Monday, April 10, 2023

Are Pre-Qualifications Masquerading as Pre-Approvals Illegal? DFI Says "Yes"

DFI Says "Yes" - it's a "Misleading and Deceptive Act." CFPB calls it "deceptive."

  • "I issued a pre-approval for a buyer and the lender wouldn't do the loan, so they had to pull the contract."
  • "I've been told a pre-qualification is worthless."
  • "If I have DU approval and docs, I can do a pre-approval."

As refinance volume dwindles and the spring housing market goes into full overdrive, these good questions increase. This is a minefield for brokers. It comes down to literal definitions. And, where it previously was an ethical issue, states now will cite brokers for pre-approvals that were not backed by a lender's approval. 

From the WA DFI

A Pre-approved mortgage means approved before the property, NOT approved before underwriting. If a loan is ready to close subject to an appraisal, that is a pre-approval. As you know, AUS approval doesn't mean ready to close. Approved means you, as a banker, are prepared to lend the money. Everything else is a pre-qualification.

Consequences of Fictitious Approvals

Some regulators will cite you - as a broker with no warehouse line or funds to make a loan - for approving a loan. You can also be sued by a seller or buyer for misrepresentation if the loan is delayed due to approval issues. In this market, where people submit contracts without a financing contingency, this becomes even more worrisome. 

Specifically, buyers expose themselves to legal action if they cannot perform under a contract. Though brokers are not parties to the contract, if their representations cause the action, then they become culpable.

Do the work up-front and get the loan approved by the lender (TBD) before you send the borrower out shopping. If your lender doesn't approve loans without an appraisal (TBD), find another lender who does pre-approvals. 

There IS Value in Pre-Qualification

Incorrect use of the term "pre-approved" connotes approved, subject to underwriting approval, which is contradictory. Pre-approval actually means "approved, subject to an acceptable property." (AKA TBD approval) The real estate industry has driven this confusion by recognizing that a pre-approval is better than a pre-qualification to satisfy a seller deciding between two offers; choose one with or without approval. Agents demanding instant pre-approvals have pushed originators to call a pre-qualification a pre-approval. Without underwriting, however, this is a fabrication.

A pre-qualification can include: "We have reviewed the documents and have received an automated underwriting approval; however, the loan request is still subject to lender approval." We suggest this because even with automated underwriting, without a review of the underlying documents, changes can invalidate automated underwriting approval. For instance, if the originator uses a salary for the income when the wages are actually variable, automated underwriting results will change accordingly. 

Does this mean pre-qualifications are useless? NO! Prequalifications are very valuable, but they represent an earlier stage in the process, the first step. The pre-qualification process allows the originator to address a customer's realistic expectations for affordability. Once you address any customer issues, you can request pre-approval and submit an application for approval through a lender's underwriter. Once approved, you can send the borrower into contract negotiations with financing contingencies waived.

Furthermore, brokers should maintain loans not submitted to lenders in their "prospect" pipeline as pre-qualifications to avoid triggering reporting requirements and excess regulatory responsibilities. The fact that an applicant has triggered the requirement for a Loan Estimate does not automatically mean the loan is an "application." It can still be a pre-qualification.

Ethical or Illegal?

While this is primarily an ethical issue, not a legal one, the CFPB is focusing more on "deceptive acts and practices" and saying a loan is approved when it is not falls into this category. It does not rise to a civil legal matter until someone cannot deliver on a "pre-approval" and the loan does not close. Then the consumer, and anyone else who relied on the misrepresentation, can take action under breach of contract, fraud, etc., because they have a cause of action. Some states (such as Virginia and Washington) have mandated that the term "pre-approval" be accompanied by an actual loan offer. What that means is subject to interpretation. It is often difficult to prove misrepresentation when there is no harm - e.g. the customer doesn't take action. 

Ethically, calling a loan approved when it is not ready to close - or the conditions precedent to closing have not been stipulated in a way that could be met by a reasonable person - is a misrepresentation and a deceptive act. 

TBD - Property to Be Determined

The term TBD is the industry jargon for approved, subject to property. That is a correct term.

There is no distinction between which origination channel - e.g., retail lender or broker - that makes calling a pre-qualification a pre-approval right. It's a misrepresentation if the loan isn't ready to close as described. However, a lender who can make loans from its own proceeds certainly can "chance it" based on internal criteria knowing that a loan is "approvable" if AU is correctly applied. A broker cannot "make" a loan - they are brokers. A broker's approval "subject to" is the lender's institutional letter of approval, not the broker's. Technically and logically, a broker could expose him or herself to liability when acting as a lender when, in fact, a broker - e.g., "making loans." A case in Iowa brought this to a head when a broker failed to deliver a loan after issuing a pre-approval. 

Saturday, April 1, 2023

A Look at AML Audits - Can you Audit Without a Risk Assessment?

We deal with known risks by establishing a plan to mitigate them. In the case of AML plans for mortgage companies, we face the risk of allowing financial crimes to go undiscovered and enter the financial system through our business. 

We create compliance plans as multi-tiered tools to deal with the risk. The tiers are the four (or five, depending on your business) pillars of an AML plan 

  1. the plan itself - which identifies the risks your business encounters and how you mitigate them
  2. training - your employees learn how to identify and report red flags
  3. compliance officer - the person who implements the procedures, files reports, and ensures the activity, such as training, audits, risk assessments, etc., takes place 
  4. an audit or exam - reviews your plan, determines if it is sufficient for the risks you face, and identifies if you are following it
  5. ongoing review of accounts - if we are servicing, for instance

Static Plans DO NOT Address the Risks - Make Sure you know what they are

We conduct hundreds of AML audits, and the BIGGEST problem we see is that AML plans don't address the risks the business faces explicitly. Furthermore, the audits or tests we see focus on whether the AML plan contains arcane legal citations or reviews a sampling of closed loan files. This is not where the risk is.  

In the mortgage business, we are experts in looking for fraud - documenting sources of funds and ferreting out suspicious income and transactions. This doesn't mean that fraud and suspicious activity doesn't make it through (CoreLogic reports 1 in 131, or 0.76% of loans, are fraudulent). Still, it does mean that the MAJORITY of incidences probably aren't in the files that make it through to closing. So it makes sense to focus our efforts on loans that don't go through a complete underwriting process. 

None of the AML plans and audits we have reviewed focus on risk assessments. Hawaii is the only state we have encountered where they are requesting a specific AML risk assessment - (Bravo! Mahalo!). New York requires large-scale risk assessments of the entire operation, including AML. 

This leads me to conclude that people don't know what a risk assessment is or even why you do one. The purpose of the Risk Assessment is to look at YOUR business for areas of risk. Only then can you create a strategy to mitigate money laundering activity? 

How to Conduct a Risk Assessment?

Depending on the firm's scope, our risk assessments create a binary decision tree instead of a complex "relative risk rating" approach - e.g., low, medium, and high. We do it this way because the risk increases on an absolute basis. One red flag doesn't necessarily indicate fraud or money laundering activity; however, two levels of risk means that we should, at a minimum, document that we validated there were no red flags. We refer to this as "risk layering," where two or more inherent risks exist in a file. 

  • Higher risk components - Company-wide
    • Geography
    • Business model -
      • delegated, non-delegated, 
      • retail/wholesale, etc. 
    • Origination strategy - 
      • direct/indirect
      • relationship/transactional
  • Higher risk components - Loan Level
    • Loan Type
      • Gift Letter
      • ALT/Non-QM
      • Investment
    • Borrower Type
      • Self-employed
      • Real Estate
      • Medical
      • Cash Business
This allows us to have a methodical elevation of the review of the file. 

We do this because things that don't matter to the underwriter from an approval perspective (the loan meets guidelines) often matter for detecting and reviewing red flags. In our business, we review files for these elements, and it always surprises us how often these are overlooked. Examples include:

Deposits not needed for down payment or closing costs - the underwriter isn't concerned about whether a borrower has a $100,000 CD in one bank if he has the $20,000 he needs for closing seasoned in another account. The money has been there forever, and the account doesn't move. But does it make sense that someone who makes $60,000 a year has $100,000 stashed in an account they don't touch? Especially when they have a lot of debt? No, it doesn't. That's a SAR.

Income and Expenses from a side business - the underwriter doesn't include the borrower's side business which involves cash in the computation. He or she has enough income to qualify for the loan. The side job (documented by frequent small dollar cash deposits) is a compensating factor, and the borrower didn't need to provide tax returns because she was on salary. That makes perfect sense, except that if there is more than $5,000 of this kind of activity in the loan file (e.g., 2 months' bank statements), then that triggers a SAR report for "smurfing."

  • Focus on engagements/applications/rate quotes/pre-quals which do not complete
  • The greatest risk lies in loans or prospects not reviewed by underwriting/credit.