More on the Detrimental Impact of Too Many Rules

Disclaimer: I have written about this topic within the past three (or five) years.

I received an email today titled, "Requirement." The sender of the email is a man in whom I place a great deal of trust. I admire him because he is a thinking man who considers issues with efficiency and caution. He, however, is a player in an industry that is gasping its last feeble breaths, thanks in large part to silly, knee-jerk regulations that are applied across an entire industry, regardless of whether or not they mean anything or add to the work product.

It seems that a small cadre of consultants has been in serious breach of a specific regulation. The rule, handed down from the towers of wisdom, requires all consultants to clearly state in every report whether or not the consultant has ever worked on a specific project in any capacity in the past three years. (There is some debate about the three year rule - should you report for a five year period, lifetime, etc. One particularly inept consultant, the one who gets really excited about the rules and making sure they are obeyed and implemented, even suggested that if you mowed the lawn for someone involved in a specific project in 1987 then you are required disclose that in the report.) To be clear: I have written about this topic within the past three (or five) years.

I always include this statement in my letter of transmittal, right up front, so that my clients are clear about any past activities with respect to any given assignment. Turns out, that's wrong. The statement MUST be included in a certification (one portion of the report that bears signatures), not in the letter (which happens to be another portion of the report that bears signatures, but who's counting?). If a consultant does these things he or she is in complete compliance with regulations, unless a client requests that it be included in the letter.

Oh, and just to be sure, probably better make mention of your past experience with a particular assignment in the history section as well, as required by many clients and as interpreted by some of those who reside in the aforementioned tower of wisdom (And that particularly inept consultant, the one who gets really excited about the rules and making sure they are obeyed and implemented.). Also, best make sure that you describe any changes in your analysis and why you made said changes.

So, we now have the exact same sentence included in a single report in three separate places. Inclusion of this sentence in no way increases the reliability of a given report. It does not add to credibility to the analysis. It does not, in any way, have any impact on the conclusions derived for a given assignment. But it's in there, as required.

Certification: I, Thomas H. Humphreys, do hereby certify that I have written about this topic within the past three (or five) years. The specific date upon which I penned my last post pertaining to this peturbance was March 3, 2011. In my last discourse describing the disturbing detriments of too many directives I discussed the broad over-arching framework of too many rules. I still hold that opinion. This post, the one written today, is not a departure from my previous analysis, rather a more specific example of the broader problem, an elucidation of the sheer idiocy and voluminousness of regulations mandated by the committees that oversee a certain industry.

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?

Auditing the auditor

We get asked all the time about what information we can find about a person. Well...we can find a lot.

More than most people are comfortable with, but less than most people think. The cool thing is, for those of you out in the regular world, we get audited.

All of our information sources are under strict regulations to make sure that we do not misuse the information to which we have access. To this end, we have to submit to random audits. Just filled out one this morning. Anyway, it's nice to know that someone is watching.