the CFPB going forward. Furthermore, with the key trigger for investigations into servicing activities likely to be the level of consumer complaints (a key factor in the inception of the consent order), and consumer complaints across the industry having risen partly as a result of increased default rates, it is inevitable that this will become an increasing area of focus (please see the associated article in this edition of the CFG Update on how to rethink your approach to customer complaints). Consequently, the critical importance of having a watertight approach to vendor management cannot be underestimated. This must include having full transparency over the nature of complaints, ways to measure the effectiveness of complaint management processes and root cause resolution to ensure that consumers are treated fairly in the future.
With the historic focus of surveillance on minimal data collection and occasional site visits the development of a more comprehensive surveillance program is necessary. The resulting need to put in place a more progressive program characterized by independent performance assessments, uniform servicing standards and enhanced third-party vendor oversight requirements (that address both organizational governance and operational processes) is likely to be a challenge for many student lending operations.
A market in transition
Amidst all this turmoil the one thing that seems certain is that the student lending market will continue to be in transition for several years to come. In the private market, student loan lenders are following the lead of their mortgage loan counterparts by taking a hard look at all underwriting standards. Lenders will increasingly require co-signers and seek higher FICO scores. This, along with more aggressive competition from federal lending will keep originations in 2012 on par with the levels seen during 2011. As the job market continues to struggle, servicers may continue to see portfolio performance similar to that experienced in recent years. Delinquency is expected to increase from the current 9% range until unemployment returns to pre-recession levels.
Taken together, increased default rates, a competitive origination environment and increased regulation are likely to squeeze margins in this asset class. This may result in increased pressure on student lending businesses to manage their cost base in a very focused way (please see the related article on strategic cost management in this edition of the CFG Update). Approached positively this could represent a real opportunity for some players to position themselves strongly for the long term. Some organizations are expected to take a strategic view of the cost issues that result from the turmoil and use this as the basis of focusing investment in the areas that will enable their student lending business to thrive in the longer terms. Others may choose to exit the market or be acquired.
On the regulatory front, the CFPB will be issuing new guidance to the industry in mid-year which will build in the feedback from interested industry parties that is currently being gathered. Private lenders and servicers should begin now to proactively review this feedback and begin to evaluate their readiness to act on the key issues that it highlights. In particular, attention should be invested in revisiting their policies, procedures and controls to ensure that they are aligned with both the feedback and the initial guidelines set out in the CFPB manual.
The scale of transformation facing the industry is unprecedented and, as during any period of profound change, there will be winners and losers. For many the tendency will be to wait and see how these developments play out. More progressive businesses within the sector will take proactive steps to define what these changes mean for them and how they should position themselves strategically within this fundamentally different new business environment. Organizations that approach these challenges in this way, by treating them as an opportunity to develop a more solid and long-term strategic advantage, may grow market share and profit in this sector over the coming years.
For more information on how to respond to the developments in the Student Lending market please get in touch with our student lending team:
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.
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.
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:
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.
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.
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.
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.
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?
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.