Due Diligence and the Mortgage Crisis

due diligence (dü dil ǝ jǝns), n. 1 such constant and earnest effort required as a reasonable person under the same circumstances would use 2a the care that a prudent person might be expected to exercise in the examination and evaluation of risks affecting a business transaction 2b the process of investigation carried on usually by a disinterested third party (as accountants, private investigators, or law firms) on behalf of a party contemplating a business transaction for the purpose of providing information with which to evaluate the advantages and risks involved.

Should due diligence be part of the lending process? Does a loan officer qualify as a disinterested third party? Can we regulate our way out of this crisis? What, in the context of real estate loans, constitutes reasonable and prudent?

Let’s start with the latter. I believe it is reasonable and prudent to verify a person’s income, financial history, and even personal character prior to lending money. A home loan is not a horribly complex thing. In its simplest form a bank loans a person money to purchase a house. The house is taken as collateral. The person has a prescribed term over which to repay the money borrowed, usually in monthly installments. It really is, and should be, that simple.

Which of the following scenarios do you think represents the constant and earnest effort of a reasonable person?

Scenario 1

2006: How We Got Into This Mess in the First Place

Steve goes to Big National Bank and says, “I want to buy a house.” The teller sends Steve to a 23 year old sitting behind a faux wood desk in a cubicle constructed from modesty panels and glass. The 23 year old goes by the name Chas. He has on bass penny-loafers, pleated khaki pants, and a BNB Team golf-shirt in pale-blue.

Chas asks Steve a series of questions, “How much do you want to spend on a home?” How much do you make? Really, well that’s not a problem. We can just say that you make a little more than that. Your salary should increase next year, right? Good. Just sign here.” Steve walks out of BNB with a hew home and an adjustable rate mortgage that is set to increase in three years (eons in today’s market). 0% down + 100% financed = 100% value of the home.

Apparently Chas has committed no crime. He even received a bonus for processing the loan quickly and convincing Steve to go with the friendly ARM. BNB writes the loss off and gladly accepts TARP funds. The CEO borrows the company jet to fly to a golf tournament in Houston for the weekend. Steve has committed mortgage fraud by telling a lie on his loan documents and gets 5 in the pen, out in 3 with good behavior.

Scenario 2

2008: What’s Not Helping

Steve strolls into Big National Bank and says, “I want to buy a house.” Chas, our be-cubicled day-trading wannabe, sends Steve home with a pile of paperwork, the documents required by regulation to ensure that Chas knows Steve.

Steve comes back in a week, paperwork completed. Chas reviews the records and sends them to underwriting. Underwriting calls Chas and asks a few questions. They’ve filed all of the papers required, answered all of the questions on the forms, made sure Steve fits within the “regulated parameters”. They call Steve and tell him he can buy his new home.

Steve realizes a year later that his company no longer considers him to be a linchpin. They let him go with no severance and let him take over the lease on his company car. Steve, thanks to borrowing 110% of the house's value, is in way over his head. Chas gets a bonus for making such a fantastic loan. BNB sells the house in February for a fraction of its value and shows a profit because they “realized” the loss in January. The CEO spends a week in the Turks and Caicos. Steve made an error on one line in the mortgage documents and gets 5 in the pen, out in 3 with good behavior. 0% down 110% loan = Steve owes more than the house is worth.

Scenario 3

1995: The Way It Used to Be

Janet drives over to Local Bank and tells the bank manager, Bob, her dad’s lifelong friend, that she would like to buy her first home. Bob knows that Janet is two years into her career as a nurse. He asks her, “How much money do you have for a down payment?” She tells him that she’s saved up about $20,000 over the past two years, part of which was a gift from mom and dad. (She lived at home and worked like crazy. She has no credit card debt.)

Bob calls Janet’s boss, Virginia, over at regional hospital to verify employment and income. Bob and Virginia graduated City High together in ’59. Virg tells Bob that Janet is a dream employee, verifies her actual income, and tells Bob to bring the family by on Saturday for dinner.

Bob then runs a credit check on Janet, sees that she has no credit history. Bob has coffee every morning with Will, who owns the ladies' shoe store on 14^th. Will tells Bob that he has had a credit account for Janet for the past three years. She has made every payment on time, most of them early.

Bob sits down with Janet and advises her to look at houses in the old neighborhood. They’re a little cheaper, but they’re well built. This way she can use the portion she actually saved for the down payment, maybe use the money her parents gave her to remodel the kitchen. The monthly payment will be much easier for her to handle, even with the 15 year amortization schedule.

Bob was paid his usual bank salary for doing his job. Virginia made a pot-roast for dinner on Saturday. Will spilled coffee all over his Christmas tie on Monday morning. Janet paid the house off in the early months of 2010. She now owns it free and clear. 20% down + 80% loan = 100% value of house.

KYC

Know your customer (KYC) is a form of due diligence for banks and financial institutions and other regulated companies. Based on KYC these institutions must verify the identity of their clients and ascertain relevant information pertinent to doing financial business with them. Really? That has to be regulated? In the USA, KYC is a policy implemented under the bank security act and the USA PATRIOT Act.

KYC should, I would argue, just be a matter of common sense, not necessarily a regulated policy. One might argue that it’s not possible for BNB to know every customer. I think it actually is. You see, back in the day when I started banking with a local branch of one of the BNBs, the branch manager knew the customers.

She called customers by name when we came in to do routine banking. When I, as a young man, had a little problem with available funds, she called me personally, scolded me and helped me get the matter under control. She didn’t know my dad, or share dinners with my boss (that I know of), but she knew me and how to verify who, what, where, when I was.

I dare say she would not advise me, or any of her other customers, to choose an adjustable rate mortgage. She’s no longer with the bank. Neither am I. I removed all of my accounts from the BNB when I realized that I didn’t know a single person in the local branch. When I had an issue with a new policy the bank had regarding availability of funds after deposit, they referred me to the 1-800 customer service number.

I moved to Reliant Bank, a local bank. They only had one branch when I moved my accounts. They now have three. When I walk in the front door of any of these branches, the tellers, the commercial lending officers, and the manager all say something along the lines of, “Hi Thomas.” When I asked them, in 2009 for a refinance, they said, sure.

But they ran me through the paces. They verified all income, all accounts, all assets. They checked every reference, called employers, and expanded their queries to associates and friends. It was not an easy process, but I really didn’t mind. They were covering their bases. Making what I would call a reasonable effort to determine their exposure and risk in agreeing to lend money to me.

Here’s a thought. Private Investigators, Certified Fraud Examiners could be used in this process, up front, as a part of due diligence. Hire a professional to learn as much as possible about your customers. You’ll have no problem meeting the KYC requirements, and if your customers don’t want the scrutiny, well…maybe they aren’t quiet ready to buy that house. Yea?

[FIND] Diligence

What’s under the surface is not always bad, not always a deal killer; but if it is, you need to know.

Human capital: the stock of competences, knowledge, and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience. Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action.

As a venture capitalist, you seek great ideas, business plans, widgets the world needs. But when it comes to putting your money behind a concept, our thinking is this: You’re not investing in a company as much as you’re endowing human capital.

In a recent survey of private equity investors, nearly 70% of the respondents indicated that they believed “…poor company performance is either very often or always attributable to management issues.” But while the investors said, by and large, that they were moving away from, “…a more instinctive approach when it comes to picking talent,” they are still using outdated and loosely defined methods of assessing human capital.

What we do – the broad view.

[FIND] Investigations performs background investigations to help limit your financial and reputational risk.

What we do – the more specific view.

[FIND] Investigations can locate, identify, and/or find the following:

·               Non-disclosed businesses/relationships

·               Controversial media attention

·               Lawsuit history

·               Regulatory issues

·               Conflicts of interest (IP theft, fraud, etc.)

·               Resume Fraud

·               Indications of financial stress

·               Criminal history

·               Personal history

What makes us different?

[FIND] Investigations produces well written, comprehensively researched, and thoroughly-documented reports. Our final report is a distilled analysis of potential areas of concern, not just a list or summary. We recommend deeper research where necessary. We look into problem areas in detail and help you determine what action might be appropriate: is this a deal-killer, an issue to "spin," or just a minor obstacle?

We approach our work as working professionals with backgrounds in business and research. We are writers, journalists, appraisers, analysts…we do this work for a living, not as a post-retirement-hobby. You can expect a lack of jargon in our reports. The passive voice is avoided whenever possible.

What you can expect – Clients' Bill of Rights.

[FIND] Investigations believes that you have the right to, and should demand, the following:

·               You have the right to an investigator who is as intelligent as you are.

·               You have the right to receive professional service.

·               You and your employees have the right to be treated with respect at all times.

·               You have the right to a well written, well reasoned, and grammatically correct report.

·               You have the right to a good-faith estimate of total project costs, up front.

·               You have the right to expect phone calls and emails to be returned within at least 24 hours.

·               You have the right to expect ethical conduct and complete confidentiality.

·               You have the right to a detailed invoice, clearly showing all charges.

Due Diligence and Deep Research

An article in this month’s PI Magazine called, “Evolving Background Checks into a Reputational Due Diligence Model,” while severely over-titled, is a fairly comprehensive outline of how to start a standard background investigation.

The very idea of trying to market something called a Reputational Due Diligence Model to clients is preposterous, and, I believe, even redundant. In the context of business intelligence, a background investigation should be included in the due diligence process.

[FIND] Lexicon

due diligence - noun 1 : the care that a reasonable person exercises under the circumstances to avoid harm to other persons or their property; 2 : research and analysis of a company or organization done in preparation for a business transaction (as a corporate merger or purchase of securities)

Now that we have the phrase defined, let’s break it down. Note the words I’ve highlighted: first, we’re defining the term based on what a “reasonable person” would do under “…the circumstances.” Second is the “research and analysis” component -- not just a gathering of facts, but analysis of the information.

My problem with simple due diligence as defined here is the idea that we have to limit ourselves to the research and analysis and level of care that a reasonable person would exercise. I, personally, like the idea of research and analysis being conducted by an unreasonably anal person who pays attention to detail in approximately the same infuriating manner that my tenth-grade English teacher graded my essays. A background investigation should be at least thorough, if not exhaustive. That said, common sense must be employed. You don’t want to spend valuable time chasing down obviously erroneous tangents.

Many investigators think a background investigation is simply a reporting of facts, when it should always include thorough and thoughtful analysis of the information. Granted, any licensed professional investigator with a basic level of competency can query the various databases available to him or her and get a quick list of criminal, civil, and other publically available records. But a worthy investigator should always dig deeper.

Deep Research

One standard we that must employ as a matter of practice is Deep Research. The objective of deep research is discerning observation and smart analysis. Discernment in observation calls to mind the notion of not just sensitivity, but also intelligent, wise, and judicious thought. Smart connotes sharp, shrewd, and clever, with a touch of brash and sass for good measure. The entire premise of this method is based on investigators being astute, which comes from the Latin astus, which has both the positive sense of adroitness or dexterity and the… more ambiguous, shall we say, concept of craft or cunning.

Once the initial database inquiries have been made, the basic information is compiled for further study. At this point, look to some proprietary data services that offer more information. Sources like LexusNexis and Westlaw allow natural language and Boolean queries and gather more data from a broader set of sources. This is the second phase of deep research and it involves discernment. Again don’t waste valuable investigative time chasing useless tangents.

Once the basic information and more extensive details available through various data providers are compiled, it’s time to be astute: adroit, dexterous. A dose of cunning is often useful as well. Now we’re down to…craft, or as it’s known in our circles, tradecraft.

Initial Probe

An investigator places a call, either direct or under pretext, to all references. Verify as much information as possible from the subject’s own character witnesses. Confirm all employment, education, and associations. Any claims of advanced degrees, professional designations, and awards should be authenticated. Create a synopsis of the universities attended, professional organizations, and sources of awards. If the subject attended Phoenix University and earned that MBA via the post office, let the client know. If the Association of Bank Managers is made up of four guys and a poker table, the association is most likely of no real value. If the Frank Stevens Award for Legal Letters was conferred by the next-door neighbor, your subject has been creating fiction. Investigate the veracity of all claims.

Digging Deeper

A thorough and exhaustive background investigation should include, but should not be limited to, on-site courthouse research, visits to colleges, interviews with professors, chats with neighbors and old friends, and other methods of tradecraft. The last two methods of gathering primary reference materials are straight out of the world of spycraft and almost always yield valuable insights.

It is almost always useful to place the subject under surveillance for a period of time. Get an idea of lifestyle, character, and habits. This is a chance to expand the list of associates and friends. Often an investigator can identify the subject’s true associates and check this list against the references listed. Actual physical surveillance affords the investigator a chance to get to know the subject, to study his daily routines. With physical surveillance, the investigator can develop a more intimate and realistic picture of the subject’s lifestyle.

The last piece of tradecraft discussed is arguably one of the most underhanded methods available to the field operative. Trash Cover, refuse audit, pulling trash, dumpster diving…whatever an investigator chooses to call it, it’s a messy job, but almost always produces results. The legality of this method is fairly well established. In most states, once a person has placed their rubbish in the bin and rolled it to a publically accessible place, the trash is fair game. One month of garbage usually generates a clear profile of the subject. Groceries, prescriptions, movie/theater tickets, alcohol, illicit drugs, porn, letters to girlfriends, notes to boyfriends, retail receipts, credit card statements, and on, and on, and on…To muster this information into a cohesive portrait of the subject simply takes time, rubber gloves, evidence sleeves, a few notebooks, and meticulous organizational skills.

Summary

A background investigation for due diligence should be a thorough exploration of the facts and a thoughtful rendering of those facts into a portrait of the subject. The subject provides a head shot, their best side in the nicest possible light. Our objective should not be to destroy that ideal, but to augment it with a serious dose of reality. Many investigators approach this type of work with a broad-brush methodology. They simply gather computer-generated information and report that under their letterhead with no verification or support. (Actually, a lot of investigators will just copy and paste the database information into their report.) A worthy investigator will dig deeper. They will corroborate their initial research with several sources. They will contact the original source of information and verify in person or via telephone the virtue of all claims. The true professional will take it even further. He will conduct primary research in the form of observation and evidence gathering.

The “reputational due diligence model” sounds a bit pedantic and purposefully overwrought. A quality background investigation should be thorough and thoughtful and doesn’t need a long meaningless name. Spies have been doing this work for ages. I think they simply call it a dossier.