February 2011 Address the heightened risks of your mortgage lending and servicing activities with enhanced internal controls The continuing stress within the housing and mortgage finance industries has generated significantly greater risks for mortgage lenders and servicers. Beyond significant credit risks, which for many have caused measurable deterioration in earnings and capital over the past two years, lie potentially major risks arising from: > > Mortgage repurchase obligations; > > Asset resolution efforts; > > Regulatory and legal scrutiny; and > > Financial statement disclosures. In many respects, the heightened risks are not new. However, due to the increased financial and social sensitivities arising from record mortgage delinquencies and defaults, all parties along the continuum of mortgage lending and servicing have elevated their efforts to enforce their rights, real or perceived, to the fullest extent. Mortgage lenders and servicers are being faced with financial and operating challenges that demand the most disciplined internal controls and operational execution. The financial and operating consequences of not effectively managing these risks have risen to unprecedented levels. Immediate attention is warranted and is needed well into the foreseeable future. Identifying risks Financial services companies with mortgage lending and servicing operations should undertake a comprehensive effort to identify and respond to the most critical risks present in these areas. Historically, the focus has been on effectively managing the credit, interest rate, and market risks associated with the origination, ownership, sale, and servicing of mortgage loans. Because the current market has driven most lenders to concentrate on the origination of conforming loans, and the secondary market is all but exclusively focused on sales to government sponsored entities (GSEs), the dynamics of mortgage lending have become much more routine than during the mortgage boom in the middle of the last decade. Accordingly, lenders and servicers must add the following to their list of significant risks: > > Mortgage repurchase risk arising from technical or other violations associated with the execution or documentation of mortgage loans; > > Mortgage repurchase risk arising from the non-performance by the borrower; > > Financial exposures arising from increased costs associated with asset resolution efforts; > > Legal, regulatory, and reputation risk arising from the execution of asset resolution efforts, most notably loan modifications and foreclosures; > > Disclosure risk arising from increased requirements to identify, measure, and present the financial and other exposures in the financial statements and related disclosures. These risks are by no means new to the industry. However, the financial and operating consequences of not effectively managing these risks have risen to unprecedented levels. Immediate attention is warranted and is needed well into the foreseeable future. page 1
Mortgage repurchases Since the inception of the secondary mortgage market almost thirty years ago, mortgage lenders and servicers have been exposed to repurchase obligations on loans sold, either as whole loans or as part of asset securitization transactions. Most notably, mortgage lenders have been required to repurchase mortgage loans due to documentation or procedural violations (breaches of representations and warranties) that are identified by the purchaser of the loans or insurers of securitization transactions, or due to early stage defaults (defective collateral). As the complexity and volume of mortgage loan originations increased dramatically during the 2000 s, the likelihood of documentation or procedural violations rose accordingly. Although this increased risk existed during the early and middle part of the decade, it was generally latent as the purchasers of the loans and insurers of the securitization transactions enjoyed the benefits of low default rates and strong collateral. As the default rates rose and collateral values rapidly fell, these financially interested parties elevated the level of attention devoted to identifying and alleging instances of technical violations or early stage defaults. As a result, mortgage lenders and servicers have experienced measurable increases in repurchase demands during the past 12-18 months. Most notably, mortgage lenders have been required to repurchase mortgage loans due to documentation or procedural violations that are identified by the purchaser of the loans or insurers of securitization transactions. In some instances, such as loans sold into Government National Mortgage Association (GNMA) programs, the financial risks associated with these repurchases are well-defined and generally limited. In other instances, such as more sophisticated securitization transactions, the risks may be less-defined and are subject to the variability of the value of underlying collateral. In either instance, disciplined risk management processes and controls should fully incorporate the following considerations: > > Establishment of a Board-level policy that sets forth the specific responsibilities within the organization for the management of mortgage repurchase risk, including specific standards and guidelines related to risk tolerance, monitoring, measurement, and response. > > Development and regular execution of a comprehensive estimation process that: Identifies the population from which mortgage repurchase risk may arise; Determines the probability of the frequency of repurchase obligations; Estimates potential loss, based on historical experience appropriately adjusted for current circumstances and other qualitative factors, such as the severity of loss arising from repurchased loans; and Reconciles all key components of the estimation process to the financial records of the company that are subject to the normal system of internal controls. > > Timely consideration of the effect of any measurable repurchase obligations on other accounting or risk management processes, including: The allowance for loan and lease losses; Asset/liability management; Liquidity management; and/or Regulatory capital adequacy measurements. > > Communication of the results of the regular estimation process to financial management, executive management, and the Board of Directors. page 2
Asset resolution costs The efforts of financial services companies to react to one of the most severe real estate credit crises of our time has resulted in the emergence of a previously narrow and non-descript business. Asset resolution involves a wide range of investors, professionals, specialists, and other service providers that contribute to an ever-increasing cost burden related to the efforts to remove distressed or other non-earning credit related assets from the balance sheets of financial services companies. In addition, the costs associated with maintaining these assets in anticipation of their resolution continue to mount. Most significantly, holders of non-performing mortgage loans are incurring holding costs such as real estate taxes, hazard insurance, utilities, and other maintenance expenses, for more loans over longer periods of time than ever before. In addition, in those instances in which foreclosure is necessary to protect the lender s interest, the costs of legal proceedings and documentation, as well as real estate appraisals, have increased notably. Further, because of significant backlogs in the many jurisdictions throughout the country, the time period for effectively executing asset resolution activities, especially foreclosures, has expanded measurably thereby increasing the associated costs. In those instances in which asset resolution efforts are being pursued, management must be keenly aware of the corresponding financial burdens. In those instances in which asset resolution efforts are being pursued, management must be keenly aware of the corresponding financial burdens. To enhance their ability to understand and control these costs, management should give consideration to the following: > > Identify specific asset resolution strategies that are acceptable to the organization, including establishing the methods and timetables through which these strategies will be executed. > > Assign specific responsibilities for the execution and approval of all material asset resolution efforts, including specific financial standards and expectations for the completion of these efforts. > > Identification of approved counterparties, professionals, and service providers with which the organization is willing to conduct its asset resolution efforts. Establish clear and manageable financial arrangements with professionals and service providers. Legal, regulatory, and reputational considerations The continued challenges within the mortgage industry have attracted a significant level of legal, regulatory, and reputational attention. Unprecedented financial losses throughout the mortgage continuum have generated increased legal actions by borrowers, investors, insurers, and other interested parties. As these entities increase their efforts to recover losses, their willingness to initiate targeted claims directed at mortgage originators and servicers elevates. Even though some of these legal claims may eventually prove to be unfounded, the cost and operational burden required to defend against such claims may be considerable for mortgage lenders and servicers. Focused attention of management and legal counsel is critical to effectively understand and respond to these risks. Timely and informed decisions to defend, settle, or otherwise negotiate asserted claims will enable mortgage lenders and servicers to mitigate the potential exposure. Financial institution regulators also have weighed in on the heightened exposures associated with mortgage lending and servicing. Regulatory examinations, both scheduled and targeted, are focusing significant attention on the risks associated with these activities. Exposure to mortgage repurchases, compliance with mortgage regulations, and inappropriate foreclosure actions have attracted the most attention of the regulatory agencies. page 3
In response to these risks, regulators are mandating higher capital levels in those instances where these risks are believed to represent a threat to the financial stability of the organization. As always, management teams and boards of directors must heed regulatory concerns over the risks associated with mortgage lending and servicing activities. Specifically, financial institutions must be able to demonstrate a robust system of internal controls in all aspects of their business, as well as a documented understanding of the effect on their capital, earnings, and liquidity. Lastly, the social awareness of the mortgage crisis and depressed housing market has increased the sensitivity of the public to the actions of mortgage lenders and servicers. Asset modification or resolution actions taken by lenders and servicers, executed with fair intentions, are being interpreted by the public as being non-accommodating or punitive. Financial institutions are often finding themselves trapped between their obligation to mitigate losses for stockholders or mortgage investors, and offering the most socially-responsible resolution to distressed borrowers. Boards of directors and management teams must maintain constant awareness of these competing influences and develop asset resolution strategies that seek the most effective balance between achieving the financial objectives of the company and maintaining appropriate social responsibility. Users of financial statements and related disclosures presented by companies with mortgage lending and/or servicing operations are requiring much more granularity in the information provided. Enhanced disclosures As the frequency and severity of financial losses resulting from the prolonged mortgage crisis have increased, so has the call for greater transparency in financial reporting related to mortgage lending and servicing activities. Users of financial statements and related disclosures presented by companies with mortgage lending and/or servicing operations are requiring much more granularity in the information provided. Beginning in 2011, financial statements of mortgage lenders and servicers are required or expected to include: > > Detailed information, at the loan category level of: The primary quantitative and qualitative contributors to the estimation of the allowance for loan and lease losses (ALLL); The specific components of the ALLL (e.g., specific, general, and unallocated) at each measurement date; and The changes during the reporting period of each of the identified components of the ALLL. > > Detailed information related to the amount and form of loan modifications (troubled debt restructurings), including information concerning the performance of such loans and their contribution to current period earnings. > > Detailed information related to the amount and type of loans comprising the portfolio of loans serviced for others, including: General identification of the owners of the loans; Nature and extent of any repurchase obligations, including disclosure of the representations and warranties made to which these repurchase obligations relate; Nature and extent of any implied or stated guarantees or insurance; and Results of foreclosure activities associated with these loans, including the financial effects of any delays or other matters arising in the course of these activities. page 4
Although many of these expanded disclosures are targeted at publicly-held companies, as with most higher profile areas, one can expect these disclosure requirements to extend to all companies with significant mortgage lending and/or servicing operations. More information about these increased disclosure requirements, as well as internal control considerations can be found in: > > FASB Accounting Standards Update 2010-20 Disclosures About the Credit Quality of Financing Receivables and the Allowance for Credit Losses > > PCAOB Staff Audit Practice Alert No. 7 Auditors Considerations of Litigation and Other Contingencies Arising From Mortgage and Other Lending Activities Achieving maximum risk awareness Because of the deep challenges in today s mortgage market, it is not likely that lenders and servicers will fully avoid the consequences of the related risks. Accordingly, risk awareness needs to be at its highest levels throughout the organization. Consistent efforts should be directed at risk and loss mitigation through responsive internal controls, disciplined execution of asset resolution strategies, and timely and comprehensive reporting of the existing and potential exposures to mortgage lending and servicing. For more information on these new guidelines, connect with us: Timothy Kosiek tim.kosiek@ 312 729 8327 Christine Fenske 414 777 5415 christine.fenske@ page 5 Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party. Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International. The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. 2011 Baker Tilly Virchow Krause, LLP