Increasing Portfolio Value and Reducing Risk
The Need to Perfect Loan Collateral and Document Custody
by Debbie Lastoria and Meaghan Hanley
Every loan has a value at origination. The loan officer makes their commission, and based on the secondary market, the investor pays for a loan in accordance with the underwriting basis for which it was closed. This value should survive the life of the loan—but we all know it may not. The value may be impacted by a refinance for a better interest rate or default by the borrower, and this is considered based on statistics. However, there is an exposure that exists with the condition of the collateral file, which is not often taken into consideration upfront. Having a solid process of tracking and maintaining (at a minimum) the mortgage note, recorded mortgage, and title policy at origination is key.
In a perfect world, you would originate all your loans and have that process put in place. Now enter the complex world of mortgage banking, where your portfolio was not self-originated, but rather acquired or purchased. Then add into the equation that your purchases include re-performing or non-performing assets. If the collateral file is the underlying basis of your loan value, how do you manage to a complete and perfected file regardless of the origination source?
The growing need for a more complete custody process
Before the financial crash, investors focused their loan origination requirements on a solid loan underwriting process. The assumption was that a good process would reduce the risk of loss should the borrower run into a financial setback and default. We all know that this was not the case, and then suddenly in 2008, the collateral file became the most important factor to sell a loan, foreclose, or even successfully release the lien. The problem was, while everyone was focused on the underwriting factors, the collateral file management was a secondary afterthought at best. Fast forward, it has been reported that homeowners in some form of default are back to 11% when pandemic related forbearance is considered. This, compounded with increased origination and payoff volume, along with the work from home challenges will again put stress on any collateral handling practices including the well-managed ones.
With the challenges of 2020, the needed controls on managing a perfected collateral file have become more of a priority at origination. However, we are still seeing literally hundreds of thousands of collateral files with important documents missing, sometimes even the promissory note or endorsement to the proper interested party/entity. Regardless of whether you know the condition of the file, a perfected collateral file will be required for ALL life of loan events—which may be much more costly to manage when required than a proper review and remediation upfront.
For example, this caused serious problems during the foreclosure crisis because servicers were not able to provide the courts with proper documentation indicating their right to foreclose. In judicial foreclosure states, this problem proved to be very costly. In some states, the inability to produce the signed note meant the servicer’s entire case was lost. As a result, servicers are now required to validate their standing prior to first legal proceedings. This process includes not only a review of the collateral file but also a comparison to current land records to ensure all assignments of record are considered in the determination of the lender of record. While the number of loans in default had returned to pre-crash levels with proven successful loss mitigation efforts, this costly review process is still impacting the cost of servicing overall and will only get worse again as we prepare for the impact of pandemic related forbearance fallout.
The market for whole loan sales is re-opening and all indicators point to a healthy expansion in 2021 especially when factoring in the non-QM origination and EBO (Early Buyout Program). Purchasing and/or selling these assets typically requires loan review factors such as the underwriting and the mortgage position, as well as the condition of the actual collateral file validated with the land records. Typically, in today’s environment, this process could include:
1) a due diligence firm,
2) a title company,
3) a custodian,
4) a collateral remediation expert,
5) attorneys, and then the custodian again.
Not only does each contributor charge at a minimum a per order intake fee to begin the work, but the compilation of results from all parties in this fast-moving market is also taking too long. To further complicate matters, the results are inconsistent, causing further delays. The result is that some buyers are finding it difficult or impossible to combine analytics from all these parties relating to the loan in time to know the real value of the portfolio so they can make a quick resale back into
the market.
If a firm that has just purchased a portfolio with the intention of turning it right away cannot quickly, and accurately, assess the value of the loans, they are likely to undersell. We have personal experience with a firm that, after successfully completing a project of the type outlined in this story, increased their purchase price by $50 million from the data compiled vs. the data confirmed. This suggests that the downside risk of failing here will be measured in tens of millions of dollars lost.
Clear signs that the industry needs a better solution
In our work of helping portfolio sellers prepare their pools for sale, we have found that the existing exception reports are often inaccurate even when reviewed by multiple firms. The non-note collateral is often improperly married to the note collateral and improperly handled trailing documents fill backlogged queues. Worse, where each of the parties investigating the files returns a different result, it must be re-reviewed to resolve the discrepancies.
Some new origination or seasoned portfolio issues that should be considered for best execution downstream are:
- Ensuring you have proper controls for Agent and/or Corres-pondent follow-up
- Building a tracking and reporting vehicle that incorporates third party data sets
- Pre-sale review and remediation to proactively resolve known issues for first mortgages (Jumbo and Agency), CRA Loans, HELOCS, and stand-alone second mortgages, Non-QM, HECM, and non-performing and re-performing loans
- Complete collateral due diligence on all file locations
- Validate MERS compliance including a file to land record comparison
Quantifying the high risks in the current system
These problems result in lost time and money for everyone involved. Financial services firms are paying too much to involve several different vendors and sometimes still only getting a partial solution. This exposes them to substantial risk because, without timely and accurate information, it is impossible to make good decisions about what to sell, how to price it, or what to buy.
Document Custody has traditionally been the last line of defense for a quality portfolio and the first source of information for a loan under inspection, but without the research and remediation components, it simply cannot get the job done. The result is that portfolio sellers must remediate the collateral files on a reactive basis. This is costly for several reasons, including investor penalties, fines, enforcement actions, and curing and management of side letter exceptions, just to name a few.
In terms of time, it can be up to 60 days before the buyer receives the exception report from the document custodian. Then, the buyer must wait even longer for another firm—which charges an additional intake fee—to validate and fix the problems. By the time the pool is finally ready for sale, the market may have shifted, impacting the demand and price. Worse, the seller can price the pool without good information on the loans within it and undersell it by tens of millions of dollars or oversell and be flooded with side-letter exceptions as well as buybacks.
What a better system looks like
Whether it is foreclosure, portfolio sales, compliance, or some other reason that the industry must call upon the loan’s collateral file for information, the industry will continue to struggle until it can combine all the important elements into a single solution. Without fixing the problem of effective document custody, investors cannot even effectively put a value on the loans they own.
Consequently, the job of the document custodian must evolve. A custodian must be a partner to the investors and servicers, with solid procedures in place to ensure the integrity of the collateral over time.
After studying this problem for at least the last decade, we have arrived at a set of core functions that must be included in a complete process that can solve these problems the industry is encountering today.
These include:
1) Secure and efficient document custody. To keep the documentation safe and readily available, the solution must offer a state-of-the-art vault with advanced physical security, fire and other disaster protection, climate control and effective file and document tracking.
2) Effective remediation support. The solution must offer the ability to perfect the files by locating missing documentation or creating new documents if required.
3) Efficient collateral review. When it is time to determine the value of the loans in a pool, the solution must be able to provide fast, efficient information about the collateral files. The document custodian of the future post-pandemic must be able to house and remediate massive pools quickly to keep the industry moving and not add to the problem by backlogging or losing vital documents. It must also be able to report status on very short timelines, providing ample time for effective decision-making.
Against the grain of a traditional custodian, this may be the only solution.
This goes well beyond the scope of today’s document custody providers, but it is essential if we are to have any hope of solving the problems we have seen in the past and expect to grow in our industry this year due to the pandemic.
