Cognizant Reports

Remaking IT for New U.S. Mortgage Rule Compliance

To benefit from the improved housing market, lenders need to play offense by finding new ways to efficiently comply with regulations, tighten controls over the lending process and better engage with customers.

cognizant reports | March 2014

Executive Summary
The ongoing recovery in the U.S. housing market bodes well for the mortgage industry. Loan origination volume has strengthened, and regulations from the Consumer Financial Protection Bureau (CFPB) are beginning to offer some clarity regarding future loan origination standards and new levels of compliance, control and consistency. The CFPBs new Qualified Mortgage (QM) and Ability to Repay (ATR) rules are not only forcing lenders to improve their level of underwriting accuracy and thoroughness, but they are also motivating them to create processes, infrastructure, technology and a reporting framework to ensure ongoing, repeatable and standardized compliance practices. Despite improved market conditions, the battles continue. Lenders face increasing origination and servicing costs, as well as challenges in maintaining transparency and providing proof of compliance to regulators. As such, the mortgage industry needs solutions that establish greater process control, consistency and transparency, as well as improve the customer experience. A major overhaul of current processes will be an essential step for building a new, compliant processing framework. Lenders need to reconsider the use of underwriters and processors for making assessments and decisions across every step of the process, as reliance on these employees results in subjective and manual decisionmaking. This can hamper the goal of developing a compliant, consistent and cost-effective process model. While deep subject matter expertise is essential for a highly compliant process, such solutions need to be leveraged at the right point in

the process, and at the right time, which can only be achieved if processes are broken down to their most meaningful level and managed by systems with robust and well-defined data models. An appropriately decom- An appropriately posed process allows a multithreaded divide and decomposed conquer framework that process allows enables human resources a multithreaded to focus on simplified and repeatable tasks rather than divide and conquer large, complex decisions. It framework that also enables decision-mak- enables human ing to shift from people to automated systems that can resources to focus readily consume the inputs on simplified and of the process. When pro- repeatable tasks cesses are decomposed and architected appropriately, rather than large, automation can also enable complex decisions. deeper transparency into process data and decisions that address the need to present compliance documentation to regulators and investors. In addition, expanding customer touchpoints to include digital channels in an industry that currently relies heavily on call centers can help providers improve their level of customer engagement and intervention. Rather than just responding to customer needs, lenders need to begin preventing and even predicting needs. By embracing a more proactive framework, lenders can move toward a model in which their top priorities are predicting customer needs and preventing customer issues, and resorting to traditional processes only as a last line of defense.

Increasing Net Cost to Originate

$5,000 $4,000 $3,000 $2,000 $1,000 $0

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Source: Mortgage Bankers Association Figure 1

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Lenders also need to expand the sales lifecycle to reflect the reality that customers are never completely sold until a loan is funded. Customers need to be engaged and managed differently as the process lifecycle unfolds, and not every consumer interacts the same way with people, technology and processes. Recognizing these differences and responding to them will allow lenders to engage with the right customer, at the right time, through the right engagement channel during the process lifecycle. While considering all of these dimensions, lenders need to drive toward a very clear end-state vision and solution that is clearly defined, tightly aligned with strategic goals and designed to enable incremental value as it is implemented and expanded.

companies and enforce federal consumer financial protection laws. While the new mortgage industry regulations have brought some clarity to the origination process, the breadth of the Dodd-Frank regulations has resulted in delayed rule and policy making, as evidenced by the mortgage industrys response (see Figure 2). The uncertainty and delays will require lenders to keep compliance at the top of their agendas. Impending CFPB regulations focus primarily on the ATR/QM rule definitions, as well as servicing standards. These regulations will affect loan originations and default servicing, raising the possibility of ongoing hefty penalties for nonconforming institutions. (see Figure 3, next page). Ability to Repay The most important criterion mandated by the CFPB is the consumers ability to repay the loan (both the principal and interest in its entirety). Therefore, loans must be underwritten with verified financial information based on the following factors: 1. Current income or reasonably expected income, or the assets held by the borrower. 2. Employment. 3. Credit history. 4. The amount of the monthly payment. 5. Loans associated with the property and the monthly payment on those loans. 6. Monthly payments for mortgage-related obligations, such as property taxes and insurance.

Impending CFPB Regulation

The U.S. housing industry is on the rebound. In 2013, new sales increased 29%, while existing home sales rose 9.1% over the previous year.1 As a result, inventory dropped, and home prices increased, spiking 12.4% from August 2012 to July 2013.2 While this is a healthy sign for the mortgage industry, the net cost to originate loans is increasing (see Figure 1, previous page), and the cost of originating purchase loans is projected to increase 19% between 2012 and 2014.3 The mortgage industry also continues to respond to new regulations managed by the CFPB, which was created in 2011 under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The CFPBs mandate is to write rules, supervise

Delay in Implementation of Regulations

Banking Regulations 5 34 4 1

Mortgage Reforms

15

29

Consumer Protection 0 10

30 20

2 1 3 30 40

27 50 60 70

Number of required rule-makings Finalized Missed deadline: proposed Missed deadline: not proposed

Future deadline: proposed

Future deadline: not proposed

Source: Davis Polk, Dodd-Frank Progress Report, October 2013; Cognizant Research Center Figure 2

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7. Additional debt obligations, such as other loans, alimony and child support. 8. Monthly debt-to-income ratio. Some of this information can be verified through reliable third-party sources, such as credit bureaus; however, lenders are ultimately responsible for verifying compliance with these factors. An additional lender requirement calls for the maintenance of compliance records for three years after a loan is originated. The record of actions taken regarding the loan must also be maintained for one year after the loan is discharged. CFPB mandates the documentation of all transactions, including communication with the borrower and the security instrument establishing the lien securing the mortgage loan.4 New Qualified Mortgage Requirements The CFPB also defines qualified mortgages. A loan can be considered a qualified mortgage if it has the following features:

Underwriting is based on the maximum interest rate during the first five years. Is based on verified current or reasonably expected income or assets and current debt obligations, alimony and child support. Monthly debt to income ratio may not exceed 43%.5 QM loans will have safe harbor6 provided they meet the QM and ATR guidelines; non-QM loans will need to meet the ATR guidelines to receive a rebuttable presumption. However, there is considerable concern among lenders regarding the effort it will take to meet borrower safe harbor challenges. The standards to achieve either safe harbor or rebuttable presumption are so numerous and detailed that proving it in the heat of a confrontation is going to be a torturous event, according to Thomas Vartanian, who chairs the financial institutions practice at Dechert LLP.7 Borrowers may challenge whether their loan is a QM, which will result in the lender having to provide documentation supporting QM and ATR guidelines. If the loan is non-QM, the lender will need to maintain supporting underwriting documentation proving the loan is compliant with ATR guidelines. Safe harbor will not apply to lenders that are unable to evidence compliance with applicable QM and ATR guidelines. As a result of these potential safe harbor challenges, it is incumbent upon the lenders to maintain all supporting underwriting documentation. The new provisions are expected to dramatically impact growth in the mortgage market.

Substantially equal periodic payments, subject to interest rate adjustments. Is not a negative amortizing mortgage. Does not defer principal. Does not have a balloon payment, wherein the remaining principal is repaid at the end of the loan period. Does not have excessive fees (those exceeding 3% of the total loan amount on a loan exceeding $100,000). Loan term does not exceed 30 years.

CFPB Fines Assessed in 2012

$70M $60M $50M $40M $30M $20M $10M $0 Bank A Bank B Bank C Total Note: This figure depicts the range of fines assessed to large banks in 2012. $6M $29M $27M $63M

Source: http://mcgladrey.com/pdf/3-steps-to-cfpb-compliance.pdf
Figure 3

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The Impact of QM Regulations

Generally, the factors with the biggest impact on mortgage originations are home prices, mortgage rates and borrower income. But as Figure 4 indicates, the new QM requirements are sure to impact loan origination volume. The biggest expected negative impact (24%) on loan originations is the stringent debt to income (DTI) ratio requirement, which will result in fewer new borrowers able to qualify for a mortgage. Although loan originations will decline, lending risk will also likely decrease by more than 90% (see Figure 5, page 6). Figure 5 also illustrates the incremental and cumulative effect of each new QM requirement on mortgage default risk. The rules are slightly different for small banks and credit unions, of which there are 9,200 in the U.S.8 Even if the loan recipients debt-to-income ratio is greater than 43%, small banks and credit unions can issue loans if they keep the loan in their portfolios. Mortgage origination with a balloon payment is allowed for small banks for a period of two years until the CFPB completes its study on small bank lending. Mortgage origination at 3.5% above the average prime offer rate remains in effect for small banks and credit unions. Compensation to individual loan originator employees is removed when calculating fees and points for loans that comply with the ATR/ QM rules.9 Any violation of these regulations will impact the lender.

Liability for Violations If ATR/QM provisions are violated, the lender must pay the actual damages, up to $4,000 per loan, statutory damages and any associated legal fees. For larger damages related to noncompliance with these provisions, lenders are required to cover the sum of all finance charges and the fees paid by the borrower. This penalty can be overturned only when the lender can prove that noncompliance is immaterial. Even a private right of action10 can be brought, since the law allows private parties to bring a lawsuit even though no such remedy is explicitly provided for.11 This can be done before the end of the three-year period from the date of the violation. Consumers can also assert a violation as a claim in foreclosure whenever it occurs, regardless of the time period. This defense to the foreclosure provision is driving lenders to be overly cautious when applying credit standards because defending a consumer lawsuit can run between $70,000 and $100,000. The claim for enhanced damages would further increase the cost. Since the borrower can claim violations at any point during the lifetime of the loan, the foreclosure timeline could also potentially lengthen. Such factors are creating major challenges for lenders.

Taking the Offensive

For lenders, it is time to step up the management and planning of their lending and compliance processes. An implementation plan, developed by a committee headed by senior executives, creates a hassle-free platform for a compliance

Qualified Mortgage Requirements Heavy Impact

Impact Per Slice

10% Down Payment 5% Down Payment 3% 9% 2% 16% 1% 24% >30-Year Term Low or No Doc Neg Am/Balloon/IO Debt-to-Income Ratio Credit Score

Source: CoreLogic
Figure 4

5%

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platform solution. The plan must focus on develop-ing work streams and setting realistic timelines to finalize impleOrganizations For lenders, it is mentation. must also revise business time to step up practices and update polithe management cies and procedures. Legacy must be upgraded and planning systems or decommissioned, and of their lending new system requirements and compliance must be quickly developed improve underwriting processes. to and compliance measures. Despite ongoing planning across these dimensions, lending organizations still face additional servicing and legal costs. For instance, the cost to service and manage documentation increases the processing cost of loans that qualify for safe har-bor. This can be challenged by consumers if they believe the QM definition is not met.12 Lending companies need a thorough understanding of the QM criteria to properly implement them, and they must strengthen underwriting standards for both qualifying and non-qualifying mortgages. In addition to implementing the requirements, lenders will need to review their compensation structures for loans. Mortgage servicers also need to revamp their exist-ing document handling processes and underlying systems. This is because mortgage servicers fre-quently buy and sell the rights to service a loan, and in the absence of real-time reporting, lenders find it difficult to monitor the

status of loan servicing.13 Additionally, during this transfer, paperwork for items such as loss mitigation is not typically labeled or can be difficult to locate. In many cases, protocols do not exist for handling key documents such as trial modification agreements.

Need for Automation

With new QM and ATR regulations, lending rules are clearer, setting the stage for mortgage market certainty. An overhaul of the current system is overdue, including the creation of a clearly defined framework and automated processes for determining loan repayment abilities. Under the new rules, lenders are not only expected to document compliance, but they are also urged to implement an efficient processes, infrastructure, technology and reporting framework to ensure compliance. The tracking and preservation of documents is also crucial, as new regulations require storage of compliance documentation for three years following loan origination. By introducing a robust automated system, lenders can mitigate noncompliance risks, such as significant legal costs, interruption of loan origination activities and increased scrutiny by regulatory authorities. Since the mortgage industry is highly document-centric, it is extremely critical to ensure accuracy, consistency, transparency, trust and control with respect to regulatory compliance. To ensure proper compliance, lenders need to collect and apply data from documents and traditional sources against structured rules and policies. The associated borrower loan application data would

Qualified Mortgage Requirements Address Default Risk Concerns

Serious Delinquency Impact Per Slice

3% 15% 1% 9% 0% 36%

10% Down Payment 5% Down Payment >30-Year Term Low or No Doc Neg Am/Balloon/IO

28%

Debt-to-Income Ratio Credit Score

Source: CoreLogic
Figure 5

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be processed through a loan origination decision model, which would assess compliance with existing underwriting guidelines. This process could be implemented using the organizations proprietary capabilities or by leveraging outside solutions. Such an assessment can be conducted both for ATR and QM instruments, using a pay-per-use model. Doing so would provide true transparency into critical process decisions and risk, as well as improved borrower communication, participation of key stakeholders and collaboration.

management systems. However, by transitioning to a new compliance process solution with embedded rules and policies, lenders can perform an automated analysis of the captured data, benefit from consistent and fast decision-making and quickly respond to ongoing regulatory reforms. Such an approach can enable lenders to embrace new techniques in process control and automation while leveraging new approaches to customer engagement, in order to contain costs and improve compliance. Creating a consistent, transparent and controlled process within a framework that provides the highest levels of customer experience requires a thoughtful approach. The organization needs to clearly define the end-state vision, tightly align the solution with its strategic goals and ensure it is able to provide incremental value as the solution is implemented and expanded. The loan origination framework must also be constructed with active cooperation of all parties. The project management and program management organizations will need to shepherd key business participants through the software delivery lifecycle (SDLC) and develop a roadmap to identify the incremental steps within the loan origination process that can be automated. Process automation would be achieved by designing a decision tree to address each critical step within the loan origination process. These incremental steps can be identified by breaking down and dissecting the critical steps within the loan origination process. These steps will serve as toll gates within the origination process, and the decision model will be leveraged to route the mortgage application within the loan origination cycle. The automation of these decisions is based on the input of business SMEs and IT professionals. The automated decision model will create consistency across the process, reducing the somewhat subjective nature of underwriting, which can expose the lender to potential discriminatory practices. The subjective steps, in which an individuals opinion can determine the approval of an application, will be removed and replaced with automated rules designed by key organizational participants. As such, every borrower will be analyzed against the same decision model criteria and compared with any suitable loan products based on the borrowers needs and qualifications.

Customer experience can also be a significant competitive differentiator for loan originators. Minor improvements in the customer experience will win business, resulting in massive increases in revenue due to loan application pull-through.

Customer experience can also be a significant competitive differentiator for loan originators. Minor improvements in the customer experience will win business, resulting in massive increases in revenue due to loan application pull-through. Insights into borrower behavior and sentimentcan be obtained through analysis of credit trig-gers, borrower activity and public records. Such insights not only help lenders reduce production and support costs by anticipating rather than reacting to customer issues, but they also lead to an improved customer experience. An early understanding of each borrowers ability to qualify for a mortgage and/or related underwriting obstacles will allow the underwriter and customer to quickly address these challenges with appropriate resolution. With a compliant solution, for example, a borrower requesting a correction to his credit history will either be allowed to qualify or will be shown a clear and prompt understanding of why he will not meet underwriting guidelines.

Looking Forward: An Enhanced Compliance Process Solution

Mortgage lenders commonly believe that ensuring compliance with revised regulations will be daunting, time-consuming and expensive. Given the long list of enhanced compliance requirements, many companies will face the need to upgrade their IT infrastructure and data mining capabilities, as well as improve the accuracy and consistency of their traditional loan

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The new process will be consistent, transparent and objective, resulting in a repeatable process. For any given mortgage applicant, the framework produces a compliant process that will stand up to any regulatory scrutiny. The decision model must be highly adaptable to changing mortgage regulations. Given the large amount of regulatory agencies with various agendas, the new regulations and rules must be be addressed by the lender. It is very likely that changing the decision rules within the model will be more efficient than retraining an entire staff of loan processors and loan officers. The changes can be initiated with new requirements and executed within the SDLC process. Moreover, they will be well documented and reviewed by the organizational partici-pants. Additionally, if new regulations are properly implemented within the solution, the lender is less likely to face regulatory compliance issues. An added benefit of this consistent and automated framework is the ability to enhance the

customer expe-rience by identifying key milestones within the loan process that can then be communicated to the borrower. Additionally, exceptions within the process, such as missing documents, can be routed properly and commu-nicated to the lender and the borrower.

It is very likely that changing the decision rules within the model will be more efficient than retraining an entire staff of loan processors and loan officers.

Borrower notifications can be generated based on borrower preferences, whether by e-mail, text, mail or customer contact. Each applicant would receive consistent information rather than subjective answers based on the understanding of thecustomer service representative or loan processor. A consistent and responsive level of communication and service will enhance the customer experience.

Quick Take
Four Steps to De-risk Noncompliance
For a better-managed system that offers reduced risk of non compliance, loan processes need to pass through four phases, including:

Phase 1: QM validation. This requires data capture and consistency checks against digital and physical document formats. Phase 2: Borrower income validation: The policy and data creation formula should be stored in a data repository. This also involves deploying reporting capabilities (primarily compliance) as required by regulatory authorities. Phase 3: Process automation, which requires the implementation of decision models and exception management. This addresses events or items that require remediation before advancing to the next process step. Phase 4: Accommodating future regulatory changes that extend to other business functions. While the impending CFPB regulations trigger a host of issues for lending companies, they also present a timely opportunity for companies to strengthen their processes and, ultimately, develop a resilient compliance- and customer-focused system. While lenders can benefit from an adaptable and compliant underwriting framework, customers also receive quality service until the loan is closed. For lenders, it is time to shift gears.

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Footnotes
1

U.S. Residential Mortgage Market Update, Deloitte, April 2013, https://www.deloitte.com/assets/ Dcom-UnitedStates/Local%20Assets/Documents/FSI/US_FSI_Residential%20Mortgage%20 Market%20Update_April%202013_052813.pdf. Home Prices Steadily Rise in July 2013, S&P Dow Jones Indices, Sept. 24, 2013, https://www.spiceindices.com/idpfiles/spice-assets/resources/public/documents/53129_cshomeprice-release-0924. pdf?force_download=true.

Mark Fleming, Making the Most of 2013, CoreLogic Market Pulse, Vol 2, Issue 2, Feb. 12, 2013, http://www.corelogic.com/downloadable-docs/MarketPulse_2013-February.pdf. Summary of 2013 Mortgage Rules Issued by the Consumer Financial Protection Bureau, Promontory Financial Group LLC, June 14, 2013, http://www.promontory.com/uploadedFiles/Articles/Insights/ CFPB_Mortgage_Whitepaper_Refresh_130614_FINAL.pdf.

List of Subjects in 12 CFR Part 1026, http://files.consumerfinance.gov/f/201301_cfpb_final-rule_ ability-to-repay-amendments.pdf. Protection from lawsuits under safe harbor rules is a legal provision to reduce or eliminate liability as long as good faith is demonstrated.

Rachel Witkowski, Safe-Harbor QM Loans May Not Protect Banks, National Mortgage News, Sept. 6, 2013, http://www.nationalmortgagenews.com/dailybriefing/Safe-Harbor-QM-Loans-May-Not-ProtectBanks-1038649-1.html. According to the Code of Federal Regulations, small bank means a bank that, as of December 31 of either of the prior two calendar years, had assets of less than $1.098 billion and that issue 500 or fewer mortgages each year, as well as certain nonprofit organizations that originate 200 or fewer loans per year.

The Qualified Mortgage and Ability to Repay Rules, Navigant, 2013, http://www.navigant.com/~/ media/www/site/downloads/corporate%20finance/qualified%20mortgage%20and%20ability%20 to%20repay%20rules.ashx). Employees Private Right to Sue, Attorney Generals Office, http://www.mass.gov/ago/doing-business-in-massachusetts/labor-laws-and-public-construction/wage-and-hour/private-right-to-sue.html.

10

11

CFPB Ability to Repay Standard, PricewaterhouseCoopers LLP, January 2013, http://www.pwc. com/en_US/us/financial-services/regulatory-services/publications/assets/pwc-cfpb-ability-to-paystandard.pdf. Richard Finger, Banks Are Not Lending Like They Should, and With Good Reason, Forbes, May 30, 2013, http://www.forbes.com/sites/richardfinger/2013/05/30/banks-are-not-lending-like-they-shouldand-with-good-reason/.

12

13

Automation and Analytics: Two Levers to Revitalize Retail Debt Recovery, Cognizant Technology Solutions, June 2013, http://www.cognizant.com/InsightsWhitepapers/Automation-and-AnalyticsTwo-Levers-to-Revitalize-Retail-Debt-Recovery.pdf.

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Credits Author and Analyst

Sanjay Fuloria, Senior Researcher, Cognizant Research Center

Analyst
Krishnakanth Sutrave, Researcher, Cognizant Research Center

Subject Matter Experts

Nathan Longfellow, Senior Director, Cognizant Business Consulting, Banking and Financial Services John Geertesma, Senior Manager, Cognizant Business Consulting, Banking and Financial Services

Design
Harleen Bhatia, Design Team Lead Suresh Kumar Chedarada, Designer

About Cognizant
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