Mortgage Banking Update - PwCAs always, we welcome your feedback on our newsletter. Should you have any questions, or any areas where you would like us to explore, please feel free

MortgageBankingUpdate and more . . .

Vol.3, Issue 1 — Winter 2001

In This Issue1 Building Online Relationships —

Achieving Customer Loyalty

6 Roundtable Draws Attention to Retention Challenges

8 A Customer Relationship Management Primer

11 Don’t Forget About the Realtors

13 Managing Compliance Risk UnderGramm-Leach-Bliley Consumer PrivacyRegulations — Are You Ready?

16 Regulatory Alert — CaliforniaReconveyance Statute

17 Foreclosure and Reserve Modeling: Do You Know Where and Why Losses Are Occurring?

21 Industry Practices in Foreclosures

22 Is USAP Relevant for Today’s Mortgage Servicer?

24 Manufactured Housing Industry Aims forStandardization of Lending Practices

27 Highlights from thePricewaterhouseCoopers WarehouseLending Collateral Handling Operations Survey

29 FAS 140 Replaces FAS 125

32 Complexities in the Asset Securitization Industry

35 Regulatory Concern Over Residual Valuation

37 Exception Reporting in Alternative Asset Classes

39 Critical Success Factors in Implementinga Successful Technology Related Project

40 Analyzing the Trend toward ProfitabilityFocused Scoring

Building Online RelationshipsSecond of a series focused on building profitable online relationshipsSuccess in today’s competitive Internet environment is a constant and ever-changing challenge. There has been tremendous growth in online activitywith businesses spending millions of dollars for Web sites that providevaluable content and transaction capabilities. With competition just a clickaway, however, it is becoming increasingly clear that companies need to domore than just have an online presence. Businesses must engage consumersand consistently meet their expectations through a quality online experienceand effective customer service if they hope to achieve profitable onlinerelationships. Businesses that effectively attract browsers and convert themto loyal customers will ultimately succeed.

(continued on page 3)

A Note from Tim Ryan and Mike Seelig, Co-Chairs of thePricewaterhouseCoopers Mortgage Banking Services GroupSome of you may have noticed that we modified the name of our newsletter to “Mortgage Banking Update andmore . . .” The name change reflects the addition of content that is not solely focused on mortgage bankingoperations. It also echoes the way many in the industry are not solely offering traditional mortgage products. Ascompanies redefine themselves based on customer needs and technological advances, they are offering or aligningthemselves with other companies that offer alternative asset class products.

This issue of our newsletter features several articles that address aspects of different consumer finance operationssuch as challenges in raising capital through asset securitization, exception reporting in alternative asset classes, bestpractices in warehouse lending operations, and performance standards in the manufactured housing industry. Wehope you agree with our new direction and that you find our perspectives on industry hot topics valuable.

As always, we welcome your feedback on our newsletter. Should you have any questions, or any areas where youwould like us to explore, please feel free to contact us:

Tim Ryan, Boston(617) [email protected]

Mike Seelig, Minneapolis(612) [email protected]

2 Mortgage Banking Update and more . . .

The online mortgage industry has continued togrow as businesses recognize the importance of providing loan origination and servicing

capabilities online. The TowerGroup, a leading financialservices research firm, recently stated that while Internetoriginations will account for only 1.4% of the over $1trillion in originations in 2000, this is expected to growto 10.2% of the total by 2005. TowerGroup alsoexpected US lenders to spend $249 million on Internet-related mortgage technologies in 2000 with projectedspending to reach $502 million by 2005.1

A recent Fannie Mae study echoes this by reporting that one-third of those surveyed currently consider theInternet a viable method for obtaining a mortgage and51% believing that most home mortgages will behandled online by 2005.2

As companies move to develop an online presence and take advantage of the growth of e-business, they are spending significant resources to provide in-depthinformation and technical transaction capabilities.While all of this is beneficial, many businesses arefailing to consider the customer perspective by notaddressing the overall experience and customer serviceprovided online. This customer focus is critical toachieving customer loyalty and profitable onlinerelationships. As a recent Harvard Business Reviewarticle stated, “In the end, loyalty is not won withtechnology. It is won through the delivery of aconsistently superior customer experience.”3

Two key ways to deliver a superior customer experienceare to provide a user-friendly, easily guided Web siteand to support effective and efficient customer service.Focusing on these critical drivers of an e-businessstrategy will enhance customer loyalty, a requirementfor profitability.

Create a Superior Customer-Focused Online ExperienceBoth media and industry analysts have come to thesame conclusion — Web sites must focus more oncustomers. Forrester Research recently stated that many

sites “are designed for marketing — not customer —goals” and that to improve, sites need to be organizedfrom the customer’s perspective and provide apersonalized and easily-guided experience. In a recentreport, “Financial Web Sites Underserve Customers,”Forrester found that of the financial services sitesreviewed, only 35% were organized by customer goals,24% wove customer service into their site, and only18% offered a guided search capability.4

Site organized by customer goals

Companies have been focused on the content andtransaction capabilities when developing their sites and many have done a good job including privacy andsecurity disclosures as part of this online content. Thisis important as consumers still consider online privacyand security a top concern and they are more confidenttransacting business with a company that sufficientlydiscloses their privacy and security policies. With the implementation of the Gramm-Leach-Bliley Act,however, financial institutions will be required toprovide a certain level of disclosure and companies will have to do more to gain a competitive advantage.One of the ways to achieve this is by making a Web site more customer-focused.

Most companies with an online presence are expendingsignificant resources to provide a lot of information such as loan terms and rates, payment calculators, and application details. While this is all-important tothe online lending process, few have considered what a customer is looking for and how they may go aboutfinding it. Even at those companies that have consideredcustomer needs, the information is often not organizedin a manner consistent with customer goals.

PricewaterhouseCoopers 3

70%

60%

50%

40%

30%

20%

10%

0%FinancialServices

Non-FinancialServices

35%

62%

1 TowerGroup, Needham, Massachusetts, towergroup.com, October 2000.

2 “Web Mortgages Taking Hold in U.S.,” E-Commerce Times, October 5, 2000.

3 Reichheld, Frederick R. and Phil Schefter, “E-Loyalty: Your Secret Weapon on the Web,” Harvard Business Review, July-August 2000.

4 Shevlin, Ron and Paul Hagen, “Financial Web Sites Underserve Customers,” Forrester Research, August 23, 2000.

For example, few companies provide FAQs to addressthe questions that customers ask or to explain why they are collecting certain information or making certain requests. If customers cannot readily find theinformation they are searching for or if they are leftconfused, the chance of them doing business with thatcompany via more costly but traditional channels islow, and the likelihood of clicking over to acompetitor’s site is high.

Customers are looking for a site that is comprehensive,yet provides a user-friendly, easily guided experience.Businesses can exceed customer expectations andprovide such an experience by looking at their site fromthe consumer perspective. Research has shown thatthere are key areas that impact a customer’s onlineexperience. These customer-specific drivers include:

■ Site structure — Does the site layout present the siteconcept in a user-friendly and informative format toits targeted users?

■ Product descriptions — Is the information providedclear, concise, valuable, and applicable to assistall levels of consumers in comparing and purchasing products?

■ Ease of locating products and information — Canconsumers immediately locate products and relevantinformation? Is there a clear menu structure withpredictable and logical categories?

■ Ease of navigation and interaction — Are onlineprocessing capabilities functional and is thenavigation scheme intuitive?

■ Quality of user resources and tools — Are resourcesprovided to consumers informational and functional?

■ Ability to obtain assistance — Are consumersprovided with easily accessible assistance through awide variety of mediums, such as tutorials, demos,FAQs, and “contact us” capabilities?

■ Site functionality — Are site links and downloadsfunctional and timely?

■ Security and privacy disclosures — Are completedisclosures made to address security and privacy?

Assessing a site against these drivers, as well asbenchmarking it against them is key for a company that desires to provide a competitively superior onlineexperience to its customers that will enhance customerloyalty to its site.

Provide Effective and EfficientCustomer ServiceAnother key driver of customer loyalty is the customerservice experience. Financial services companies haveexcelled at providing high quality customer servicethrough their established call centers. As people move to the Internet to obtain information and performtransactions, however, they will also want the ability toask questions and obtain service online. This onlinecustomer contact, through a site’s “contact us” featureand e-mail, is a new customer service channel thatbusinesses must now master if they hope to gain loyalonline customers.

It is becoming increasingly clear that high qualitycustomer service is essential to build customer loyaltyand motivate consumers to become repeat transactors in the online environment. A recent Business Wire articlenoted that seven of ten consumers whose service requestwas responded to within 24 hours gave the site a highsatisfaction rating on customer service, and eight of tensaid they would be very likely to repurchase from thesite.5 There appears to be a gap, however, between whatconsumers think is important and the current quality ofcustomer service. An April 2000 Jupiter Communicationsstudy noted that 72% of online customers believecustomer service is important, while only 47% weresatisfied with the service they received.6

A May 2000 study by Celent Communications presentsan even bleaker picture of the state of customer serviceamong financial institutions. In a survey of 150 firms,56% did not accept Web queries or respond toelectronic customer inquiries and over 20% providedinadequate information, such as an overload of genericinformation, a request to call the call center, or areferral back to the Web site that had not provided theadequate information originally. Only 23% of the firms


5 “Harris Interactive E-Commerce Survey Affirms Importance of Effective Customer Service; Respond and Resolve - And Do It Within 24 Hours,”Business Wire, June 6, 2000.

6 April 2000 Jupiter Communications Study reported in “Wanted: Loyal E-Shoppers,” Industry Standard, August 7, 2000

provided acceptable responses.7 While businesses arestarting to recognize the importance of providing qualitycustomer service, it is evident that many still have somework to do. Forrester Research reiterates this lack ofreadiness in a recent report that noted that while 70%of firms view the contact center as critical, only 26%have Web-enabled their call centers.8

While businesses must focus on their customer serviceto gain customer loyalty, there are many other benefits to making this effort. Customer communications are also a rich source of marketing and operationalinformation. Analyzing the nature and content of onlinecustomer contact, as well as evaluating a company’spolicies and procedures for online customer service,present a significant opportunity for a company toreduce costs, increase reliability of products andservices, and enhance the effectiveness of theirmarketing and online presence.

What could a company gain by analyzing its customercontact? For starters, repetitive questions regarding itsmortgage products or the transaction process may meanthat the company’s online information is confusing orincomplete. Multiple complaints about incorrect accountbalances may imply that there are problems with theprocessing of payments. Analyzing these communicationswill enable a company to identify the root cause ofcontacts. Not only will this allow a company to assess theeffectiveness of its online marketing and customer service,it can act as an early warning signal of more significantoperational issues. In addition to learning more aboutcustomers, marketing, and operations, reviewing customercontact will also help reduce costs. Servicing customersthrough e-mail and the Web site’s “contact us” area issignificantly less expensive than servicing through the call

center. Understanding and monitoring customercommunications, as well as identifying ways to shiftcontact to less expensive channels, will become morecritical to online success as businesses focus on customerservice and its impact on customer loyalty and profitability.

PricewaterhouseCoopers has worked with severalorganizations to improve their online business from theirconsumers’ perspective which, in turn, has helped thesebusinesses provide the competitively superior onlineexperience that is critical to building customer loyalty.

Focusing on customer needs and expectations meanslooking at the problem from the customer’s point ofview. Our experiences show that focusing on customer objectives and value drivers and evaluatinghow well the site is aligned with customer expectationsis critical to building profitable online relationships.This assessment often involves improving the content,structure, and functionality of the site to better engagecustomers and encourage transactions.

In our experience, companies that have focused on thecustomer experience have realized significant benefitssuch as:

■ A higher conversion from browsers to loyalcustomers by engaging them in a superior online experience that encourages initial and repeat transactions.

■ Reduced incidences and costs of customermisunderstandings.

Customer loyalty is also significantly driven by thecustomer service received. Identifying the common root causes of customer inquiries, comments, andcomplaints, assesses potential weaknesses in thecustomer contact area, and provides insight into theprocess flow and ultimate resolution of customercommunications. Analyzing these areas has helpedcompanies improve their service levels and movedthem closer to providing a superior customer serviceexperience for their online customers. In addition, the companies are provided with insights intoconsumers’ perceptions of product, service, delivery,and experience.


100%

80%

60%

40%

20%

0%

AcceptableResponse

Other

Referred Back to Web site

Overload with Generic Info

Asked to Call the Company

InadequateInformation

Did NotAccept WebQuery/NoResponse

23% 20%

14%

25%

41%

21%

56%

}

Source: Client Communications Study, as reported in Bank Marketing International, 8/23/00

7 “Financial Services Companies Not Responding to E-Mail,” Bank Marketing International, August 23, 2000.

8 Forrester Research, “Kick-Starting Contact Centers,” October 2000.

Retention Units Becoming More PopularAwareness of the fact that it is more cost effective tokeep current customers than obtain new ones has led many companies to employ a customer retentionstrategy. As a result, many mortgage companies haveformed some sort of retention unit within theirorganizations to support retention efforts. Two major structures were noted:

1. Some companies have formed a separate salesretention group or telemarketing group that receivesleads from scripted employees in the servicingoperation. Tactics employed to receive the leadsrange from paying for closed sales to “trinkets”for recognition.

2. Other companies send the retention leads to theloan officers. In some cases loan officers receiveless commission on existing customers.


Analyzing customer communications and the customerservice process has yielded significant benefits forseveral companies, including:

■ Identification of ways to shift contact volume from amore costly channel, such as the call center, to theless costly channel of e-mail and the Web site’s“contact us” feature.

■ Identification of customer service processimprovements that can lead to increased productivity of the customer service department,decreased volume of contact received, increasedquality, and decreased cost of contact responses.

■ Identification of common causes of contact that can help companies proactively address the causes,develop standard responses to contact received, and identify sales opportunities.

■ Establishment of a monitoring system for changes incommon causes of contact.

Everyone is now recognizing that customer loyalty is a necessity for businesses to achieve online profitabilityin today’s competitive Internet economy. By engagingconsumers and consistently meeting their expectationsthrough a competitively superior online experience and effective customer service, businesses will achievethe customer loyalty required to build profitable online relationships.

❖

For more information on web site assessments and customer

contact analyses, please contact PricewaterhouseCoopers’

BetterWebSM at (877) 792-6363, Maryann Murphy at (617) 439-

7369 or [email protected] or Stan Gorski at

(973) 236-5179 or [email protected].

Roundtable Draws Attention to Retention Challenges In September 2000, members of the PricewaterhouseCoopers Mortgage Banking Group hosted acustomer retention roundtable for 14 top mortgage companies to discuss the increasing importance ofretention in the mortgage industry. The objective was to identify challenges, share industry bestpractices, and discuss retention metrics that would be useful to capture in PricewaterhouseCoopers’Quarterly Customer Retention Survey. This article highlights the areas discussed.


Organizationally, retention units either report to theservicing executive or sales executive but participantsnoted that the goal is to make retention every employees’job. However, this seems to be the case in a minority ofthe companies represented at the roundtable.

Channel conflict does exist, but consensus among thegroup was that it could be reduced through consistentcommunication of corporate goals and objectives. In onecase, loan officers willingly referred refinances over to thetelesales group but only as a result of much organizationalawareness and training in that particular company.

Interestingly, although recognized managerially ascrucial, retention is not yet a key goal that is integratedthroughout most mortgage companies.

Cost of Retention Industry models for retention costs are generallyrudimentary, but improving. Only now are the truecosts of retention being recognized. Accountingtreatment permits companies to carry the servicing rightasset at “market.” This affects income in future yearswithout a direct impact on current year’s profitability.

Roundtable participants with retention sales units saidthey try to direct customers to those channels to keepdown the cost of sales. Participants also discussedvarious customer relationship management systemscurrently offered in the industry but there was concernwhether the cost of these systems will be paid forthrough improved retention.

Products Supporting Retention EffortsAgency streamlined products and their relativeimportance was discussed but the participants generallyfelt that product was a component of retention, not theonly answer. One group member shared the results ofan exit survey of customers who left his company. Inthis case, “product” was the reason for leaving only11% of the time.

The notable exception was the offering of a loanmodification. This can be extremely efficient if the loanis in the company’s portfolio and not with an investor.

What Works in Retention?There were several tactics discussed that participants feltwould lead to keeping a customer. It was noted thatany retention strategy should involve a combination ofseveral devices as no one tactic is the key to success.These include:

■ Accessing Multiple Listing Services (MLS) databasesand determining if a house in the portfolio iscurrently under a listing agreement with a Realtor

■ Ascertaining through some sort of service when acustomer’s mortgage credit has been checked

■ Soliciting customers when a “pay off” is requested (Itwas generally agreed that this was not very effective.)

■ Utilizing “campaign management techniques”to efficiently target home equity loans and lines of credit

■ Obtaining “vertical” lists of life events for need based marketing

■ Statement messaging

Measuring RetentionPricewaterhouseCoopers currently conducts a Quarterly Customer Retention Survey for over eighttop companies. In an effort to better measure retentionefforts, the group indicated that they would like to seethe following metrics in future surveys:

■ Overall Retention Rate: The total number of loans“rewritten” divided by the total number of loans lost

■ Channel Recapture Rate: The number of loansrecaptured by a channel as a percentage of totalnumber of loans lost, irrespective of the channelfrom which the loan ran-off (sum equals the overallretention rate)

■ Individual Channel Recapture Rate: The number ofloans running-off within a channel that arerecaptured by the same channel

■ Refinanced versus purchase retention rate

■ It was generally agreed that correspondent loanscoming back into the portfolio should be includedand home equity loans excluded

Summary The current rate environment and changes in themortgage industry have heightened the importance of customer retention. Measurement abilities areimproving, but are still relatively unsophisticated. Many companies now have active retention units andthese units utilize a number of tactics. Unfortunately,there does not appear to be a single cure for retentionproblems but relatively small percentage pointimprovements in retention may mean considerableprofit increases for the company that employs asuccessful retention strategy.

❖

If your company is interested in participating in thePricewaterhouseCoopers Quarterly Customer RetentionSurvey, please contact Tony Muoio at (617) 428-8178or [email protected] or Martin Hurdenat (617) 428-8463 or [email protected].


A Customer Relationship Management PrimerCustomer relationship management (CRM) is the new buzzword at mortgage banking organizations. Itseems that everyone now has a CRM strategy. In our experience in working with large companies onCRM initiatives, we have often discovered that there is a misunderstanding as to what exactly CRM isand why it is important. Thus, in this article we explain the basics of CRM.

CRM is an idea that is gaining a lot of momentum in the Internet era. The driving force behind CRM is toenhance the future value of customers by understandingand satisfying their unique needs. Mortgage bankers arerecognizing that to operate in the customer economythey need to deliver what the customer wants, when andhow the customer wants it. CRM is a set of processesand capabilities that helps identify, acquire, retain, andmaximize customer relationships. To succeed in a CRMenvironment mortgage banks need to understand allrelevant aspects of customer relationships and interactwith customers at all levels to build lifetime loyalty.

Brick and mortar companies have typically beenproduct management companies. Product managers are responsible for generating sales and measuring thesuccess of various products. In these companies acustomer is a transaction that is counted at the cashresister. In a typical mortgage bank a customer issynonymous with a loan. Loans — not customers — are assigned unique identifiers. Therefore, when acustomer refinances, a new loan number is assigned andcorporate memory of this customer is potentially lost.Analysis and segmentation are usually performed at theloan (product) level. A typical mortgage bank tries to


predict when a loan could possibly refinance due tomarket condition changes, often ignoring customerlifestyle changes that are usually a significant catalyst in domestic economic decisions.

In a customer centric company a customer is truly thecenter of all activity. This is a paradigm shift for mostorganizations where the company has been organizedaround a product. To succeed in a customer centricenvironment mortgage banks will have to rethink theirbusiness processes, and reorganize to reflect this new focus.

A relatively common mistake is to assume that CRM is a technology issue. While it is true that CRM isenabled by technology, it is usually organizationaland/or business process issues that will make or break a CRM implementation.

A CRM application creates measurable value forany organization:

■ Increased customer retention. With the advent of theInternet, customer loyalty is at a premium. Customerretention is cheaper than customer acquisition.

■ Decreased customer acquisition costs. Increasingretention also has a direct benefit of reducing acquisitioncosts. Target marketing efforts at sections of thepopulation that are most profitable for a company willalso significantly reduce acquisition costs.

■ Improved customer profitability. CRM applicationswill enhance the ability of a company to maximizerevenue per available customer. Enhanced cross selland upsell capabilities as well as the capability tomanage underperforming customer segments are key features of a successful CRM implementation.CRM applications will also allow a company totransform every customer contact into a revenueenhancing opportunity.

■ Increased customer lifetime value. Understandingwhat is important to customers and anticipating theirneeds will create a sense of company/brand loyalty.Loyal customers translate directly to bottom line profit.

■ Established optimal customer contact strategy.Customers are the most valuable asset of anycompany. Therefore companies should protect thisasset to ensure an ongoing fruitful relationship.

This means the company should respect the right to privacy of its customers. Regulatoryrequirements also require that corporations respectthe customers’ right.

To ensure success, the responsibility for a CRM initiativeshould lie within the business. Typically the marketingorganization spearheads a CRM implementation and isresponsible for the development of the application. TheIT organization should be responsible for infrastructuresupport as well as support services. A CRM applicationmust allow mortgage banks to answer some keyquestions such as:

■ Who are my most valuable customers, and why?

■ What should I do to retain these customers?

■ Who are my least profitable customers and how canI make them profitable?

■ Who were the customers who called in the last 30days requesting a payoff quote?

■ Which customers curtail the same amount with eachloan payment?

■ Which customers converted to ACH payment in thelast few months and why?

The ability to answer these questions will help refine an acquisition, retention, and a cross-sell strategy.Understanding these customers will also provide thecompany with characteristics to look for in newcustomers. Armed with this knowledge, marketingprofessionals can design targeted programs to acquireand retain profitable customers. As the customerpipeline is filled with valuable customers, companieshave the ability to start segmenting these customers intovarious levels of profitability. The challenge is then tofocus on increasing the profitability of each level.

The basic components of a typical CRM application are:

■ A customer data repository

■ A data-mining system

■ Permission based marketing

A customer data repository is typically a data mart thatis derived from the corporate data warehouse. It doesnot have to be the largest or most complicated data


mart in the enterprise. The purpose of this data mart is to collect all customer information available in theenterprise and manipulate it so the enterprise can seea clear picture of customer profitability.

The data-mining system allows analysts to understandpreviously undiscovered relationships within their data.This understanding, combined with existing knowledge,forms the basis for a successful customer segmentationprogram. Once a customer is placed in a segment,custom tailored marketing programs can be executed toretain and improve the profitability of these customers.

Permission based marketing is the execution arm of theCRM process. This is a key concept responsible for thesuccess of CRM applications. Permission based marketingallows the company to communicate directly with itscustomers provided the customer has “opted in.” Allcustomers must be given a choice to “opt in” or “opt out.”If a customer chooses to opt out he or she should notreceive any direct communication from the company orany of its partners. It is the responsibility of every company

to protect the privacy of its customers. If a companyabuses that relationship then it will violate the trust that isthe foundation of every fruitful customer relationship.

A good permission based marketing system will allowcompanies to deliver targeted messages to customers.Custom offers and/or messages are typically designedfor different customer segments. Executed results arethen tracked to measure the success of a program aswell as to get a better understanding of what workedand what did not.

Keep in mind that there is no one way to build asuccessful CRM environment but the goal is the same —creating a truly customer centric organization.

❖

For more information on CRM, please contact BejiVarghese at (678) 419-6417 or at [email protected] or John DelPonti at (704) 344-7583or [email protected].


Don’t Forget About the RealtorsIt was the best of times, it was the worst of times . . . now it looks pretty good again with refinancespicking up in the latter part of 2000 and early part of 2001. According to the Mortgage BankersAssociation, applications for mortgages during the week ended January 4, 2001 were up 61% from thepreceding week, and refinancing accounted for 55% of the new applications vs. 45% the precedingweek. As loan officers start targeting prior customers to refinance, they may want to start nurturing evenmore relationships — this time with their local Realtors who can be a significant source of businessduring the less volatile purchase volume market.

During 2000, many online mortgage bankers whofocused on the refinance market failed and closed up shop, or are teetering on the edge. Many onlinemortgage companies moved to a B to B model thatreflects a major trend in the online mortgage industry.More and more firms have left behind the frustratingbattle for the elusive Web consumer and have retreatedto the more comfortable world ofselling services to the establishedmortgage industry.1 An October 4,2000 survey by Fannie Mae foundthat 56% of recent homebuyers used the Web to search forinformation, but just 4% applied for a mortgage online. Only one in 50 actually completed themortgage approval process using theInternet.2 It may not be the businessplan that is flawed but that companiesare overlooking the notion that Realtors can be criticalto the mortgage process, especially in a purchasevolume market.

To many first-time homebuyers their local real estateagent is their first point of contact when it comes toobtaining a mortgage. This agent has just walked thepotential homebuyer through his or her dream houseand the first-time homebuyer asks, “Now what?”Granted, there are some people who were pre-qualifiedbefore they drove by the first house. But, there aremany first-time homebuyers who ask the Realtor torecommend a mortgage lender.

When the first-time homebuyer asks about the next step,the agent is ready with a list of his or her closest andmost trustworthy loan officers who will provide service

to the agent’s customer. It is imperative for the loanofficer to provide quality service to the customer andqualify that customer as quickly as possible. The moreefficient and effective the loan officer, the sooner theagent gets paid and the more likely the agent will referhis next customer to that agent. It is no coincidencethat the agent will steer the homebuyer to the loan

officer for the customer’s benefit aswell as his own.

Sales leaders/management that haveidentified the beneficial role that theRealtor can play consider Realtors tobe their customers and have spentconsiderable time and expense toleverage these relationships.Marketing to and courting Realtors isa primary function within theselenders’ companies. These

companies also recognize the need to stay focused andnurture the “stable” part of their business.

Sure, it is easier to generate new business during a refimarket but no one knows how long it will last. Thosemortgage companies that are not paying attention to the Realtor driven purchase market, and that areimplicitly or explicitly relying solely on refinancingto attract customers, are missing an influential forcein the mortgage process, and may be sacrificing thelong-term health of their company. Don’t forget aboutthe Realtors.

❖

For more information, please contact Brian Williamson at(617) 428-8528 or at brian.williamson@ us.pwcglobal.com.

It may not be the business plan that is flawed

but that companies areoverlooking the notion thatRealtors can be critical to

the mortgage process,especially in a purchase

volume market.

1 Conger, Barry, “LoanTrader Shifts Its Approach,” Real Estate Finance Today, November 20, 2000.

2 “Mortgage.bomb,” Specialty Lender Weekly, November 6, 2000.

The date has been set for this year’s Mortgage Servicing Asset Conference presented by Executive Enterprises and sponsored byPricewaterhouseCoopers LLP:

Mortgage Servicing Asset 2001: Can You Still Compete?April 30-May 1, 2001Arlington, VA

A sample of topics and panel discussions include:

MSRs from the Perspective of ExecutiveManagement

FAS 133 Update from the SEC Perspective

Regulatory Update

The Importance of Customer Retention

An Analyst’s View — The Impact ofMSR Valuation and Hedging Practiceson Mortgage Company and MortgageInsurance Company Stocks

Insights into the DerivativeImplementation Group (DIG)

The Economics of MPF Servicing Rights

OAS Analysis and Custom Prepayment Models

The Nuts and Bolts of FAS 133

A Capital Markets View of MSRs

Pete Makowiecki, Chief Financial Officer, First Horizon Home LoansGlenn Mouridy, Executive Vice President, Chase Manhattan MortgageThomas Wind, President, CitiMortgage

E. Michael Pierce, Professional Accounting Fellow, Office of the Chief AccountantSecurities & Exchange Commission

David Mansfield, National Bank Examiner, Office of the Comptroller of the CurrencyDan Weiss, Director, Regulatory Advisory Services, PricewaterhouseCoopers LLP

Tony Muoio, Director, Mortgage Banking Services Group, PricewaterhouseCoopers LLPRobert S. O’Neill, Senior Vice President, Bank of America Consumer Real EstateLawrence P. Washington, Senior Executive Vice President, First Nationwide Mortgage Corporation

Gary Gordon, Managing Director, Financial Services Group, PaineWebber Equity Research

Timothy Bridges, Vice President, Derivatives Products Group, Goldman Sachs & Co.,DIG MemberDeidre D. Schiela, Partner, PricewaterhouseCoopers LLP, DIG Member

Frank Whelan, Senior Vice President, Mortgage Partnership Finance Operations,Federal Home Loan Bank of Chicago

Andrew Davidson, President, Andrew Davidson & Co., Inc.

James Edwards, Senior Vice President, Global Finance Director, HomeSide Lending,Chairman of the MBA’s SFAS 133 Working GroupAlison B. Utermohlen, Senior Director, Financial Management, Mortgage Bankers’Association of America (MBA), Staff Representative to the MBA’s SFAS 133 Working GroupDavid Guy, Manager, Mortgage Banking Services Group, PricewaterhouseCoopers LLP

Simon P.B. Aldrich, Director, CDC Mortgage CapitalWilliam R. Greenberg, Director, CDC Mortgage Capital

For more information, contact Andrea Connor at [email protected] or check out Executive Enterprises’ Web site at www.eeiconferences.com.

MARK YOUR CALENDARS — THE 2001 MORTGAGE

SERVICING ASSET CONFERENCE


Managing Compliance Risk Under Gramm-Leach-Bliley Consumer PrivacyRegulations — Are You Ready?With the enactment of the Gramm-Leach-Bliley Act (the “Act” or “GLBA”) and the subsequent adoptionof privacy regulations by the banking agencies and the Federal Trade Commission (“FTC”), the issue ofpersonal data protection has moved to the top of the priority list for most mortgage banking companies.To protect the trust placed in the mortgage industry by the public the industry needs to proactivelyimplement privacy protections for customers and consumers. Not to do so will invite adverse publicityfor individual institutions and the industry, regulatory enforcement action, and more limiting legislationto protect the privacy of borrowers and loan applicants.

At first glance, achieving compliance with the new privacy regulations may appear to be a fairlystraightforward exercise: develop a privacy policy,communicate that policy, give customers andconsumers notice and the ability to opt out beforesharing data with nonaffiliated third parties, andimplement appropriate measures to ensure the security and confidentiality of customer data. However, as mortgage companies and bankinginstitutions begin to interpret and analyze the practical implications of the regulatory requirements,there is an immediate realization of the complexitiesand challenges that lie ahead.

In a competitive environment where institutions havepressure to increase revenues and profits, all knowledgeincluding information about consumers is in play.Therefore, mortgage companies or business units oflarger financial services organizations should carefullyevaluate their existing operations and develop a strategyto protect their consumers’ nonpublic personal andfinancial information within their complex and changingbusiness model. Comprehensive privacy statements willbe needed and these statements must be accurate withrespect to an institution’s information sharing practices.Accordingly, back-end data management practices willhave to be reviewed to ensure they support the privacystatements. As part of privacy due diligence and impactstudies, all marketing strategies, joint marketingagreements, customer service strategies, e-businessstrategies, and operations and mergers and acquisitionswill need to be reviewed.

One of the biggest challenges facing all financialinstitutions is coordinating the privacy compliance effort of all business units and affiliates. Although theultimate responsibility of complying with the privacyregulations may lie with legal counsel or the compliancearea, without full cooperation and dedicated resourcesfrom each business unit and support function withinthe company (and its affiliates) the implementation of a detailed work plan and timetable will be ineffective and inefficient, and the company will increase the riskof a breach of the regulations.

GLBA Privacy Regulations BackgroundThe Gramm-Leach-Bliley Act (also known as FinancialModernization) was signed into law on November 12,1999. This legislation opened the door for competitionand convergence within the financial services industry.The sponsors of the bill, understanding both the potential value and risk of a single institution holding an individual’s banking, insurance (e.g., health), andinvestment information, developed Title V of the Act toregulate and protect certain aspects of consumer privacy.

The Act requires the applicable regulatory bodies (SEC,FTC, OCC, FDIC, OTS, etc.) to develop regulations thatenforce the spirit of Title V. Those regulations havebeen finalized and will apply to all mortgage companiesfrom November 13, 2000. The FTC has broadened itsauthority by widening the definition of a financialinstitution. Any company significantly engaged in


providing financial services to individuals, families, orhouseholds are scoped in. This includes mortgageoriginators, brokers, and servicing companies. In short,the FTC’s privacy rules:

■ Are based on requirements outlined in Title V of the Act;

■ Require a financial institution to provide certainnotices to consumers and customers about its privacypractices and policies;

■ Describe the conditions under which a financialinstitution may disclose nonpublic personalinformation about consumers to nonaffiliated third parties;

■ Require the implementation of reasonable measuresto ensure the security and confidentiality of customerdata; and

■ Provide a method for consumers and customersto prevent a financial institution from disclosingtheir personal information to nonaffiliated thirdparties by “opting out” of that disclosure, subject tocertain exceptions.

Compliance with the privacy regulations is mandatory for all affected companies by July 1, 2001. To clarify, thesystems, data management practices, opt out notices,privacy statements, customer service strategies, e-businessstrategies, etc., must be in place and operational by thisdate. Additionally, the regulators have made it clear thatalthough the cut-off for compliance extends to the summerof 2001, they may begin judging the readiness of particularcompanies as early as the fourth quarter of 2000.

Implementation Issues Specificto the Mortgage Industry Due to the complexities of the mortgage process and the dynamics of the active secondary market,implementing the privacy regulations is going to bemore difficult for mortgage companies than for mostother financial services institutions. Some nuances ofthe mortgage industry have been specifically addressedby the rules issued by the FTC and banking agencieswhile others will require very careful analysis andinterpretation of the regulations against current business practices and processes.

For example, the determination of an institution’sconsumers and customers is critical. The regulationsrequire initial and annual privacy notices to bedelivered to all customers whereas consumers needonly be provided with an initial privacy notice if theinstitution plans to share nonpublic personalinformation about that consumer. A customer is definedby the rules as a consumer with whom the companyhas an ongoing relationship. In working through thesedefinitions and implications, a mortgage company must consider the chain of events that can occur after a potential borrower signs an application form. TheFTC’s regulations state that a customer relationship isestablished when a loan is originated. However, if the servicing rights are transferred or sold, then thecustomer relationship is also transferred. Consider also the scenario where the loan is purchased withoutservicing rights, i.e., the originator retains the servicingrights. The rules provide that the purchasing institutionwould establish a consumer relationship, thereforerequiring that company to give notice if the consumer’snonpublic personal information were to be shared withnonaffiliated third parties. A broker establishes acustomer relationship with an individual when the


individual engages that broker to find a suitable loan.When that individual completes an application form fora particular lending institution, a consumer relationshipis established between the potential lender and theapplicant. A customer relationship is not establisheduntil the loan is closed.

Other examples of practical considerations for mortgagecompanies include:

■ Determining whether certain relationships andinvestments constitute an “affiliate” per thedefinitions of the regulations. For example, allacquisition channels as well as limited partnershipand equity investments should be reviewed.

■ Performing due diligence and establishing controlsover information practices of third party vendors,such as appraisers, title insurance companies, closing agents, mailhouses, telemarketing partners,sub-servicers, etc.

■ Developing privacy training and an employeeprivacy program to ensure compliance with thecompany’s privacy policy at all times.

■ Delivery of privacy notices and opt out forms to joint account holders and to online customers and consumers.

The Workload to Comply IsSignificant and Potentially CostlyAlthough the founding principles of privacy legislationare normally straightforward, the regulatory, political,and operational considerations add significant complex-ity to implementation. Companies are being faced withmatters of policy and interpretation with few relevantbenchmarks and without industry precedent. As OrsonSwindle, FTC Commissioner, recently stated,

“The Commission has extended the deadline forcompliance with the Rule until July 1, 2001, becausethere are likely to be substantial costs for financialinstitutions - including those operating online —associated with modifying their practices to complywith such a broad and intricate rule.”1

The privacy regulations also require an institution’s privacynotice to be accurate with respect to the organization’sbusiness practices. Consequently, an institution must havea comprehensive understanding of its data collection,management, and sharing policies and practices, as wellas those of its affiliates, and the nonaffiliated third partieswith which it shares customer data.

What Should You Do Next?The first critical step in ensuring your organization meetsthe July 2001 deadline is to assign formal responsibilityand accountability for achieving compliance with theprivacy rules. This should include forming an executivelevel steering committee to set policies and providestewardship to a working task force. The working task force should be responsible for implementation,coordination, and communication of a detailedcompliance project plan and timetable. The detailedplan should include mechanisms to track progress andthis should be communicated regularly to the executivelevel steering committee and ultimately the Board. Idealcandidates for the working task force are representativesfrom compliance, legal, IT, marketing, operations, e-business, customer service, and each business unit orproduct line. The biggest challenge for many institutionswill be the coordination between various business linesrequired to ensure consistent privacy practices andpolicies within the enterprise.

Other critical steps in moving towards compliance include:

■ Comparing current privacy and security policies andpractices to the regulatory framework and applicableagency rules.

■ Identifying inconsistencies between current practicesand public position on privacy and security.

■ Identifying and understanding in detail datacollection, use, and sharing practices across affiliatesand with nonaffiliated third parties, and determiningthe need for opt out notice and implementation.

■ Performing due diligence on third party providers toensure they are also moving towards compliancewith the privacy regulations and will use customerinformation appropriately at all times.

1 Orson Swindle, FTC Commissioner, “E-Commerce: The Future of Banking and Financial Services,” June 16, 2000, Boston MA.


Regulatory Alert — California Reconveyance StatuteOn June 19, 2000 the Fourth Appellate District of the State of California delivered its decision in thematter of Bartold vs. Glendale Federal Bank, a more stringent interpretation of California civil code 2941.The court’s decision imposes new, more demanding requirements on mortgage companies in theirprocessing of reconveyances, and the amount of time allowed for a “request for reconveyance” on a loanpayoff in the State of California. In effect, the statute now requires a request for reconveyance to becompleted the same day a loan is satisfied.

■ Determining system and process requirements forproviding opt out notices and for processing andcomplying with consumer responses.

■ Developing an ongoing compliance framework tomonitor continual compliance with privacyregulations as well as relevant state privacy laws andother federal privacy initiatives.

Complying with this myriad of rules can be a costly,inefficient, and risky undertaking or, if approachedproperly, it can be a catalyst for improving operationalefficiency and strengthening customer relationships.Companies that focus on short-term regulatory compliancewill lose the ability to manage privacy as a competitiveissue. The effective management of privacy issues isbecoming a core competency for any organization that

depends on the collection, use, and sharing of personalcustomer information in order to do business. The key tosuccess is to think strategically and develop a structuredapproach — built on an informed interpretation of thelegislation — which addresses all applicable aspects of theregulations across multiple business units, channels,products and partners or affiliates.

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Should you have additional questions regarding theimpact of privacy and the regulatory requirements onyour organization please contact Tara Laybutt at (617)428-8915 or [email protected] or MaryannMurphy at (617) 439-7369 or [email protected].

In order to fully understand the new restrictions, it isimportant to examine the process of lien reconveyance.At the time of origination the borrower executes apromissory note and a deed of trust (i.e., the loandocuments) as a security interest in the property to thelender. In order to give notice to third parties of theencumbered property, the documents are recorded atthe county recorder’s office. Further, a trustee holdslegal title until the mortgage is paid in full. Themortgage company generally sends certain keydocuments to a custodian company that holds the documents in custody for the mortgage bank until theloan is paid in full.

Once a borrower has satisfied his/her mortgageobligation, the mortgage company, in most cases,requests a copy of the loan documents from the

custodian. The loan documents are then delivered tothe trustee (the request for reconveyance has takenplace after the trustee has received the documents),signed, and sent to the county recorder’s office. Thecounty recorder’s office images the documents andsends a copy back to the mortgage company. Themortgage company is responsible for delivering thedocuments to the borrower.

The California civil code 2941 subdivision (b) 1 states,

“When the obligation secured by any deed of trusthas been satisfied, the beneficiary, (mortgage bank)or the assignee of the beneficiary shall execute anddeliver to the trustee the original note, deed of trust,request for full reconveyance, and other documentsas may be necessary to reconvey, or caused to bereconveyed the deed of trust.”1

1 California Statute 2941


Foreclosure and Reserve Modeling: Do You Know Where and Why Losses Are Occurring?Best practice reserving modeling currently involves the creation of loan level default data warehousesthat evaluate a loan’s current default operational compliance rate with accounting information (bycomparing tracking event data to investor standards) to project future losses. The focus of this article isto provide an understanding of this type of model and how it helps a mortgage company both preventand detect default related financial losses. In addition, the article provides information on the methodsfor implementing such a model.

Under the California statute, after a loan is satisfied, amortgage company is required to execute a request forreconveyance (as noted above in the civil code), andcomplete the full reconveyance process soon afterwards.The statute is designed to ensure the borrower of timelyrecording of reconveyances, and encourages a promptreconveyance by penalizing any unwarranted delay ofthe process.

As a result of the new ruling of Bartold vs. GlendaleBank, it would appear that the complicated and typicallytime consuming process of requesting reconveyancemust now be completed the day the mortgage issatisfied. Most mortgage companies would find itdifficult to complete the request for reconveyanceprocess the day the loan is paid off.

There are financial penalties associated with non-compliance with the new California statute. Thestatute requires that a borrower is entitled to $300 from the mortgage bank if the request for reconveyancedoes not take place in a timely (i.e., simultaneous) fashion. The consequences to this clause are clear:

for each 5,000 loans there is $1,500,000 worth of exposure and for each 50,000 loans, $15,000,000worth of exposure. In addition to collecting the $300,the borrower reserves the right to take legal actionagainst the mortgage bank for failure to comply with the statute (further unlimited exposure).

While additional steps and procedures can bedeveloped to meet these stringent requirements goingforward (for example, the transfer of trustee status), thereis clearly a significant cost associated with thosechanges. In addition, the mortgage company shouldconsider the potential liability for reconveyances alreadycompleted under existing processes and therefore non-compliant. This is a significant issue for any companythat services loans originated in California.

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For further information please contact Shaan Elbaum(212) 596-5598 or [email protected] orSteve Davies (617) 428-8742 or [email protected].

Average Historical Loss Methodsand the Need to Connect FinancialLosses with Default OperationsThe current foreclosure reserving methodology that ispredominantly used in industry practice is based on aprojection of average historical losses. This method has

proven effective in operational environments where the compliance and amount of operational backlogsremain fairly constant. In environments where defaultoperations are either improving or declining, theaverage reserve methodology will significantly lagoperational reality. As a result of this disconnectbetween operations and accounting some companieshave been forced to take material charges to reserves


without knowing specifically the cause of the losses orwhen the losses were expected to stop. They simplyknew their average loss per loan was rising at an ever-increasing pace.

In nearly all mortgage companies where we have seensignificant default losses there has been inadequatemanagement reporting. The common thread with thisreporting is that there is no connection between thedefault compliance rates and their correspondingfinancial impact.

Default operations personnel can state, “This is my firstlegal compliance rate” or “This is my conveyance rate.”Accounting personnel can answer the question, “What ismy average loss for the month?” In most environmentsneither can say, “My first legal compliance rate for thismonth was 86%. Of the 14% of loans that just missedfirst legal, we have already beencurtailed one month of debentureinterest that is costing the mortgagecompany $500 per month per loan.”

Default operations compliance and processing timeliness are ofteninternally measured based upon units of accounts without regard to its investment in the underlying asset of the foreclosure. Accounting departments oftentrack advances outstanding and losses on a historicalbasis. Future loss projections impacted by historicalperformance ignore current favorable and unfavorabletrends in default performance. The impact of currentinternal performance is not measured until post claimprocessing is completed and a loss is analyzed.

This delay in performance measurement has driven theneed for more refined tools to identify where losses areoccurring and why they are occurring so that bothcorrective action can be taken and material financialsurprises can be eliminated. Outlined below is howcompanies are using loan level reserve models as thetool to answer the key questions of where and whylosses are occurring.

Creation of Loan LevelForeclosure Reserve Models inthe Mortgage IndustryUtilizing the tracking information contained in thedefault modules of a company’s servicing system anddeveloping “expert program code” to evaluatecompliance with various investor and state guidelines,loan level reserve models have been developed.

In addition to projecting loss reserves, these datawarehouses link a servicer’s outstanding advances toprovide the organization’s finance and servicingdepartments with the ability to match unit operatingperformance to outstanding ledger advances forforeclosure advances and GNMA pool buyouts. Armedwith this information these mortgage companies

developed sophisticated reportingmodules to age and evaluate theadvances.

The prioritization of workflows cannow consider the outstandinginvestment of the account beingworked and can identify interestcurtailments as a result of missing keyforeclosure timelines.

Linking the general ledger to the organization’s defaultmodules via a default data warehouse provides definiteadvantages to any organization. Government insuredloans have uncontrolled losses built into their programsas well as events that create losses that are considered“controllable.” For government insured loans, a modelcan be constructed to incorporate the following concepts:

■ Event driven loss recognition permits the recognitionof losses at the occurrence of the event that causedthe interest curtailment.

■ The model is defined to allow default operations andfinance to arrive at a uniform loss definition thatserves to build good communication between theunits through “speaking the same language.”

■ The model can take projected loss information and buildpredictive factors to better anticipate future loss trends.

In nearly all mortgagecompanies where wehave seen significant

default losses there hasbeen inadequate

management reporting.


Steps to Build a WorkingForeclosure and Reserve ModelData WarehouseOnce the decision has been made to create the model,the implementation team, consisting of a mix of default,accounting, and IT professionals, performs the followingkey steps:

■ Performing a walkthrough of existing defaultprocesses to identify key source systems andassessing technology infrastructure needs.

■ Mapping fields required for the reserving model database.

■ Designing key reserving and operational reports tomeet company specific needs.

Performing a Walkthrough of Existing Default Processand Assessing Technology Infrastructure

Management should complete a high-level walkthrough of the default operating environment. This should include discussions with management of key operating units and a review of internal managementreports used to manage the day-to-day operations. Thisprocess would include the identification of key data and key source systems that must be mapped to a datawarehouse environment. Most of the servicing anddefault system software products developed todayprovide the tools to efficiently create this data mappingenvironment. Key systems to identify would include:

■ General ledger

■ Servicing system

■ Default loan systems — claims, loss mitigation,foreclosures, REO, bankruptcy, and loss analysis

■ Ancillary systems associated with documents,records, and inspections

A review of the company’s technology resources andrequirements needs to be incorporated into the modeling process. The organization’s technology structure, available resources, and processingrequirements are critical to the success of establishingan efficient environment to create and maintain aforeclosure and reserve model. Requirements would

consider factors such as availability of a dedicatedserver, database software, the LAN environment andconnectivity considerations to databases, ad hoc querytools, and ancillary reporting systems. Technologystaffing requirements would include the availability ofhardware and technical personnel and programmingpersonnel. The population of end users using the modelalso needs determined.

Mapping Fields Required for the Reserving Model Database

Mapping data and systems to the data warehouse iscritical and would include several steps:

■ A determination of systems that require importing.

■ Detail identification of where each required field tobe mapped is located.

■ Preparation of the definition of how to presentvarious categories of work activities along theforeclosure timeline. Typically, these categoriesfollow the organizational structure of the defaultasset management division.

■ A determination of the population of loans to beincluded which generally includes loans active in a default workstation, loans with outstandingforeclosure advances, and other delinquent loansthat require a reserve.

■ The identification of all accounting advances that aredefined as foreclosure advances and claims receivablefrom GNMA pool buyouts. Loan investments, accruedinterest, and pool interest advanced can also beincluded in this identification process.

■ The incorporation of reserve methodology policieswithin the model environment to identify specificlosses on reserves.

Designing Key Reserving and Operational Reports toMeet Company Specific Needs

Output from the model can provide some veryimportant information to assist in controlling the foreclosure operating environment, including the following:

■ Presentation of key category aging classifications.

■ Exception reports to provide a guide to prioritizeworkflows and to “slice and dice” data.

■ Building the reserve, isolating “controllable” losses (interest curtailments and other disallowedexpenses) from “noncontrolled losses” (two monthsinterest, debenture rate differences, and certain out-of-pocket advances).

■ Identification of loans eligible for GNMA early pool buyout.

■ Loan level data reporting for reserves, advances, and losses.

■ Trend analysis of losses and identification of rootcauses for inefficient operating performance.

■ Best execution models in comparing expected lossesto alternative loss mitigation actions.

Factors in implementing a successful foreclosure andreserve model as described include the following:

■ Communication and understanding of terms betweenaccounting and default asset management personnel.

■ A commitment from internal IT personnel in buildingand supporting the model.

■ A commitment of personnel to utilize exception andtrend reports.

■ Availability of hardware and database software.

■ Availability of mandatory information to meetminimum information mapping requirements.

■ Cooperation and information from outsource vendors.

■ Validation of the quality of the data being importedinto the model. (It is critical that key action datesincluding first legal dates, reporting dates, sales andconveyance completion dates, and claims filed dates,are accurate.)

■ The identification of an “owner” of the system whosupports the model.

■ The development of controls over importing data andsecuring and changing program code.

■ Documentation of the model.

The creation of a foreclosure data warehouse andforeclosure and reserve model can provide a powerfulaccounting tool for default and finance management tomeasure default asset management performance on areal time basis. By bringing together default assetmanagement, finance, and technology, a company widesolution can be offered to control and understand oneof the most significant servicing expenses.

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For more information regarding the development of aforeclosure and reserving model, please contact JohnAdams at (617) 428-8016 or [email protected] or John DelPonti at (704) 344-7583or [email protected].



OverviewIn June 2000, PricewaterhouseCoopers invited thelargest servicers of government loans to participate ina survey of industry practices surrounding the reservefor foreclosure losses, the processing and analysis offoreclosure losses, and accounting for early poolbuyouts. Sixteen of the top 25 government servicersparticipated. In the aggregate, these 16 mortgagecompanies service over $350 billion, or nearly two-thirds of all GNMA servicing.

The following observations were made from theinformation received:

Reserves

■ A majority of servicers establish a reserve forforeclosure losses based upon the loan’s delinquencyor foreclosure status. Most of the servicers includeall government insured loans serviced in establishinga reserve and increase the loss requirement on theloan as its state of delinquency deteriorates.

■ Most servicers establish reserves at a rate per loanbased upon historical loss experience. Lengths ofhistorical experience vary, but the most commontime period is 12 months.

■ Several servicers establish their reserves based upona specific identification of losses within the existingportfolio, which we anticipate will gain acceptanceas servicers develop more sophisticated models tocapture foreclosure and accounting data.

■ Nearly all servicers include VA no bids as a portionof their foreclosure reserve split equally betweenestimating future losses based upon historical levelsof no bids and allocating losses for specificallyidentified no bids.

■ Half of the mortgage companies surveyed reserve forconventional loan losses.

■ Responsibility for calculating the reservepredominantly rests with the company’s corporateaccounting/finance unit.

Early Pool Buyouts

■ Most servicers utilize an early pool buyout strategy,generally buying loans out of pools at 90 or 120days. Over half of the servicers with an early poolbuyout strategy base their buyout decision using afloating rate of interest based upon an internal cost of funds index as opposed to a fixed rate of interestthat generally ranges from 8.0 % to 9.5 %.

■ Servicers are split as to whether they hold theirbuyouts as an investment or sell these loans.

■ Seventy-five percent of the servicers accrue intereston GNMA pool buyouts, with the majority accruingat the VA and FHA program recovery rates for theapplicable period that is recoverable.

Supplemental Claims

■ Servicers are split with respect to the accountingtreatment of supplemental claims. Half of themortgage companies set up a receivable forsupplemental claims while the other half treat thecollection of supplemental proceeds as a recovery.

Foreclosure Losses and Disallowed Expenses

■ The level of disallowed out-of-pocket expenses forFHA loans ranged from $164 per loan to $2,490 per loan, with a median of $935 per loan. Bestpractice performers substantially eliminate delays inconveying properties to HUD and eliminate costlyunrecoverable property and preservation costs. Bestpractice performers are also successful in reinstatingforeclosure action timely on discharged bankruptcies.

Industry Practices in ForeclosuresForeclosure expenses represent one of the more significant cost elements in the mortgage industry andare evaluated in a multitude of ways. The recognition and presentation of foreclosure expenses areimpacted by several factors including: (1) how the foreclosure reserve is established; (2) the impact ofearly pool buyout programs; (3) how interest is accrued for loans bought out of GNMA pools; and (4) thetiming and methodology in analyzing and writing off foreclosure advances. PricewaterhouseCooperscompiled information to provide a general framework of common practices among mortgage companiesso as to compare their losses to the mortgage industry.

In the early 1990s, the mortgage banking industryunderwent many changes including the advancement oftechnology, consolidation, the creation of mega-servicers,and increased legislation that has impacted mortgagebanking operations. While these changes have takenplace, the minimum standards that measure servicerperformance have remained unchanged since 1993.

At that time, the Mortgage Bankers Association (MBA)revised the USAP after careful deliberation with leadersof the MBA, public accounting firms, the Association of

Certified Public Accountants, representatives ofsecondary marketing agencies, and the Affiliation ofMortgage Banking Auditors to ensure the standardsadequately addressed servicer and investor concerns.The USAP program represented the best thinking ofthese parties at that time about the minimum servicingstandards by which servicers and investors couldmeasure the effectiveness of a company’s servicingoperations. However, with all the changes in theindustry in the past seven years it may be time to revisitthis important doctrine to ensure it meets the current

■ The level of disallowed expenses for VA loans rangedfrom $200 per loan to $2,300 per loan, with amedian of $589 per loan.

■ Of those servicers disclosing loss information,unrecovered interest losses on FHA loans ranged from a gain of $2,925 to a loss of $3,188.Unrecovered interest losses on VA loans ranged froma gain of $3,210 to a loss of $3,238. These interestlosses were impacted by the interest accrual policiesof the organization, the average UPB of loans heldby the servicer, and the quality of operations inmitigating curtailed interest losses.

■ The four most common reasons for foreclosure lossesare untimely initiation of first foreclosure legalaction, untimely reinstitution of a foreclosure actionon a discharged bankruptcy, missing insurance andguarantee certificates, and delayed conveyance dueto property and preservation issues.

Analysis of Loss Information

■ Most servicers present loan loss information byinsurer to management.

■ A majority of servicers analyze their governmentlosses by segregated loss components betweenunrecoverable interest and disallowed out of pocket expenses.

■ Though current industry practice is trending toward more detailed information to analyze thecomponents of unrecoverable interest, half of the mortgage companies indicated they presentunrecoverable interest loss information tomanagement in one single category.

■ Half of the mortgage companies present disallowedout-of-pocket expenses in detail sub-categories byreason in presenting information to management.

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For more information on default related issues pleasecontact John Adams at (617) 428-8016 or [email protected] or Dylan Mann at (414) 212-1751 [email protected].


Is USAP Relevant for Today’s Mortgage Servicer?At year-end thoughts begin to turn to the extensive effort required to produce audited financialstatements, 1098 and 1099 tax documents, and, of course, the required Uniform Single AttestationProgram (USAP) letters. This minimum servicing attestation program involves significant commitmentfrom multiple disciplines across the mortgage banking industry. Particularly impacted by this work areservicing management and personnel, internal auditors, and certified public accountants as they seek todeliver a value added product to investors and the management of the mortgage company.


needs of interested parties by covering the operationalrisks now faced by this ever changing industry.

Many within the mortgage banking community arecurrently asking this same question and a diverse groupof mortgage industry participants has recently organizedto open discussions among itself and with the MBA todetermine if the time is right to revise the USAP.Currently, USAP focuses on such areas as custodialbank account reconciliations, escrow analysis anddisbursements, application of payments, recording ofdisbursements made on the behalf of borrower andinvestor records, and adjustment to ARM loans. Andwhile the current standards address delinquencies, therecurrently are no particular requirements for addressingthe significant risks associated with the foreclosureprocess such as meeting time lines provided by theFederal Home Administration (FHA) and by VeteranAffairs (VA). Other potential risks not addressed by thecurrent USAP standards include the following:

■ The implementation of new legislation such as theHome Owners Protection Act of 1998 that requiresmortgager servicers to notify borrowers that PMI is nolonger required once a loan achieves a loan-to-valueratio of 80%

■ The implementation of the various privacy acts and legislation

■ Management of the outsourcing arrangements forsuch functional areas as taxes and insurance,customer services assignments, etc.

■ The increased reliance of servicing systems and thecontrols surrounding the systems

■ Compliance with pooling and servicing agreementsbetween servicers and investors

■ Potential financial impact of not meeting lien releasedeadlines that vary among states

The key to effectively revising the USAP program is to add benefit to servicers and investors by providing a consistent measure of operational risks faced bymortgage servicers and by improving the efficiency with

which the necessary program steps are executed.Additionally, benefits that may accrue include:

■ An improvement in foreclosure loss rates andassociated expenses as inefficiencies and processissues are discovered

■ A reduction in the amount of time needed tocomplete compliance testing of the minimumstandards that may release human capital to performother activities

■ The identification of opportunities to reduce loan servicing costs by analyzing process flows for efficiencies

■ An improved understanding of the overall system ofinternal control and an opportunity to leverage thiswork to meet COSO requirements for entities subjectto this regulation

In October 2000 an initial meeting of the USAP workgroupwas convened in Washington, DC to discuss the possibilityof revising the USAP. Representatives from the internalauditing departments of most mortgage servicers, as well as the public accounting firms responsible for issuing thesigned servicing letters, gathered to open the dialogue withthe MBA. The basis for the discussion was a listing ofpossible USAP revisions and related benefits that werecompiled from all constituents. Essentially, the workgrouphas decided that USAP does need to be updated and hasresolved to approach the AICPA with their concerns and suggestions.

The last decade has given rise to several substantialchanges in the mortgage industry. Given the dynamicindustry in which mortgage companies operate, doesn’tit make sense that the minimum servicing standards forwhich companies are required to maintain are everchanging to respond to new risks and technology?

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For further information regarding USAP and the taskforce please contact Gene Johner of Chase ManhattanBank at (212) 701-5102 or Kimberly Wilson at (410)860-5903 or [email protected].

Over the past 18 months, the national manufacturedhousing industry trade association, Manufactured HousingInstitute (MHI), has developed a standardized group ofminimum performance standards for the lenders withinthis sector of the asset-backed securities marketplace.The primary rationale for establishing these performancestandards is to enhance the level of assurances to thefinancial markets regarding the quality of the industry’sfinance receivables. Rating agency, investment banker,and investor confidence in lending products secured bymanufactured housing is critical to the continuous flow ofcapital into this important sector of the asset-backedsecurities market. Absent this support and regular flow ofcapital, the entire manufactured housing industry —including manufacturers, retailers, lenders and mostimportantly, the manufactured home buyer — wouldsuffer from the resultant financial constraints.

Program OverviewMHI’s initiative, currently referred to as the Lender BestPractices Program, is a voluntary program under whichlenders within the manufactured housing industry mayparticipate to facilitate the financing component of amanufactured home sale transaction. This program hasbeen developed by an MHI task force comprised ofvarious manufactured housing lenders and retailers.While final roll-out of this program is subject to theapproval of various interested parties, the underlyingminimum performance standards central to the programhave been substantially determined and defined.

The central theme behind the Lender Best PracticesProgram is to establish a framework specificallydesigned to increase the volume and stability of fundingsources available to a participating lender by

demonstrating loan quality control through theconsistent application of systems and operationalstandards in the financing process. The Lender BestPractices Program, as currently developed, would workas follows:

■ First, the lender must choose to participate —participation is not required of all lenders as theLender Best Practices Program is a voluntaryprogram; however, to participate, the lendinginstitution must a) be a member of MHI; b) agree tocomply with all aspects of the Lender Best PracticesProgram; and c) agree to pay the fees associated withparticipation in the program.

■ Second, the participating lender must create a planthat details the systems, policies, and procedurescurrently established (or which will be established) tomaintain adherence to the MHI-developed minimumperformance standards.

■ Next, the participating lending institution’s plan — aswell as their ongoing compliance with the provisionsof the plan - would be subject to examinations by anindependent, third party firm (as approved by MHI)to ensure that:

— the plan conforms with the minimumperformance standards, and

— the participating lender’s ongoing operations arein compliance with the provisions of theirinternally-developed plan.

■ Lastly, a participating lender satisfactorily meetingthese requirements and demonstrating continuedcompliance with the minimum performance standardswould be awarded with a status designation that couldbe used in advertising and other communications.


Manufactured Housing Industry Aims forStandardization of Lending PracticesIn an effort to consistently provide quality credit products into the asset-backed securities sector of thefinancial marketplace, the manufactured housing industry has recently embarked on launching a bestpractices program to establish a minimum set of performance standards for lenders. The following articlepresents a brief overview of this voluntary program and the key components of the minimumperformance standards.

This status designation would be recognized by therating agencies, investment bankers, and investorswithin the asset-backed securities market, therebyindicating that the participating lending institution hasconsistently applied a system of policies andprocedures designed to assure the validity of theunderlying credit information.

Minimum Performance StandardsLending institutions participating under the Lenders BestPractices Program must demonstrate a minimum level ofstandards in the following four performance areas:

■ Program Guidelines and Quality Control;

■ Loan Origination, Underwriting, Servicing, and Reporting;

■ Borrower Information and Verification; and,

■ Business Partner Approval, Training, and Information Verification.

Each of these four areas and the related minimumperformance standards are briefly summarized in thefollowing section:

■ Program Guidelines and Quality Control — Theinitial performance area relates to the appropriatenessof safeguards against misrepresentations and otherfraudulent activities and the specific guidelinesregarding actions to be taken if misrepresentationsand fraudulent activities are encountered. Keycomponents of the minimum standards in thisperformance area would require the lender to havein place the following:

— policies and procedures to prevent fraud and misrepresentation

— rules of accountability for employees involved inthe origination and purchase of manufacturedhousing loans

— periodic training requirements

— quality control plans and review procedures

— corrective actions to be taken when policyviolations are identified

■ Loan Origination, Underwriting, Servicing, andReporting — The next performance area relates tounderwriting criteria and the systems in place for theservicing and reporting of loan performance. Keycomponents of the minimum standards in this areawould include:

— verification procedures for borrower income,employment status, and downpayment

— loan closing and document retention policies and procedures

— quality control plans and review procedures

— policies and procedures for underwriting,including specified limits for judgmental andpolicy overrides

— independent validation of internally developedcredit scoring models and automatedunderwriting systems

— policies and procedures for collection ofdelinquent loans as well as foreclosure andrepossession activities

— periodic training requirements

— reporting of historical loan performance

— compliance with fair lending and other regulatory considerations

■ Borrowers — This performance area relates to theaccuracy and completeness of borrower informationobtained through the financing process. Keycomponents of the minimum standards in thisperformance area would include:

— independent verification of borrower information

— analyses of credit bureau information and loan application information and proceduresundertaken if any inconsistencies identified

— exception funding approval policies and procedures

— corrective actions to be taken if fraud and/ormisrepresentations identified

■ Business Partner Approval, Training, and InformationVerification — The final performance area isintended to provide additional assurances thatmanufactured housing retailers, brokers, and otherbusiness partners within the financing transaction


perform pursuant to agreed-upon practices andprocedures, with appropriate monitoring ofperformance by the lender. Significant standardswithin this area include:

— policies and procedures related to the approvaland qualification of business partners

— corrective actions to be taken if fraud and/ormisrepresentations are identified

— ongoing standards/requirements to maintain thelender-business partner relationship

— dispute resolution procedures

SummaryIn recent years, the manufactured housing financeindustry has been experiencing inconsistent credit andfinancial performance with respect to the delivery ofquality lending products into the asset-backed securitiesmarketplace. This has, at times, tainted the overallconfidence of the investment community in the

industry’s loan products. The Lender Best PracticesProgram initiative as currently developed by theManufactured Housing Institute is an example of theindustry’s internal, ongoing efforts to provide additionalassurances to the financial marketplace regarding thequality of the industry’s loan products. The minimumperformance standards proposed within the Lender BestPractices Program represent fundamental controls thatare integral to the operations of any institution lendingin this sector, particularly those desiring to restore ratingagency, investment banker, and investor confidence.

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PricewaterhouseCoopers has assisted the ManufacturedHousing Institute in the development of the minimumperformance standards and the Lender Best PracticesProgram and has significant experience with the lending,servicing and securitization activities within this sector ofthe asset-backed securities marketplace. For moreinformation, contact Michael Stork at (612) 596-6407 [email protected].

NO TIME TO TRAIN?

PricewaterhouseCoopers offers customized mortgage banking continuing education courses to help train new hires,cross-train experienced personnel, and keep corporate staff, supervisors, and department leaders up-to-speed oncurrent issues impacting the mortgage banking industry. Courses recently conducted for our clients include:

Mortgage Banking Overview

Secondary Marketing Tactics and Techniques

The Course on Mortgage Servicing Rights

Executive Level FAS 133 Issues

The Impact of FAS 133 on the Mortgage Banking Industry

Customer Care Techniques

Accounting and Reporting in Mortgage Banking

Servicing Compliance

Over 1,000 individuals have participated in these specialized courses. Courses are customized to attendees’ businessand experience level and are taught by experienced professionals.

For more information, please contact Jason Leitner at (212) 596-7427 or [email protected] or AndreaConnor at (617) 439-7395 or [email protected].

Strong collateral handling operations remain an integral part of a warehouse lender’s operations and riskmanagement practices. As the field of players in theindustry continues to decline and the characteristics ofthe typical warehouse lending customer move towardsthe small to mid-sized mortgage company, strongcollateral handling practices are becoming anincreasingly important tool to mitigate the risk of lossand ensure the efficiency of operations to help thebusiness remain profitable. Additionally, the warehouselending industry has begun to see a steady increase inlosses over the past few years, when the business hashistorically had very minimal losses. Several of theserecent losses have been due to fraud, therefore controlover the underlying collateral has been an increasinglyimportant aspect of the business.

Survey ResultsThe following observations were noted from the survey:

Organization and Structure of the Department

■ The warehouse lenders surveyed indicated that“middle-market” customers comprise the majority ofthe portfolio. Middle-market was defined as a mediumsized independent mortgage company, generally withtotal assets consisting of $100 million or more and aservicing portfolio of $2 billion or more.

■ Collateral handling operations are structured bycustomer, and collateral handling operationspersonnel are assigned primarily by the complexityof the borrower or credit.

Advance Methodologies

■ The most commonly used advance methodologyis matched funding, or the process of providing

advances against the warehouse line at the individualloan level for the collateral. Borrowing bases areused as an advance methodology; however, thismethodology is most often reserved for largermortgage companies that have excess liquidity and do not require funding on a loan by loan basis.

■ The average number of sublimits (i.e., concentrationlimits by product, wet vs. dry advances, committedfor sale in the secondary mortgage market vs.uncommitted, etc.) contained within the warehouselines is four.

■ Availability calculations under the line commitmentand sublimits are generally performed prior to eachadvance request from the customer.

Funding

■ Most respondents typically fund advances against thewarehouse line of credit twice each day, with oneadvance being a swing line advance.

■ The most often used funding mechanism foradvances is wire transfers.

■ Most respondents perform secondary wireauthorizations that consist primarily of a verificationof the accuracy of the input to the wire system.

■ Loan operations or a funding department withincollateral handling operations is the primary arearesponsible for processing funding of advancesagainst the warehouse line of credit, as well asprocessing payoff against the line of credit fromproceeds from sale of the underlying mortgage loan collateral in the secondary mortgage market.


Highlights from the PricewaterhouseCoopersWarehouse Lending Collateral HandlingOperations SurveyPricewaterhouseCoopers conducted a comprehensive survey of industry practices surroundingwarehouse collateral handling operations. This article summarizes some of the findings of this survey,for which many of the top 15 warehouse lenders (based on outstanding commitments) participated.


Miscellaneous Collateral Handling Issues

■ Most collateral handling processes are performedmanually, including wet advance requests, updates to the collateral system upon receipt of the dry loanpackage, and shipping of the dry loan package to theultimate investor, etc. We see this as one opportunityfor most warehouse lenders to improve the efficiencyof their operations through automation of theseprocesses by electronic uploads of data to the collateralhandling system, as opposed to manual updates.

■ E-mail and bulletin boards are the most often usedmedium for electronic data transmissions. Very fewrespondents indicated use of the Internet, which webelieve is a medium that could significantly improveefficiency of operations for warehouse lendersthrough automated updates to the collateral handlingsystem, as well as report generation for its customers(i.e., detail of mortgage loan collateral on thewarehouse line, summaries of daily activity, etc.).

■ Most respondents verify dry loan packages prior toupdating the loan status on the collateral handingsystem or giving credit in the calculation of availabilityon the warehouse line and within the sublimits.

■ Statements and reports of activity are generallyproduced daily and provided to the customers forreconciliation. These reports are generally sent tothe customers by fax or by mail.

■ Audits are performed on customer’s collateral andoperations; however, there was not a consensus onwhen the audit should be scheduled, such as when acustomer becomes troubled or when the lender notes“red flags.” We see this as one area where mostwarehouse lenders should consider performing theseoperation reviews of customers when potential redflags occur, as opposed to on an annual cycle priorto renewal of the warehouse line, or when the loansbecome troubled. Considering the changing natureof the customer base for most warehouse lenders(i.e., a continued shift toward the small to mid-sizedmortgage companies that originate more than justconforming agency paper), warehouse lendersshould consider a more risk based approach to these operational reviews.

Management Reporting

■ Most respondents receive detailed volume and agingreports; however, trending, exception, and profitability

reports are not as widely obtained. Most respondentsindicate limitations of the collateral handling systemused as the reason these reports were not generated;however, alternate processes have generally not been developed to provide this information. We see this as one area upon which most warehouselenders could improve. Timely receipt and review of trend and exception reports can help to identifypotential problems or red flags early, which will putthe warehouse lender in a better position to mitigate the risk of loss. Additionally, thorough profitabilityreports by customer and product will help warehouselenders to properly price their products for risks taken,as well as provide the information necessary todetermine whether the lender is making a reasonable profit from its relationships.

Collateral Valuation

■ There is not a significant difference between theadvance rates used for prime products vs. subprimeand home equity products. Given the vast differencein the liquidity of the market for some of these productsand the difficulty in hedging certain products, wewould have expected to see lower advance rates forcertain loan products.

■ Independent valuations are generally required forloans collateralized by mortgage servicing rights.

SummaryGiven the changes in the market place, strong controls over collateral handling is crucial to the efficiency andprofitability of a warehouse lender. We see significantopportunities for most warehouse lenders to improvetheir operations by investing in technology to improvethe efficiency and effectiveness of operations; providinginformation necessary to identify trends and potentialproblems early through better management reporting;and structuring transactions such that the risks of theloan and the underlying collateral have beenappropriately considered.

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For additional information about the survey, or to learnhow you can participate in future surveys, please contactTimothy Kviz at (612) 596-6436 or at [email protected].


OverviewThis past September, the Financial AccountingStandards Board superceded FAS 125, “Accounting for Transfers and Servicing of Financial Assets andExtinguishment of Liabilities” with FAS 140. As a directreplacement of FAS 125, it carries forward many of theprinciples of FAS 125 while incorporating technicalamendments to certain key points.

In essence, the Statement revises the standards for theaccounting for securitizations and other transfers offinancial assets and collateral, and in places requiressubstantial new disclosures. Although many of FAS125’s provisions have been carried over withoutreconsideration, there are some major changes that will need to be considered.

The effective date for the Statement, further explainedbelow, can vary. But in summary, the new disclosures willneed to be adopted for any period ending after December15, 2000 and new transfers of financial assets shouldgenerally follow FAS 125 until after March 31, 2001.

Key AmendmentsQualifying Special Purpose Entity’s (QSPEs) —Qualifications and Consolidations

■ The qualifying conditions for a QSPE have beenamended slightly. The key change is that in contrastto the 1% threshold dictated in FAS 125, third partiesmust now acquire at least 10% of the QSPEs’beneficial interests (based on fair values), unless thetransfer is a guaranteed mortgage securitization(defined as a “securitization of mortgage loans that iswithin the scope of Statement 65, as amended,including a substantive guarantee by a third party”).

■ In addition, for the first time FAS 140 limits what theQSPE may hold, for example, to passive financialassets transferred to it, passive derivative financialinstruments that belong to beneficial interests issuedor sold, and guarantees and collateral rights thatpertain to the assets it holds.

■ Finally, a qualifying SPE cannot be consolidated ontothe books of the transferor or its affiliates.

Removal-of-Accounts Provisions — Narrowing of theTypes of Provisions Compatible with Sale Accounting

■ FAS 140 significantly restricts the number of sellercall options, commonly know as removal-of-accounts provisions, that can be retained over theassets transferred and still obtain sale accounting for the transfer of the financial assets.

■ Whether such provisions preclude sale accountingdepends on whether the transferor maintainseffective control over the transferred assets.

■ The new guidance in the Statement focuses on specific provision themes to consider, namely, whetherremoval of assets already transferred can be undertakenunilaterally and for specific assets as identified by thetransferor. In contrast, transfers of financial assetssubject to calls embedded by the issuers of thefinancial instruments, for example, callable bonds orprepayable mortgage loans, do not preclude saleaccounting. Such embedded calls do not result in thetransferor’s maintaining effective control, because it isthe issuer rather than the transferor who holds the call.

■ Clean-up calls should continue to be allowable forsale treatment.

Significantly Enhanced Disclosures for Securitizationsand Retained Interests, When Accounted for As a Sale

■ Disclosure requirements in this area are now greatlyexpanded, especially where a transfer of financial assetshas been undertaken during the period and a sale hasbeen recognized. As discussed, these disclosurerequirements are effective December 31, 2000. Foreach major asset class the entity must now disclose:

1. Accounting policies used to measure any retainedinterests and the methodology used to determinetheir fair values.

2. The characteristics of securitizations and the gainor loss recognized from sales of financial assets insecuritizations.

3. Key assumptions used in measuring the fair valueof retained interests at the time of securitization.

4. Cash flows between the securitization SPE and thetransferor, unless reported separately elsewhere inthe financial statements or notes.

FAS 140 Replaces FAS 125

■ Additional disclosures are also now required for anynew interests an entity has retained in securitizedfinancial assets during the latest reporting period.These should include:

— A sensitivity analysis or stress test showing the hypothetical effect on the fair value of those interests of two or more unfavorablevariations from the expected levels for each key assumption, and a description of theobjectives, methodology, and limitations of the sensitivity analysis or stress test.

— For securitized assets and any other financialassets that it manages together with them:

■ The total principal amount outstanding, theportion that has been derecognized, and theportion that continues to be recognized ineach category reported in the statement offinancial position, at the end of the period.

■ Delinquencies at the end of the period.

■ Credit losses, net of recoveries, during the period.

— Finally, enhanced disclosures for collateral nowrequire disclosure of the entity’s policy forcollateral and security lending and the amountsof any assets pledged as collateral not disclosedseparately elsewhere in the financial statements.

Disclosure of Gains and Losses with RetainedSubordinated Interests

■ When a securitization features a subordinatedinterest retained by the transferor, FAS 140 nowrequires the transferor to identify and explain ifany gain recognized at sale would have been greater than if the entire asset had been sold instead(with no retained interest), or to the contrary, if any losses recognized on the sale would have been higher. The new Statement requires this to beexplained in the notes to the financial statements asit states that it is therefore likely that the impact ofthe retained interest being subordinate to a seniorinterest has not been adequately considered in thedetermination of the fair value of the subordinatedretained interest.

Elimination of Special Treatment for FDIC Insured Banks

■ To level the playing field, FAS 140 eliminates anyspecial treatment for FDIC insured banks, requiringthem to be held to the same isolation standards withrespect to securitizations as any other entity.

Implementation RulesFAS 140 comes into force for new transfers of financialassets effective March 31, 2001. Until then, FAS 125continues in force and should be followed. But it is notquite as simple as that:

■ Any transfers made after March 31, 2001 underexiting commitments to beneficial interest holdersunaffiliated to the transferor or its affiliates andagents, should continue to be accounted for underthe accounting principles in place at the date thecommitment was made.

■ Any QSPEs that do not qualify under FAS 140 can be‘grandfathered’ provided they maintain their QSPEstatus under FAS 125, do not issue new beneficialinterests after March 31, 2001, and do not receiveassets over and beyond commitments already in place.


■ The new disclosures discussed must be adopted in full this year for fiscal years ending after December 15, 2000. However, FAS 140 does not requirecomparative disclosures for securitizations in periodsending on or before December 15, 2000. In addition,the new disclosures and reclassifications required forcollateral transferred in secured financings areeffective December 15, 2000 with prior periodcomparatives not required.

■ Finally, any collateral previously recognized bycreditors under FAS 125 but no longer allowableunder FAS 140 should no longer be recognized in financial statements for periods ending afterDecember 15, 2000 and the prior periodcomparatives should be restated for that effect.

Summary FAS 140 introduces some significant changes in itsreplacement of FAS 125. As a replacement of theprevious Statement rather than a separate amendment tobe analyzed, it should be easier to digest. This articleextracts the key changes but the entire Statement shouldbe read in full to fully appreciate the extent and natureof some of these changes. A draft on an implementationguide should follow from the FASB before March 31,2001 to further assist in determining how theamendment will affect business.

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For more information on FAS 140, please contact TomJeter at (415) 498-7569 or [email protected],Richard Rollinshaw at (415) 498-7872 [email protected] or David Guyat (612) 596-8101 or at [email protected].

LOOKING FOR BEST PRACTICES

IN THE MORTGAGE INDUSTRY?

The Mortgage Banking Services Group ofPricewaterhouseCoopers has been at the forefront ofdeveloping and publishing surveys regarding emergingtrends and significant issues affecting the industry. Ifyour company would like to participate in one of oursurveys, please contact the following survey leaders:

Quarterly Customer Retention SurveyMartin Hurden, (617) 428-8463,[email protected] Muoio, (617) 428-8178, [email protected]

Quarterly MSR Survey*Jon Martin, (617) 439-7368, [email protected] Vatev, (617) 428-8821, [email protected]

Foreclosure Loss SurveyJohn M. Adams, (617) 428-8016, [email protected] Mann, (414) 212-1751, [email protected]

Warehouse Lending SurveyTim Kviz, (612) 596-6436,[email protected]

Alternative Asset Class Exception Reporting MetricsMike English, (212) 596-7357, [email protected] Hollerich, (212) 520-2696, [email protected]

Please note that all surveys are published on a “no-name”basis and all information is held in the strictest confidence.Surveys are generally not distributed in the public domainbut an overview of survey results is occasionally includedin our newsletter and other select publications.

*Our MSR Survey currently covers the industry’s top 15mortgage servicers and focuses on accounting, valuation, andrisk management issues associated with their mortgageservicing right portfolios. There has been a lot of interest fromcompanies that fall out of that range to participate in thesurvey. Companies outside that range have indicated that inorder to compare data more accurately, a separate surveywould be more beneficial and, as such, have requested aseparate survey. If you are interested in taking part in such asurvey, please contact Jon Martin at (617) 439-7368 [email protected] or Petko Vatev at (617)428-8821 or [email protected].


Complexities in the Asset Securitization IndustryAsset securitization is an increasingly attractive source of funding. In fact, in 1999 the industry saw more than $400 billion mortgage-backed and over $350 billion of asset-backed instruments issued.Contributors to these markets include residential mortgage, commercial mortgage, home equity,collateralized bond obligations (CBO) and collateralized loan obligations (CLO), credit card, auto, andother equipment, and trade receivable collateral products.

Growth in the industry continues to be driven by newasset types, structures, tax and accounting regulations,and a further acceptance of securitization in the capitalmarkets. However, as the industry matures, it continuesto experience its share of bumps and bruises. Servicerdefaults, incorrect payment calculations, and incompleteor delayed reporting are just some of the events thathave investors and the rating agencies asking thefollowing questions:

■ Once a transaction has closed, what happens to it?

■ Who is responsible for the ongoing calculations,reporting, and monitoring of the collateral and bond distributions?

■ Who is monitoring the parties performingthe calculations and reporting for capabilities and capacity?

■ How accurate should investor reporting be?

■ To what degree should transactions be monitored?

■ What happens when a good deal goes bad?

■ With increasing complexities in the market, how cancompanies leverage technology?

Unfortunately, with the complexities that surround this industry, there are no easy answers.

Understanding the Roles andResponsibilitiesFrom the servicer to the trustee to the issuer to the rating agency, each party to a transaction must have anunderstanding of its responsibilities. Although these arenormally written and explained in the governing

documents, they can be deal or program specific, andcan change throughout the life of the deal, i.e., it maybe necessary for an organization to take on additionalroles when certain events occur.

In order to mitigate the effects of taking on additional responsibilities, an organization must trackany amendments to the governing documents as theypertain to each party’s compliance to the transaction.They may also monitor responsibilities by identifyingthe occurrence and frequency of reporting revisions andmispayments, and track the outstanding delinquenciesand cumulative losses experienced in the pool ofcollateral. The performance of the pool can be anindication of the performance of the parties involved.

Not adequately monitoring and preparing for suchevents can lead to unanticipated operational burdensand expenses. Policies and procedures — and thedocumentation behind them — need to be complete to capture such changes and include guidelines andimplementation plans should they occur. And for thetransaction, neglecting these events can lead to apossible downgrade in the ratings that ultimatelyreduces its liquidity.

Accuracy and Timeliness of InformationThe accuracy and timeliness of information can alsoinfluence the liquidity of a transaction. The incorrectapplication of funds can throw balances off from month tomonth and can have an effect on the payments of principaland interest made through the trust and to investors.Incorrect data concerning the performance of the assetscan greatly influence triggers built into the structure.


Assurance that this information is being compiledcorrectly and in a timely matter can be caught byperforming independent calculations, through shadowprocessing and payment verification. Implementing such procedures comforts investors, rating agencies, andissuers that the transaction is performing as well as itshould and serves as the quality control measure thatassures its liquidity in the secondary market.

Leveraging TechnologyAsset securitization has evolved into a technicallycomplex, highly competitive market. As the industrygrows, it places pressure on the systems involved tohandle an increase in the number of assets and thenumber of data items processed. The trend is largelydriven by new types of assets being securitized and thestructural and reporting requirements of the securitiesbeing issued in the marketplace. Other factors such astimeliness, quality control, organizational growth andindustry consolidation, and pricing are also placing theirrequirements on systems. The reliance on systems andthe ability to overcome such factors of data storage, aggregation, flow, and reporting is critical for anorganization to remain profitable in the industry.

Data Requirements

The complete, accurate, and timely aggregation of asset level data are fundamental requirements for theongoing calculations of servicer remittances and bondpayments for mortgage and asset backed securities.New collateral types and new structures entering themarket are adding strains on the systems currently inplace by expanding the typical data elements requiredto process a transaction.

New collateral types introduce characteristics and data elements that are specific to that asset type — fromamortization characteristics to performance measures.New security structures may include structural features,or “triggers,” that act as credit enhancements to theoutstanding certificate holders when the collateralperforms poorly. These characteristics and features mayrequire new data to be collected at either the asset levelor at some other intermediate level.

Systems need to be designed to accommodate the storage and flow of data and be flexible for the additionof new collateral types.

Data Processing and Reporting

Many problems experienced by industry participants are directly related to the processing and reporting ofcollateral level data, the significant increase in thenumber of assets and data items processed, and theshrinking window of time allotted to perform thecalculation and reporting functions.

Collateral processing requires systems that can handlelarge volumes of information and be utilized as a toolfor users for data validation and aggregation of assetlevel data. Periodic processing of data requiresflexibility in the timing and frequency of data updateswith batch processing features being available.

Reporting should be designed to include all datanecessary to perform bond payment calculations andany pool performance data necessary to perform anytrigger calculations. The reporting should include anyother items as they pertain to compliance to thecovenants in the governing documents to thetransaction. And finally, it should include all collectionsand disbursement information necessary to reconcile theprincipal and interest account held by the servicer.

Technology has given way to new, effective avenues for processing and investor reporting. Sophisticateddatabase and Web based applications allow for timelyand effective processing while offering a wide variety ofdelivery and presentation methods.

Performance Measures and Forecasting

Access to periodic collateral data should be madeavailable to parties from both inside and outside of theorganization. This ensures that the same data is used by all of the parties involved with the transaction.

Internal finance, compliance, and quality controldepartments depend on asset level data to determinethe existence of documentation on the assets andpossibly value of the assets prior to securitization. This access can be used to verify performance andcompliance to program guidelines.

Market participants rely on asset level reporting as thebasic source of information that is needed to analyze,price, trade, and settle the offered securities. Periodicbalance and asset information allows for projectionsand forecasting of cash flows and the application of

“what if” scenario analytics. The ability to accesscollateral data on demand, in various formats ormediums, allows the parties to make timely decisions in the secondary market.

Finally, periodic data allows participants to track assetand servicer performance, and can be used for riskanalysis when evaluating a portfolio. Systems that canbe accessed for these ad hoc uses can add value and,consequently, liquidity to a portfolio.

In the industry today, it is critical to build systemsflexible enough for portfolio level covenants andongoing ad-hoc requests from either inside or outsidethe organization. Reporting requirements on thetransactions are becoming more robust with data beingoffered through “on demand” Web-based applications.

Structural AnalyticsWith new collateral types being securitized and themarket maturing, master servicers, calculation agents,and trustees must be able to handle sophisticated

analytic and payment calculations. Accuracy of thesecalculations — and the data behind them — require a controlled, secure systems environment. Investorreporting requires portfolio level collection anddisbursement information, pool performance, cashreconciliation, and activity. Each piece requiresinformation to be gathered on the asset level andaggregated on the pool or portfolio level. The data may come in from one source or from multiple sourcesover multiple mediums. Tests need be established tocheck for accuracy and/or reasonableness of the data as it can have a bearing on the actual payments ofprincipal and interest to the investors.

Overcoming the complexities involved in the industryand placing controls to handle them requires a highlevel of expertise as well as having access to systemsthat can perform sophisticated cash flow modeling andreporting. The ability to understand and monitorproduct specific or deal specific issues, and the abilityto make critical decisions, requires knowledge andexperience. Today’s employment environment placesan added burden on the organization to prepare for the



turnover of existing staff and training of new employees.Further, this demands greater surveillance of thecomplexities of the transactions and the partiescontracted to perform these duties.

Portfolio Growth and DiversityAs the industry grows, portfolios have increased in sizeand features. Further, due to recent economics andstrategic positioning, loan servicers, master servicers,and trustees have experienced a large amount ofconsolidation. This has lent to the increase of theportfolio sizes through acquisition, which requires theplayers to take steps to understand each transaction.The larger and more diverse aspects of the portfolioincrease the exposure to extraordinary events.

Prospects for Growth in the IndustryPeering into the future, the industry is expected tocontinue to expand with asset securitization being usedby more participants to raise capital. This expansion is pushing across traditional collateral types, such asresidential and commercial mortgage products, as wellas introducing new products such as future flow assets

and less traditional trade receivables. Withsecuritization expanding across the globe, organizationsmust be aware of the applicable rules and regulationsthat govern such transactions, the treatment of foreigncurrencies, and the ongoing tax implications.

Competition and pricing structures have the serviceproviders scrambling to increase efficiencies and decreasecosts. Consolidation amongst the players is expected tocontinue, adding to the volume of information and dataprocessed in the limited time allotted to turn around thecalculations and reporting on the portfolio.

Accordingly, each of these points addresses the need for enhanced services and sophisticated technology. For organizations involved in securitized transactions,acquiring the best services and technology is of critical importance.

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For more information on the post closing servicesoffered by the PricewaterhouseCoopers AssetSecuritization Group, please contact Holly Holland at(703) 741-1729 or [email protected] orDrew Persons at (703) 516-8408 or [email protected].

Regulatory Concern Over Residual Valuation On December 13, 1999 the Federal Banking and Thrift Regulatory agencies jointly issued a guidancedocument on asset securitization activities in which they expressed their concern regarding industrypractices. The agencies emphasized that both initial and ongoing valuation of the retained portion ofsecuritized assets must be supported by reasonable, conservative, and objectively verifiable assumptions.

The regulators indicated that they would be morerigorously assessing how regulated entities manage and report on securitized assets and related retainedinterests. The guidance stated that “institutions that lackeffective risk management programs or that maintainexposures in retained interests that warrant supervisoryconcern may be subject to more frequent supervisoryreview, more stringent capital requirements, or othersupervisory action.” The regulators embarked upon aprogram to train examiners and hire new staff to morecarefully evaluate securitization activities. Many

regulated institutions prepared for this heightened levelof review in order to avoid unpleasant surprises. Someof the more common problems encountered by theseinstitutions and lessons learned follow.

The most frequently encountered problems havestemmed from significant weaknesses in the securitizationpractices of some institutions, including non-bank issuers;namely, (1) failure to recognize and hold sufficient capitalagainst recourse obligations; (2) excessive or inadequatelysupported valuations of retained interests, including, in

some cases, failure to comply with the requirements ofFAS 125 (now superceded by FAS 140); (3) liquidity riskassociated with over-reliance on securitization as afunding source; (4) inadequate skills to service the loansproperly; and (5) absence of adequate independent riskmanagement and audit functions.

To assure that the securitization process is withoutincident, institutions need to align their current policiesand procedures with agency expectations. In reviewingexisting policies and procedures, institutions should notconsider where they stand against minimum standards,but against industry best practices. Areas that should bereviewed include:

■ Funding — The stability of existing sources of funds and the plans to access alternative sourcesof funding.

■ Underwriting — Monitoring of policy exceptionsand judgmental overrides, as well as scorecarddevelopment and use of risk-based pricing tools.

■ Servicing — Collection practices and loss mitigation,bankruptcy, and other processes.

■ Reporting — Deal maintenance and investorreporting, as well as collateral management process.

■ Hedging — Reasonableness of hedging strategies andinstruments, and an analysis of hedge effectiveness.

■ Valuation — Assumption development, tracking andchange process, sensitivity analysis, and validationsby independent third party.

■ Internal Review — Periodic transaction testing andverification, and compliance with policies,procedures, and covenants.

A significant part of the recent focus by regulators has been on the valuation methodology (specifics of the financial model) and the reasonableness of theassumptions for residual valuations, including retainedservicing rights. Accordingly, assumptions should bewell supported and well documented, principally bystatic pool analysis and back-testing. Securitizationpool performance should be evaluated under expectedperformance and, generally, under stress cases as well.Sensitivity of all key variables, such as prepayments,

delinquencies, losses and charge-offs, and excessspread, reflecting their impact on earnings and capitalshould be conducted as part of the modeling process.

Regulatory capital considerations should be reviewed in the context of the assumptions and model employed.Accurate and timely reporting of recourse obligations,reasonableness of risk-weighting of assets with recourseand related contingencies, deal structure and performancereview to identify implicit or inadvertent recourse, andconsideration of servicing rights are built into regulators’review of the capital needs. Newer asset classes andthose that have been more volatile historically, such assub-prime mortgages, will likely attract particularlydetailed scrutiny. Again, support and documentation ofthese decisions must be thorough and complete asevidence of a robust process.

In summary, the regulatory agencies are making asubstantial commitment to better understanding andevaluating residual valuations, assumption derivation, and model development. This commitment is being madefor several reasons: first, to avoid unpleasant surprises withinstitutions that rely heavily on securitization for theirfunding sources, and second, for those larger institutionswhere securitization is an integral, but not dominant, partof their funding strategy, regulatory agencies haverecognized the need to be able to accurately assesscapital charges. Securitization is here to stay and theregulators are planning to be on the inside of the process,not on the outside. Absent efficient markets to providerealistic market values for these instruments, evidence of a thorough and rational valuation methodology is oftenthe best method by which regulators can evaluate residualinterest valuations.

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For more information on processes and methodologiesto assist in the residual valuation process, please contactTom Glanfield at (703) 741-1932 or [email protected] or Matt Brockwell at (703) 741-1933or [email protected].



A key component of managing these alternative assetclasses is exception reporting. Exception reporting is required in order to provide accountability to acompany’s business rules. With more focus onexception reporting on first mortgage underwriting and servicing, it is easy for the scope of reporting inalternative asset classes to be too broad, or in somecases non-existent. This article will explore reportingmethodologies and review some key reporting metricsthat should be tracked in alternative asset classexception reporting.

Exception Reporting TheoriesReporting for operations that are proceeding accordingto plan should be minimized and attention should befocused on those elements that represent significantdeviations from expectations — a fine theory indeedwhen applied to a bank’s primary operation, such asunderwriting and/or servicing first mortgages. But whatif the appropriate focus isn’t being given to an operationin the first place? Meaning, if an operation isn’teffectively reporting on its core business (i.e., firstmortgages), then how does a bank or loan servicerimplement meaningful exception reports to alternativeasset classes?

To achieve true exception reporting, one must be able toselect records for inclusion in a report based uponsignificant deviation between an operation’s measureand a budgeted, or baseline, amount. Selection ofrecords for inclusion based solely on the magnitude of

an operation’s measure is inadequate for exceptionreporting. For example, a company might have anexception report showing only level 3 or 4 (C or D) autopaper with a loan-to-value (LTV) over 115%. It mighthave another report to flag first mortgage loans that havenever been delinquent, but also have not been subject toa HELOC cross-sell. Reporting the exceptions allows oneto cut to the heart of both problems and opportunities,skipping the many instances in which performance is asexpected to be. Further, by establishing baselines forexception reports, the tested metrics have more meaningwhen reviewed by management against current policiesand/or industry baselines. Closely monitoring andadjusting these baselines when necessary adds evenmore meaning to a company’s exception reports.

Building on this theory of skipping instances in whichperformance is as expected, one can explore the methodof exception reporting that is referred to as the Paretoanalysis — or, more commonly, the 80-20 rule. Its premiseis that about 80 percent of the result tend to be generatedby about 20 percent of the cause. For example, perhaps80% of a company’s defaulting credit cards are comingfrom a small percentage of its customers, say, those withdebt ratios greater than 55%. By segregating out thosecustomers with high debt ratios and placing them in ahigher priority collection queue, the collection effort canbe minimized while maximizing quality collection targets.This is just an example of the way techniques can beapplied that will allow for a different view of theproblems and successes in alternative portfolios.

Exception Reporting in Alternative Asset Classes With the roller coaster ride interest rates are on and the uncertainty currently being experienced in thethree major housing indices (housing starts, new home sales, and existing home sales), many mortgagebanks are looking for new ways to generate higher and more consistent cash flows (i.e., profits). Due inpart to the consolidated banking environment, alternative products, such as credit cards, home equitylines of credit (HELOCs), and automobile loans, are now being offered by many mortgage lenders.However, underwriting practices are not as highly regulated in some alternative products as they are inthe first mortgage environment. This has, in part, contributed to that fact that delinquency levels arerising and personal bankruptcies are at an all time high. Without due attention being paid tounderwriting policies and portfolio characteristics, managers looking to alternative products for moremarginal revenue may only find decreasing returns and increasing costs of servicing.

1 Effective campaign management lends itself to exception reporting by allowing a company to track the type of customer garnered by thecampaign. If a campaign is costly or attracting non-buying or unprofitable customers (i.e., customers who typically do not utilize credit balances),then these should be considered exceptions to the scope of the campaign.

Exception Reporting MetricsLittle has been written on specific metrics used inexception reporting, be it due to corporate confidentialityor the many varying theories and combinations thatmanagers use in exception reporting. When puttingexception metrics in place, one must first analyze theportfolio and decipher from where the largest percentageof problems originate in the current portfolio. Thisrequires detailed knowledge of the business beingreviewed. By applying the exception reporting theoriesdiscussed above, with detailed industry knowledge,businesses can develop meaningful exception reports thatallow them to maximize the efficiency of collectionresources and manage underwriting rules in alternativeasset classes. Make no mistake, however, the success ofimplementing an exception reporting program dependsnot on the theory or methodology, but on the knowledgeof the business and resultant metrics that are identified.

Further, exception reports must be spread across alllevels of the business process. Exception metrics in theoriginations area can help managers focus on pricingissues and the effectiveness of campaign management.

Servicing managers must be kept aware of metricsmeasuring compliance and key collection ratios, or be

subject to possible monetary fines by state and federalagencies. The table below outlines some key exceptionmetrics in four different asset classes.

Although this is just a small sample(PricewaterhouseCoopers has identified over 2000metrics in the home equity and subprime lendingindustries alone), it demonstrates that exception metricscan help companies understand problems and act onsolutions when reviewing an operation’s alternative assetclasses. Exception reporting can make essential financialinformation available throughout the company and beuseful to the managers who are actively implementingand sustaining performance measurements that allow forimproved processes and decreased costs. Moreover,implementing exception metrics allows people on thefinancial side of the business to contribute to the successof the organization on the front end, instead of waitingfor improvements to show up on the bottom line.

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For more information on detailed metrics used in otherasset classes, please contact Mike English at (212) 596-7357 or [email protected] or MichaelHollerich at (215) 740-3938 or [email protected].


Asset Class

Auto Loans

Sub-Prime HomeLending

HELOC (Home EquityLine of Credit)

Credit Cards1

Metric

■ Credit Score < X with LTV > Y

■ Debt Ratio > X%

■ Fall-Out Reporting

■ Scorecard Monitoring

■ Servicing Performance Monitoring

■ Open lines with no withdrawal in X months

■ Campaign Management

■ Campaign Respondent Quality

Description/Purpose

Track internal credit policy exceptions by measuring potential high-riskcustomers.

Track number of instances where underwriter approvals fall outsideinternal policies and/or industry baselines.

Monitor potential negative pricing trends and processing inefficiencies(e.g., application to funding ratio).

Provides management with the ability to monitor ‘spread’ or ‘mix’ ofbusiness over multiple credit grades. Exceptions arise when volume inone grade of business out-weighs others.

Track compliance with investor, HUD and/or individual state servicingguidelines.

Track existing customers for addition to mail lists and other campaigns.These exceptions may lead to more business from existing customers.

Track performance/effectiveness of campaigns by measuring cost to response rate ratio.

Measure customer quality of campaign respondents vs. existing ‘like’customers.

The mortgage industry in particular lends itself to theopportunities and challenges of deploying technology to increase efficiency, enable better decision making, improvecompetitiveness, enhance revenue, and reduce costs. Electroniccredit scoring and approval methods, automated appraisals, loanlevel prepayment models, integrated general ledger reporting,and customer relationship management systems are just a few ofthe many areas where mortgage companies are spending their ITdollars. However, there is not a direct relationship between theamount of money and resources allocated to the implementationof an information technology project and its complexity. In fact,each project — no matter how big or small — can be driven bysome fundamental key concepts. Our experience has shownthat without these “basics” as the foundation for the project, therisk of failure increases substantially. Interestingly, none of thesuccess factors is focused on technology itself. Outlined belowis a listing of some of the strategies that help ensure a technologyimplementation has the highest likelihood of success:

Solves critical business problems

Successful technology projects are enablers to address criticalbusiness problems. It is our experience that technologyprojects that are aligned with strategic business objectives have a very good chance of succeeding.

Has executive sponsorship

Executive sponsorship is a critical success factor for anyproject. This commitment will ensure that the appropriateresources are committed and that when decisions need to bemade that impact multiple parts of the organization, they canbe done quickly. The executive sponsors need to stayengaged with the project and typically will be part of aproject steering committee.

Has appropriate focus

The importance of the project to the organization shoulddictate the level of involvement of resources from theorganization. For mission critical applications it is importantto have dedicated resources. The project manager should beresponsible for resource allocation and management.

Engages teaming

Successful technology implementations result from acollaborative partnership between business and IT efforts in

which both groups share responsibility for the initiative.“Team” is a key concept for successful projects. The projectsponsor has to assemble the skill sets required for successfrom the various parts of the organization and create acohesive project team.

Entails frequent communicationThe key to successful communication is to overcommunicate.It is also important to ensure that the project teamcommunicates with all of the stakeholders. Successful projectstypically have three main types of communication:

■ Daily updates — At these meetings the project managerensures that the team is working toward the milestonesin the plan and that all issues are identified andaddressed. During these meetings the manager canhave the team review its accomplishments from theprevious day, discuss issues, and agree on the tasks/goalsfor the day.

■ Weekly core team meeting — The core team meetingscomprise the front line project manager, businessmanagers, and IT managers. At these meetings the projectmanager will review progress and bring to the team’sattention any issues so that tactical decisions can be made.

■ Biweekly steering committee meeting — The purposeof this meeting is to ensure that project sponsors areapprised of progress. Critical issues are raised that mayrequire executive support.

In the end, a company that can ensure that the projectmeets a critical business need, that the company iscommitted, that a cross functional team of both businessand IT is in place, and that through strong projectmanagement skills any issues/problems are quicklycommunicated to all key sponsors, is one that has laid thefoundation for success.

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For more information, please contact John DelPonti at (704)344-7583 or [email protected] or BejiVarghese at (678) 419-6417 or [email protected].

Critical Success Factors in Implementing aSuccessful Technology Related Project

Many participants in the mortgage industry believe thatthere is a strong relationship between these scores andprofitability. This belief has resulted in the increaseduse of borrower, loan, and entity scoring in the industryfor the purpose of making credit decisions, setting loanlevel pricing, determining the optimal mix of servicingtechniques, and monitoring third parties such ascorrespondents and brokers.

However, current limitations in the ability of mortgagecompanies to track certain operational and financialinformation at the loan level preclude them fromengaging in the statistical modeling analyses that wouldreturn a profit score with true predictive value. Instead,while technology strives to keep pace with dailyoperational data demands, some data gurus haveresorted to a more basic analysis of the major factorsthat drive profitability and are currently tracked withintheir systems.

Unfortunately, there are relatively few factors that affectthe overall profitability of a loan for which data istracked at the loan level, the most significant of whichare prepayment and default. The propensity of aborrower to prepay affects both actual cash flows, suchas payoff interest lost, and opportunity costs, such aslost servicing fees. The tendency of a borrower todefault affects the cost to service the loan and the netcredit losses incurred.

In an effort to confirm or refute the idea that certaincharacteristics of a borrower and a loan could

accurately predict prepayment (and ultimatelyprofitability), PricewaterhouseCoopers performed astudy using loan level data, the results of which arehighlighted below.

PrepaymentsIn general, prepayments occur for five reasons,including (1) interest rate reduction and equity cash-outrefinances; (2) relocations and trade-ups; (3) partialpayoffs or curtailments; (4) defaults, includingforeclosures and bankruptcies; and (5) other reasons.Of these reasons, item 1 is the most prevalent and, assuch, represents the largest component of prepayment-related cash flows.

Of the factors that affect the borrower’s decision torefinance, the deviation of the borrower’s note rate tocurrently prevailing interest rates is the most obviousfactor. However, note rates themselves do not bear astrong relationship to refinancings, as borrowers tend torefinance across all interest rates, dependent upon othervariables noted below.

Of the other factors that correlate to a borrower’stendency to refinance, loan size is the most important.The theory behind this relationship is that changes ininterest rates affect the total cost of a jumbo loan moresignificantly than a conforming loan size. Therefore,more than any other factor, the higher the loan balance,the more likely the borrower is to take advantage ofopportunities to refinance. As expected, our research


Analyzing the Trend toward ProfitabilityFocused ScoringScoring uses statistical modeling to analyze various attributes related to a representative population ofloans for the purpose of determining a composite numerical rating for each loan or borrower. There aremany different forms of scoring currently in use within the mortgage industry, including borrower or creditscores, loan scores, and entity or institution scores. Borrower scores typically use information collectedfrom various credit reporting agencies about an individual in order to gauge his or her propensity to repaydebt obligations. Loan scores use borrower credit scores as their basis, but also factor in attributes specificto the loan itself, such as note rate and loan-to-value ratio, to determine the probability of the loan beingrepaid. Entity scores go a step further, by combining the results of either borrower scores or loan scores toassess the quality of loans from a third party, such as a correspondent or broker.


corroborated this theory, indicating an almostexponential relationship between the level ofprepayments and the loan balance for loans above$300,000. This relationship is also influenced by thecharacteristically high incomes, high credit scores, andlow loan-to-value ratios exhibited in borrowers withlarge loans.

In addition to loan size, loan-to-value ratios appear tohave a strong inverse relationship with a borrower’spropensity to refinance. Not surprisingly, our dataindicated that loans with lower loan-to-value ratios had ahigher propensity to prepay. This makes intuitive sense,given that lower loan-to-value ratios are often indicativeof borrowers with strong income and credit, all of whichincrease their ability to refinance. Furthermore, low loan-to-value ratios are often experienced on more seasonedloans, when borrowers may be interested in trading upinto a bigger home.

The channel through which a loan is originated alsoappeared to be a recurring factor in the refinance datastudied. The theory that correspondent and brokeroriginated loans would represent a large percentage ofrefinances due to third party solicitations of borrowersand the probability of the borrower having a lack ofloyalty to their loan servicer was demonstrated. Our datareflected that correspondent and brokered loans were upto 1.5 times more likely to prepay than retail loans.

Geographic region has long been viewed as a keydriver of refinance activity, based upon the belief thatcertain demographic areas may, at certain times,experience economic conditions that contribute to faster prepayments such as mobile borrowers and higher home appreciation rates. Our data reflected that, for the period reviewed, the fastest prepaymentswere experienced in states such as Colorado, California,Nevada, Wyoming, and Oregon. Other states that hadnotable prepayments included South Dakota,Wisconsin, Arkansas, and Iowa.

The age of a loan also appears to have a slight causalrelationship to refinance activity. Our data suggests thatas borrower incomes and property values increase overtime, there is a natural tendency to prepay, as evidencedby a 30% increase in prepayments between new loansand seasoned loans. This also makes sense given the

probability that there is typically little financial incentiveand desire on the part of the borrower to repeat the loanorigination process soon after completing it.

Surprisingly, we did not find a strong correlation betweencredit score and the tendency of a borrower to prepay.Rather, the distribution of refinanced loans was relativelystatic across different credit score ranges. Borrowers withboth high and low credit scores have strong incentives to refinance at different times and for different reasons.Borrowers with high credit scores have low barriers torefinance due to their characteristically higher incomesand lower loan-to-value ratios than borrowers with lowcredit scores. On the other hand, borrowers with lowcredit scores also have a propensity to refinance as theircredit quality improves over time, explaining the staticdispersion of refinance activity across all credit score ranges.

The observations from our study need to be put into perspective. Much of the data, while historical, may not be an accurate predictor of future behavior.Furthermore, we do not purport the ability to model

human behavior; in the end, every loan is different.Furthermore, due to the small relative size of thepopulation of loans studied, these results may not beconsidered to be statistically valid. Nevertheless, eventhough these results are not groundbreaking on theirown and may not be statistically valid, they dorepresent some of the basic information necessary tocompute a rudimentary profit score.

In the future, as data tracking mechanisms within the industry become more sophisticated, mortgagecompanies will use a combination of borrower, loan,and entity scores to do more than predict borrowerprepayment behavior. Ultimately, industryparticipants will be able to accurately predict theoverall profitability of a loan before it is originated,using factors such as the expected gain or loss onsale, the propensity of a borrower to pay late fees, the cost of advancing funds on behalf of the borrower,and the average float earned on loans sold to a

specific investor. The profit score will become anincreasingly powerful tool in designing campaignmanagement programs to target new loans to specifictypes of borrowers and to improve the profitability ofexisting borrowers.

Through time, mortgage companies not employingsimilar technology will be at risk of being adverselyselected during the origination process and during bulkacquisitions. Eventually, the use of this technology willbe necessary to stay competitive. Until then, mortgagecompanies that take advantage of this technology willsee improvements in operations that will be reflected onthe bottom line.

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For more information on credit scoring, please contactBrett Williams at (212) 597-3597 or [email protected].


© 2001 PricewaterhouseCoopers LLP, PricewaterhouseCoopers refers to the U.S. firm of PricewaterhouseCoopers LLPand other members of the worldwide PricewaterhouseCoopers organizations. All rights reserved.

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