Should Loan Originators be Risk Rated?

From CAMELS to CORE™

For thirty years, a supervisory risk rating has been used by federal regulators to evaluate the overall condition of the country’s banks. The Uniform Financial Institutions Rating System (UFIRS), adopted by the Federal Financial Institutions Examination Council (FFIEC) on November 13, 1979, set forth the rating system that provided a unique and methodical way to determine bank stability.

Under the UFIRS a bank is assigned ratings based on performance in the following five areas: Capital Adequacy, Asset Quality, Management Capability, Earnings, and Liquidity. Given the acronym CAMEL, this system has been used ever since by federal supervisory agencies to evaluate the safety and soundness of a banking institution. In January 1997, the FRB revised the UFIRS by adding a sixth component for Sensitivity to Market Risk. This CAMELS rating system provides a composite of a bank’s condition and overall performance, and it has been adopted by many countries, including, of course, Hong Kong.

However, no similar rating system has ever been devised or federally mandated for entities that originate residential mortgage loans. If such a system were in place, standardizing all findings, the regulatory and state licensing agencies as well as the public would be assured of the kind of oversight that will serve to strengthen the mortgage industry and consumer confidence.

In 2007, we developed a risk rating system to evaluate the safety and soundness of loan originating entities. Called the CORE Compliance Matrix™, our procedures assess four critical components and five composite ratings that must be considered when evaluating the safety and soundness of an entity originating residential mortgage loans. We evaluate a company’s Compliance Program, Organizational Structure, Regulatory Risks, and Enforcement Strategies. Our methodology uses the acronym CORE™. The CORE™ review findings are derived through the risk rating protocols of our CORE Compliance Matrix™.

Let us first take a brief look at the CAMELS rating system and its basic components, followed by the new CORE™ system, which takes its inspiration from the CAMELS concept, though it adapts the latter’s conceptual framework to the mortgage banking industry. 

The Last Straw that Breaks the CAMELS’ Back

The CAMELS composite ratings are generated from the ratings derived from the above-mentioned six components constituting the CAMELS acronym. Each component is rated on a scale of 1 to 5, with high performance associated with ratings of 1 or 2 and incrementally lower performance associated with ratings of 3, 4, or 5. The component ratings, therefore, are the building blocks that produce the composite rating.

A CAMELS composite rating is assigned on a scale of 1 to 5, with 1 representing the highest rating (strongest performance or condition) and 5 representing the lowest (weakest performance or condition). A bank that receives a rating of 1 or 2 is believed to have few significant supervisory issues. However, a bank with a composite rating of 3, 4, or 5 presents incrementally greater regulatory risk.

The following Table provides an overview of CAMELS ratings.

CAMELS Composite Ratings

CAMELS Composite Rating # 1	Bank is safe and sound in every respect.
CAMELS Composite Rating # 2	Bank is fundamentally sound and stable, substantial compliance with laws and regulations.
CAMELS Composite Rating # 3	Bank exhibits some degree of supervisory concern in one or more of the component areas, requires additional supervision (i.e., enforcement actions).
CAMELS Composite Rating # 4	Bank generally exhibits unsafe and unsound practices or conditions, poses a risk to the deposit insurance fund.
CAMELS Composite Rating # 5	Bank exhibits extremely unsafe and unsound practices or conditions, poses a significant risk to the deposit insurance fund. Bank failure is highly probable.

It should be noted that a financial institution’s CAMELS composite rating is confidential, only available generally to senior management and the primary regulator’s supervisory staff. CAMELS composite ratings are never made publicly available, and there has been some controversy over the years about the benefits of releasing these ratings to the public. That particular issue is still unresolved; however, generally speaking, the public can gather a good idea of supervisory concern by watching what actions the primary regulator takes with respect to a bank’s performance. Actions taken are reported by the Board of Governors.

And what are those supervisory actions?

A comprehensive, on-site examination is conducted at least once every 12 months (which can be extended if, among other requirements, the institution’s asset threshold is under a specified amount and it has a CAMELS composite rating of 1 or 2). To get any extension up to 18 months a bank must also have no enforcement actions or change in control. It is common, though, for bank examiners to conduct two or more exams a year, when needed. The results of these examinations determine the consequent supervisory actions.

An institution with a CAMELS composite rating of 1 or 2 generally presents no supervisory concerns, though a rating of 2 could have some violations that require an adjustment to the compliance program or perhaps an additional audit procedure.

Institutions with ratings of 3, 4, or 5 pose increasing levels of supervisory concern and these ratings will often bring about various actions. A rating of 3, for example, might indicate that management may have the ability to effectuate compliance, though violations discovered may be an indication that management has not devoted sufficient time and attention to consumer compliance. A typical action would be to require the institution to designate a compliance officer, or develop and implement a more effective compliance program.

A rating of 4 might indicate that a pattern or practice results in repeated violations, or perhaps management may show a lack of interest in administering an effective compliance program. Typically, supervisory actions will include a comprehensive overhaul of the compliance program, including various enforcement actions. And, finally, a CAMELS composite  rating of 5 indicates substantial non-compliance with consumer statutes and regulations and could very well point to a management that is either unwilling or unable to implement the changes needed to attain compliance. Supervisory actions in such instances may include placing the subject bank into receivership or finding another bank to take it over.

The Core™ is the Cure

In developing our CORE™ review, we eliminated certain components that are already monitored by federal and state agencies for compliance. Therefore, we do not review a loan originator’s capital adequacy, asset quality, earnings, liquidity, or sensitivity to market risk. We conduct a separate review to determine the condition and performance of a loan originator’s mortgage loan portfolio, if applicable. The CORE™ concentrates on components that are unique to residential mortgage loan originators. Based on our review, a CORE™ rating is derived that demonstrates the current performance and condition of the loan originating entity.

Like CAMELS components, the CORE™ also has components that are building blocks. These are the above-mentioned four components constituting the CORE™ acronym: the Compliance Program, Organizational Structure, Regulatory Risk, and Enforcement Strategies. And, just as is the case in the CAMELS system, each CORE™ component is rated on a scale of 1 to 5, with high performance associated with ratings of 1 or 2 and incrementally lower performance associated with ratings of 3, 4, or 5. The findings are situated in the CORE Compliance Matrix™ (CCM) and then extrapolated into the CORE Compliance Rating™ (CCR).

Click Image for CORE™ Presentation

The following Table provides an overview of the CORE™ ratings.

CORE Compliance Rating™

CORE Compliance Rating # 1	Strong performance and risk management practices relative to institution's size, complexity, and risk profile. Substantial compliance with laws and regulations. No regulatory concerns. Any weaknesses are minor and can be handled in a routine manner by management. CCM components are rated either 1 or 2
CORE Compliance Rating # 2	Overall risk management practices are satisfactory relative to institution's size, complexity, and risk profile. No material regulatory concerns. Only moderate weaknesses are present and well within management's capabilities and willingness to correct. No CCM component is given a risk rating more severe than 3.
CORE Compliance Rating # 3	Risk management practices are less than satisfactory relative to institution's size, complexity, and risk profile. Some degree of regulatory concern in one or more areas of the Core Compliance Matrix™. Significant noncompliance with laws and regulations. Failure appears unlikely, but institution exhibits weaknesses that may range from moderate to severe. No CCM component is rated more severely than 4.
CORE Compliance Rating # 4	Risk management practices are generally unacceptable relative to institution's size, complexity, and risk profile. Unsafe and unsound practices or conditions. Matrix deficiencies result in unsatisfactory performance and significant noncompliance with laws and regulations. Failure is a distinct possibility if problems and weaknesses are not satisfactorily resolved.
CORE Compliance Rating # 5	Inadequate risk management practices relative to institution's size, complexity, and risk profile. Extremely unsafe and unsound practices or conditions. Matrix findings indicate critically deficient performance. Volume and severity of problems are beyond management's ability or willingness to correct. Immediate assistance is needed to avoid failure.

Our CORE™ reviews are given exclusively to senior management and those individuals or entities that management so designates. Where needed, we recommend corrective actions and provide all the legal and regulatory compliance guidance necessary to improve the CORE™ rating. In due course, we follow up with visits to evaluate management response and assess the effectiveness of enforcing the appropriate regulatory requirements.

Should Loan Originators be Risk Rated?

Without a standardized methodology to determine the overall compliance of a loan originating entity, there is no independent way for such entities to fully anticipate, control, and coordinate the implementation of regulatory requirements.

Needless to say, waiting for a banking department examiner to point out compliance deficiencies is an example of reactive management, often leading to very strong supervisory actions, such as mandating the disgorging of fees, requiring reimbursements for violations, substantial fines, and even pursuing license suspension or forfeiture. In their role as consumer advocates, banking departments and regulators will do whatever is necessary to promote adherence to all federal and state regulations. Will the loan originating entity also do whatever it takes to pursue these same ends?

Market, strategic, and certainly capital formation risks are elevated, and often adversely impacted, due to belatedly effectuating appropriate compliance initiatives. Legal risk is mitigated by a review program, such as the CORE™ review, which looks at and risk rates all aspects of compliance affecting loan originations.

It is said that preventive medicine is the best medicine. The CORE Compliance Matrix™ is that medicine. It is always better for management to be able to independently evaluate compliance conditions and performance in advance than to find out about deficiencies from a regulator or plaintiff’s counsel.

Yes, loan originators should be risk rated!

The sooner the better: for the preservation of the residential mortgage banking industry and the continuing protection of the public.

Jonathan Foxx, a former Chief Compliance Officer of two publicly traded financial institutions, is the President and Managing Director of Lenders Compliance Group.

The Demise of Prepayment Penalties?

Prepayment penalties, once the rage of mortgage originators, will soon face their near demise. Used ostensibly to offer better terms to the borrower, and not coincidentally also providing increased income to the originator, these penalties tended to lock borrowers into their loans when they wanted to refinance, making it financially infeasible for many borrowers to refinance without loss of equity. Yet there was rarely any discipline, let alone motivation, on the part of the originators to implement policies to curtail the use of prepayment penalties.

The government, belatedly but finally, has said “Enough!”

On October 1, 2009, new restrictions will reduce the incentive to use prepayment penalties in residential mortgage loans. On that date, the new and final revisions to Regulation Z, the implementing regulation of the Truth in Lending Act, will take effect. Although the common sense features of these new restrictions have long since been apparent to many compliance and industry professionals, it has taken some time (and a mortgage meltdown) for these needed changes to become the law of the land. Especially in the current economic environment, when millions of borrowers are seeking to refinance their mortgages, the debilitating aspects of prepayment penalties needed to be reduced, if not eviscerated.

High Cost and Higher Priced Mortgages

Prepayment penalty restrictions will soon apply to not only “high cost” but also “higher priced” mortgages. The former refers to “Section 32,” so-called “HOEPA” loans (referencing Section 32 of Regulation Z, and HOEPA referencing the Home Ownership and Equity Protection Act of 1994, the high cost mortgage legislation).

A high cost mortgage loan is determined by a “test” of its rate as well as its points and fees: if a rate exceeds the rate on certain comparable term Treasury securities or if points and fees exceed the higher of 8% of the total loan amount or $583 for 2009, the loan is considered high cost.

• Exclusions: purchase money mortgages, reverse mortgages, and Open-End Credit.

The higher priced mortgage loan, a new category created under Regulation Z, tests for rate, but not fees. If the Annual Percentage Rate (APR) exceeds a new index, called the “average prime offer rate” by a specific amount, the loan is considered “higher priced.”

• Exclusions: construction loans, “bridge” loans with a term of 12 months or less, reverse mortgages, and Home Equity Line of Credit loans (HELOCs).

This index is not the same one used to calculate the high cost loans. Instead, this is a new index, based on Freddie Mac’s Weekly Primary Mortgage Market Survey, and will be published by the Federal Reserve Board. We have written somewhat extensively on the revisions to Regulation Z and the new index in our Advisory Bulletins, which can be found in our Archive, as it pertains to various Regulations.

(Visit our Archive for: “FRB Finalizes Revision to Regulation Z – Truth in Lending,” dated July 28, 2008; “FRB Proposes Revision to Regulation C (HMDA),” dated July 30, 2008; “FRB Issues Final Rule to Regulation C (HMDA),” dated October 20, 2008.)

Before and After

Take a look at the following schematic, which provides a Before and After analysis of certain restrictions of the Prepayment Penalty:

                                         HIGH COST LOANS

Prepayment Penalties PROHIBITED UNLESS ALL Restrictions Apply

RESTRICTIONS	BEFORE 10-01-09	AFTER 10-01-09
1) State or Federal Prohibitions	Unless otherwise permitted by law.	Unless otherwise permitted by law.
2) Term	After first 5 years, no penalty.	After first 2 years, no penalty.
3) Refinance Originator	Creditor or affiliate refinance does not trigger the penalty.	Credit or affiliate refinance does not trigger the penalty.
4) DTI Ratio (including mortgage PITI) *	May not exceed 50.	May not exceed 50.
* DTI = Debt to Income; PITI = Payment, Interest, Taxes, and Insurance

                                     HIGHER PRICED LOANS

Prepayment Penalties PROHIBITED UNLESS ALL Restrictions Apply

RESTRICTIONS	AFTER 10-01-09
1) State or Federal Prohibitions	Unless otherwise permitted by law: must meet BOTH high cost AND higher priced conditions.
2) Term	After first 2 years, no penalty.
3) Refinance Originator	Creditor or affiliate refinance does not trigger the penalty.
4) Periodic Payment	Periodic payment of principal and/or interest DOES NOT change for first 4 years.

Disciplining the Prepayment Penalty

Clearly, the revisions to Regulation Z contemplate reining in the kind of loan origination initiatives that utilize prepayment penalties, especially in loan products that require periodic increases to the mortgage payment. The effect of having the prepayment penalty restrictions apply to both the high cost and higher priced loan categories will be that all subprime and most Alt-A loan products will be affected.

Creditors will only be able to impose a prepayment penalty for the first 2 years after consummation, thus jettisoning the previous 5 year period imposition, and the lender’s pricing incentive in relation to the per loan revenue will be significantly lowered.

The lender must qualify the borrower’s DTI before consummation by utilizing all appropriate verifications of income and documenting them. Therefore, the borrower’s ability to repay must be verified prior to relying on it to impose prepayment penalties.

Currently Regulation Z prohibits a “pattern or practice” of lending without regard to the borrower’s ability to repay, thereby providing a presumption of a violation only if a pattern or practice can be established in which income verification is not processed or documented adequately.

This language has been removed in the final rule, further exposing lenders to heightened diligence in reviewing a borrower’s ability to repay. Consequently, it will soon be a violation of TILA for any high cost or higher priced loan (excluding a high cost bridge loan of 12 months or less) to be originated without regard to a borrower’s ability to repay from income and the collateralized assets.

Given that prepayment penalty restrictions will apply to both high cost and higher priced mortgages, many more loan products as well as borrower income, credit, and asset profiles will be included than ever before.

Although the new rules do not put an end to the use of prepayment penalties, they will have lost much of their attraction for most lenders when the final revisions of Regulation Z take effect on October 1, 2009.

Jonathan Foxx is the President and Managing Director of Lenders Compliance Group, a risk management firm specializing in all areas of mortgage and lending regulatory compliance.

Visit the Lenders Compliance Group website to view its Archive and Library.

Loan Modification Companies – A New Boom Industry

Like daisies springing up after a rain storm, loan modification companies (LMCs) are popping up throughout the country in the wake of the mortgage default crisis – willing, but mostly not ready, to assist borrowers in need of modification services. Readiness should mean only one thing: functioning within a regulatory framework and the implementation of all relevant compliance requirements. However, specific guidelines, rules, and statutes to regulate LMCs are either insufficient or non-existent in many states!

Often, these companies are former mortgage brokers and real estate brokers who have re-cast themselves as experts in loan modifications. Armed with their database of previous loan originations, whether purchase money or refinance mortgages, LMCs now contact their former borrowers to pitch them this time around in two ways: either they offer to refinance the borrower into a lower interest rate mortgage, perhaps also into a different loan product, or, finding out that the borrower is in default of the existing loan terms, they offer to provide loan modification assistance. Another way they obtain a borrower’s contact information includes perusing public notices, such as pending litigation vis-à-vis the recordation of a lis pendens.

Because we are a risk management firm devoted to the mortgage and lending industries, we often see firsthand the sometimes catastrophic results of not implementing an adequate compliance program.

Nothing cries out for regulatory compliance like the loan modification company!

In response to the need for regulatory compliance, our company developed a comprehensive program, consisting of eight essential elements, to evaluate an LMC’s, a servicer’s, or an attorney’s processes and procedures with respect to loan modifications and loss mitigation.

For the 8 ACTION POINTS, see below.

LMCs relationship with Servicers

In an effort to deal directly with the borrower, many servicers have staffed-up. Although overwhelmed, they must also contend with LMCs that may be unlicensed and unregulated. Servicers are subject to licensing and are highly regulated, so it is incumbent on them to know that an LMC is acting within the law and has a dependable compliance program. Therefore, a servicer is often wary of the information and documentation it has received from an LMC, especially if the LMC cannot provide or prove its implementation of all state and federal regulatory requirements.

LMC and One State’s Response

A typical complaint about LMCs concerns the charging of high upfront fees – regardless of services rendered. Several states now have implemented procedures to prevent this and certain other abuses. In fact, collecting any upfront fee is inexcusable: if borrowers qualify for a loan modification under current investor, Agency, HUD, or Treasury guidelines, there is no commission involved – the actual charge to modify the loan is minimal.

California has taken a lead in providing strong regulatory protection to the consumer interested in or needing loan modifications. The applicable California legislation is somewhat complex, but a brief working description can elucidate the kinds of measures one state is now undertaking.

So, let’s take a rather brief look at California’s initiatives.

In California, loan modifications are handled lawfully only by attorneys or real estate brokers licensed by the Department of Real Estate. These licensed real estate brokers are permitted to accept an advance fee only if an Advance Fee Agreement has been approved by the Department; however, to date, only a small number of these fee agreements have actually received such approval. In any event, under the California Foreclosure Consultants Act it is against the law in California for Real Estate Brokers to accept an advance fee if a Notice of Default (NOD) has been filed. Only lawyers are able to collect an advance fee from clients after the recordation of the NOD, under California law. Furthermore, California requires licensing for employees of LMCs in order to have contact with the public or present to Servicers regarding loan modifications.

In some instances in other states, attorneys may have worked with LMCs to farm and further develop these contact parameters, receiving referrals for the legal work thereby obtained and then compensating the LMCs for non-legal processing. Taking note of this ruse, the California DRE has advised in its Spring 2009 Real Estate Bulletin, that “some lawyers are collecting advance fees (or retainer fees) and offering to employ real estate brokers and/or salespersons to supervise the real estate licensees as legal assistants, paralegals, or some other sort of legal office personnel. Some lawyers are placing themselves as ‘in-house’ counsel in real estate companies and having advance/retainer fees paid to them as counsel. Such relationships and scenarios raise serious ethical and legal questions, for both the lawyers and the real estate licensees.”

Obviously, the absence of payment from the attorney for the LMC’s de facto marketing efforts is just one reason why an LMC seeks an advance fee.  However, in California the State Bar’s Committee on Professional Responsibility and Conduct has gone so far as to issue an Ethics Alert, reminding attorneys that a lawyer may not pay a referral or marketing fee to, or split attorney fees with, a “foreclosure consultant” or other person for referring distressed homeowners to the lawyer. Violations of the Rules of Professional Conduct would also include entering into a joint venture with an LMC, approving loan modification documents, and acting as a general counsel to the LMC in order to provide legal advice to homeowners.

Nevertheless, the legislation affecting foreclosure and loan modification seems not to have dissuaded some LMCs and attorneys from pursuing questionable practices. Consequently, the State Bar of California, the California Attorney General, and the Department of Real Estate are currently conducting vigorous investigations in an effort to uncover criminal and unlawful civil activities.

An LMC can be viewed as a marketing company, in some states unlicensed (and, therefore, effectively unregulated) that approaches distressed mortgagors and ramps them up to local attorneys to handle loan modifications. Using attorneys may give an air of legitimacy to a loan modification company, though this can be somewhat misleading. Applying California’s statutory requirements as an example, an LMC is not exempt from having to be licensed merely by utilizing “in-house” counsel. Of course, an attorney may obtain clients under his or her own license; but, an LMC that uses its own “in-house” attorney on loan modifications is not exempt from licensing or providing an Advance Fee Agreement, if applicable.

Legislative Activity

California has been used here for illustrative purposes. Legislatures in many states are already enacting laws to regulate LMC activity. Some state banking departments require an LMC and its employees to be licensed as a mortgage broker. The legislative consensus seems to be that any individual directly or indirectly involved in negotiating, originating, offering or attempting to negotiate or offer loan modifications for a commission should be licensed as a mortgage broker. Many states, however, have yet to provide interpretive clarification of existing statutes and guidelines or specific legislation to regulate the LMC.

Certain state banking departments have issued special bulletins and memos to address the loan modifications issue. North Carolina, for instance, just recently issued a memo to all licensees emphasizing the prohibition against assisting a borrower in obtaining a loan modification for compensation or gain; the only exception being for employees of licensed servicers and lenders involved in servicing loans on behalf of the owner of the loans. Any attempt to collect advance fees is strictly prohibited in North Carolina. Indeed, the banking department memo warns its licensees in no uncertain terms that “if you are solicited by anyone that purports to engage in the loan modification business, we encourage you not to partner with these businesses, as you may find yourself committing a crime in this State.”

8 Elements to Effective LMC Compliance

Lenders Compliance Group has developed a comprehensive review of loan modification processes and procedures, consisting of eight elements. It can be applied to LMCs, servicers, and attorneys – or any entity involved in the various dimensions of loss mitigation.

We strongly recommend proactive implementation of our program, or one like it, as this approach will assure compliance with state-specific and federal requirements.

Our program consists of the following:

1. Baseline Review: Full review of current compliance program, organizational structure, regulatory risk, and enforcement strategies.

2.  Use of Legal Counsel and Referrals Attorneys
A thorough, documented, due diligence review, includes continual oversight of in-state and out-of-state loan modification attorneys and referral of new attorneys.

3.  Legal Analysis
A state-by-state, complete review of the statutory requirements followed by in-state and out-of-state legal counsel to effectuate loan modifications and loss mitigation.

4.  Agents and Affiliates Compliance
Compliance requirements for all contact with the public and review of service level agreements to assure implementation of policies and procedures.

5.  Policies and Procedures
Infrastructure, regulatory tolerances, legal process, procedures, and federal and state guidelines are determined, tested, and updated.

6.  Training
Webinar or on-site sessions devoted to federal and state regulatory compliance guidelines, providing on-going implementation of the highest standards of conduct.

7.  Quality Control
Random sampling, quality control review of loan modification files for each state in which loan modifications are arranged, including review of state disclosures, forms, and legal procedures.

8.  Periodic Reviews
Compliance reviews, annually, quarterly, or monthly to assure that business is maintained in accordance with established policies, procedures, and existing state and federal regulations.

Click the image for the LMC Compliance Presentation.

Good and Not-So-Good LMCs

Some LMCs are operating within the law, licensed where required, and fully complying with all relevant federal and state regulations. It is the unregulated LMC that poses a substantial threat to the consumer. A few LMCs have proactively implemented a thorough risk assessment review and compliance program. Most have not.

When the regulators eventually call to conduct an examination and perform their oversight responsibilities, the loan modification companies that can prove their compliance with and enforcement of all state and federal regulations will be best positioned to avoid criminal and civil judicial proceedings.