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Automated underwriting down under. Long read but well worth it - aussie blueprint for toxic loans.
1995 article
http://www.thefreelibrary.com/Automated+underwriting+down+under.-a016783611
Australia's mortgage market provides a living laboratory of what happens when automated underwriting becomes a fixture in a market. American lenders can get a look at what the future might hold by examining the Aussie model.
The potential power of automated underwriting is just starting to be felt in the American mortgage market. While everyone agrees that automated underwriting will create change for mortgage lenders, no one knows exactly what those changes will be. But a system similar to those being introduced here by Fannie Mae and Freddie Mac has existed in Australia for some time. The results there, while not guaranteed to replicate those that will occur in the United States, still might suggest a scenario of market developments that could follow from such change. What makes this comparison more valuable and enlightening is that the market changes being explored in this article occurred in a mortgage market with at least superficial resemblance to the American market. The mortgage market in Australia contrasts with the American market in several respects. The most pronounced differences in the two mortgage markets are:
* The mortgage market in Australia is dominated by four large banks. Together they account for the vast majority (approximately 80 percent) of mortgages made in Australia. However, other smaller players also participate in the market.
* Virtually all mortgages made by these banks are held in portfolio because of the absence of a well-organized secondary market in Australia.
* All mortgages in Australia are variable-rate mortgages. The rate varies when the bank desires and to the degree that it determines. This is not dissimilar to prime-based lending in the United States.
* For a higher rate, customers may fix their mortgage rate for up to five years. There are prepayment penalties for early payoff. (Somewhat ironically, lenders in Australia are required to warn borrowers of the "dangers" of fixed-rate lending. As a legal precaution, lenders must keep written journals noting that they explained these "dangers" and that "the borrower appeared to understand." Of course, this is the direct opposite of public policy sentiment in this country.)
* Most importantly in the Australian market, loan approval is accomplished at the point of application. When a borrower applies for a loan in the bank branch, the loan officer enters all the data on-line into a computer at a bank regional center. The computer uses a credit algorithm to either accept or decline the application immediately. The system also can print closing documents, which there are fewer of in Australia, on the spot for the customer's signature.
It is this last difference - point-of-sale approval - that we see coming to the American market with the advent of Freddie Mac's and Fannie Mae's automated underwriting packages. Thus, the instant approval feature of automated underwriting will be a major focus of this article. We will consider how it has affected the Australian mortgage market and perhaps by doing so gain some insight into how it might change our own.
The implications for origination
The first place where automated underwriting makes a difference, as it's used in Australia, is in originations. The Australian borrower comes to the bank with a completely different set of expectations as to what will happen. Many customers come in with all the documentation they need (according to the bank's standards), knowing that they will get a firm decision - subject only to verification - at the time of application.
The true mortgage banker and the roving originator are rare in Australia because they cannot easily replicate the banks' ability to offer instant approval. These quick-approval systems constitute a fairly formidable barrier to entry in the Australian origination market and allow the banks to dominate the mortgage lending business as a practical matter. Hence the banks in Australia are still able to maintain a market share estimated at around 80 percent despite price competition that began in 1993.
Automated underwriting also allows the originator to print closing documents at the time of application/approval. Under the existing American system, printing such documents at application time would be a waste of time and effort since We do not know whether the loan will be approved, let alone have all the detailed information needed for closing documents. However, in Australia, all of this information is either known at application or can be readily obtained from the borrower, who is sitting right there, contract in hand, at the moment the loan is ap-proved. The date of closing can be determined from the sales contract in the case of a purchase money loan. A refinance, in theory, could be closed on the spot.
(Refinances are very rare in Australia for two reasons mentioned earlier: 1) most loans are variable-rate and every variable-rate loan changes in lockstep with every other variable loan to whatever rate the bank elects to charge; and 2) while there are loans with rates fixed for periods of up to 10 years, there are relatively stiff prepayment penalties to deter early payoff or refinance. However, there is a particularly Australian feature called a "redraw" that is very similar to a cash-out refi in America. These "redraws" are in fact accomplished on the spot, in roughly the manner described here.) If refinance loans could be closed on the spot, this would obviously constitute a giant leap forward in customer service and convenience. Further, the lenders whose systems were first able to print out all the requisite documents on the spot would gain an immense competitive advantage.
The impact on underwriting
The second functional area in which the introduction of automated underwriting would make a difference is, of course, in underwriting itself. The need for underwriters would be reduced, as I found that in my experience the automated system approves roughly 60 percent of the applications overall, with no human intervention needed on a routine basis. Branches in certain parts of Australia report automatic approval rates of more than 80 percent, which may reflect cultural factors - Australians are more conservative financially; there is no CRA or other fair-lending requirements limiting branches from selectively targeting certain geographic areas; and welfare benefits are more generous and are indefinite, enabling some welfare recipients to qualify for mortgages. On the other hand, there are financial institutions in the United States that routinely approve in excess of 90 percent of all applications with human underwriting. Thus, it seems reasonable that well-constructed, automated underwriting systems, especially neural networks, could approximate this figure. In addition, one major American mortgage company that experimented with automated underwriting several years ago found an approval rate of approximately 60 percent with then-current technology. Underwriting productivity is consequently much higher in Australia than in America, and lenders using the automated underwriting system employ far fewer human underwriters per loan volume than their American counterparts.
How it affects processing
Under an instant-approval system, verification becomes even more important. The lender is prepared to generate credit on the basis of the facts furnished to its underwriting system, so it is crucial that those facts be accurate. Note that this does not necessarily mean processors become magnified in importance, but that verification of the credit-relevant facts about the customer becomes more important than before. Alternative documentation also can provide corroboration of the information given by the borrower and eliminate the need for processors altogether. In Australia, telephone verification is sufficient, so that processing adds very little time or expense to the approval process.
Under these systems, it stands to reason that appraisals also would become very important. Surprise! Most properties are not appraised at all under the Australian system. Part of the explanation is cultural: 1) Australia is in some ways a more honest and trusting society, and so the value of the house stipulated on the sales contract is generally taken as the value of the house. 2) The local branch manager is expected to understand the value of houses in his or her branch area and to know if a contract values a house fairly or not. Thus, cultural factors make the appraisal much less important in Australia, when done there at all. Perhaps due to some peculiar cross-cultural affinity, the appraisal seems destined to become less important in America as well. Freddie Mac, in particular, has floated the idea in print of "looking at ways to use sophisticated decision models together with property data bases to eliminate, for many loans, the need for on-site appraisals." (Peter Maselli, "Mortgages in Minutes", Mortgage Banking, October 1994, page 105).
Closing loses its mystique
Closing loses much of its mystique consequently its paperwork under the regimen produced by automated underwriting. Since the borrower has been approved at the time of application, there is no reason for the system not to print closing documents for the borrower to sign on the spot. One branch I visited in Australia is actually doing this. As soon as the screen shows the borrower is approved, the system begins to print out the closing documents for the customer's signature. Closers cease to exist in this environment. The branch manager simply asks the customer sitting across the desk to sign the documents and then sends the executed closing documents to the closing agent to wait for actual closing.
One wrinkle in Australia that will take much longer to show up here (if ever) is that buyers and sellers do not attend the closing. Since the whole process has become so cut and dried, there is no need for the customer's physical presence at closing. There are no documents to sign; that was done at the time of application/approval. Customers are typically represented by an attorney whose sole function is to ensure that all goes according to plan at closing. These days, the process has become so routine that many attorneys are sending paralegals in their place. The entire closing process takes no more than 5 to 10 minutes, so that banks in a central business district such as downtown Brisbane are able to schedule closings every 15 minutes. Part of the difference derives from regulatory disclosures - in the Australian market there is nothing resembling a HUD-1, much less a final Truth-in-Lending disclosure form or other such notifications for the borrower to sign. But much of the difference must still be attributed to the fact that so much of the mortgage transaction work was done at the point of sale, leaving less to do later on.
Turnaround time dramatically shortened
The time it takes to close a loan in Australia has been dramatically shortened by the automatic underwriting process. Because there is no appraisal, no underwriting and no preparation of closing documents, loans can be closed much more quickly than under the American system. While local custom in some Australian states dictates closing 30 or even 60 days from the date the sales contract is signed, there is nothing in the lender's process that dictates such a delay. Australian loans routinely close two weeks after application, although one week is not uncommon. Indeed, processing/underwriting time is so short in Australia that one bank used to do all the work for closing, be ready to close, and then pull a second title report just a day or two before closing. It did so in order to be sure that no liens ("caveats") had been recorded in the relatively long interval between the bank's initial processing and the actual date of closing.
Financial ramifications
There are, of course, financial ramifications from all these differences. Origination costs are much lower in Australia than in America. Also, there are far fewer underwriters and closets. Loan officers are not the commissioned professionals they are here, but rather glorified platform officers in the branch, waiting for mortgage applicants to walk in the front door. While there is some business development undertaken by Australian mortgage lenders, it is nothing like the dedicated attention to Realtors that goes on in America. The result of all this is that origination costs are drastically reduced. In fact, incremental costs are practically nil. The paper required to print out the loan forms and the cost of connecting electronically with the remote automatic underwriting computer are the major incremental costs associated with the Australian origination process. This all must sound like a bonanza to origination-cost-weary mortgage bankers until we notice one more thing - there are no points in Australia. Having seen the economic benefit of competition, the Australian market has passed all the savings on to consumers, who pay no points in most instances. There is an "establishment fee," similar to the American application fee, of a fiat $600. However, competition also reduces this fee from time to time in various marketplaces.
Pipeline fallout
One would expect that the ability to deliver a firm, binding commitment so promptly would encourage customers to close with the bank that was able to deliver the commitment. Originally, this seemed to be the case for one important reason: Bank pricing tended to move in lockstep, dictated largely by changes in the government's lending rates. This meant there was little price competition. Hence the majority of Australians simply went to the bank at which they maintained their primary relationship, applied for a mortgage, received it and closed the loan. Turn-downs were rare, so most applications ended up as closed loans. One branch reported a fallout rate of 2 percent to 5 percent on a consistent basis. However, this situation is changing. With changes in the regulatory and financial markets in Australia, mortgage lending has become more attractive not only to the "Big Four" banks (ANZ Worldwide and National Australia Bank in Melbourne, and Commonwealth Bank and Westpac Banking Corporation in Sydney), but also to a host of smaller banks and other players. Margins on portfolio loans (the only type available for the most part) remain at more than 3 percent; and this type of margin in banking is attracting other players. Other lenders tapping less expensive domestic, or even foreign, sources of funds are entering the market and building share with a traditional weapon: price.
Price competition has begun to invade the market in a form similar to that of the ARM market in America. A list of comparative rates as they applied to identical ARM loans that adjust at the lender's discretion, published in the Sydney Morning Herald of November 1, 1994, varied from 7.50 percent to 9.55 percent. All of the "Big Four" banks were offering loans at 9.50 percent, while smaller banks and independent lenders offered rates below that level. Due to this variation in rates, and because the "establishment fee" is often not collected until closing (because of competitive pressures), rate shopping is becoming more common in Australia. A sophisticated area of Sydney reports closure rates of only 38 percent - a shockingly low figure by American standards, even after allowing for some definitional problems.
Which model of pipeline fallout behaviour is likely to hold true for the American mortgage market once automated underwriting becomes more widespread: Customers who simply go to their primary financial institution or customers who shop 'til they drop? It is tempting to give both answers, depending upon the current state of the American market. Widespread rate shopping is prompted by a market offering a fairly wide variation in rates, such as the ARM market in America. Conversely, a disinclination to shop is common to a market featuring narrower price ranges, such as the fixed-rate market in America.
Knowing this, we might expect the effects of automated underwriting in America to depend upon whether the prevailing market is predominantly fixed-rate or variable-rate. The former could foster considerable customer loyalty because the customer would be approved already by one lender and therefore not be tempted by the prospect of finding much more favorable rates at another. However, an ARM market would not necessarily offer any guarantees of customer loyalty because the customer, even if approved by one lender, could still shop and find a considerably lower rate at another lender. Periods of market turbulence, such as when rates are rapidly falling, would most likely work to overwhelm customer loyalty no matter what.
Refinancings constitute one important exception. As noted above, refinance loans are rare in Australia. But re-draws, which are similar to cash-out refis, have a 100 percent closure rate because they are completed at the point of sale. If the American market can actually move to the point where refis are concluded at the point of sale, which automated underwriting makes possible at least in theory, then the closure rate for refinances will improve dramatically. Because refinance loans tend to fall out of mortgage pipelines more easily than purchase money loans, point-of-sale approval of such loans should increase closure rates in any market.
Delinquency issues
Australian mortgage delinquency rates tend to be lower than delinquency rates on American mortgages. There are two possible reasons: One is that there is a cultural difference at work - Australians appear to be more concerned about keeping their mortgages current - and a second reason is the constancy of the credit-approval process. By basing credit decisions on algorithms and credit-scoring techniques, the system very efficiently and fairly approves people who have a higher likelihood of paying their mortgages promptly. This feature, incidentally, is one of the promises of credit-scoring systems - that they will reduce delinquencies to the level desired by the lender simply by setting the "passing" score at certain levels to reduce the odds of loans going bad. Interestingly, this goal of reduction in delinquency rates is one of the reasons for the development of automated underwriting systems in this country. A Freddie Mac representative said, "By incorporating a combination of these (artificial intelligence, statistical modeling, rules-based system, predictive credit model) approaches into Freddie Mac's automated underwriting system, the thinking was that it might reduce the possibility of default on loans accepted by the service." (Peter Maselli, Mortgage Banking, October 1994, page 108). The Australian experience certainly offers nothing to contradict this view of automated underwriting's potential. Indeed, the Australian model indicates lower levels of delinquency, foreclosure and credit loss stemming from such a system.
Systems offer great promise
The automated underwriting systems promised by both Freddie Mac and Fannie Mae in 1995 represent a tremendous advance in technology. However, this advance also holds great promise for improving the business side of mortgage banking by radically restructuring processes, eliminating some steps outright, and offering the customer convenience and options not currently available. Among the changes that the American mortgage lender can expect to see are the ability to approve, lock-in and print closing documents for the customer at the point of sale. Mortgage lenders should also experience greatly improved costs in areas such as underwriting, appraisal and closing, since the automated underwriting system will vastly simplify these processes. This simplification will lead to lower costs, which is a welcome development in these days of significantly reduced origination volume. Finally, it is possible that mortgage lenders will see lower levels of delinquency because of a greater consistency in the underwriting process.
In America, as in Australia, the customer will be the greatest beneficiary of this new process. Not only will he or she obtain the certainty of being approved on the spot, but the borrower will also experience shorter time to dosing and simplified closing procedures. In fact, it is theoretically possible under this system to dose a refinance loan on the spot at the point of sale so that a refinance begins to resemble a modification. Finally, to the extent that competitive pressures dictate, customers will enjoy some of the lower costs of the origination process as lenders pass on some of the savings to borrowers.
Thomas F. Neagle is a managing consultant with EDS Management Consulting Services Banking Group in Rosemont, Illinois.
COPYRIGHT 1995 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995 Gale, Cengage Learning. All rights reserved.
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