Automated Underwriting in the Subprime Market

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The Subprime Loan Machine, an article scheduled to run in tomorrow’s New York Times talks about the role of the automated underwriting engine and its facilitation of the boom of subprime mortgage lending. While I feel that the article puts a little too much emphasis on the role the system played; there is no doubt that the proliferation and acceptance of automated underwriting systems (AUS) helped qualify more people faster, and made the industry much more efficient at generating new originations.

The rise and fall of the subprime market has been told as a story of a flood of Wall Street money and the desire of Americans desperate to be part of a housing boom. But it was the little-noticed tool of automated underwriting software that made that boom possible.

It is a stretch to state that AUS "made the boom possible" when one wouldn’t have to look too far to find much more important drivers: liquidity, historically low interest rates, low worldwide investment yields, and larger mortgage product buyers and sellers. It’s not hard to argue that any of these dwarfs the role AUS played in the "boom."

That being said, AUS did make a critical impact to the industry that facilitated the extension of credit; primarily by drastically improving the speed, reducing cost and improving accuracy of lending decisions. AUS brought underwriting time down from days to minutes, reduced the need for expensive, experienced underwriters, and enabled "risk based" models for lending instead of "rules based" ones.

AUS also put underwriting capability in the hands of individual brokers and small bankers, allowing them to get decisions on loans quickly. This reduced the work load for both the broker and the lenders. Brokers could now afford to underwrite loans, banks had a standard that they agreed to accept in the format of automated underwriting findings. This improved the workflow of the industry and allowed more and more people in to the origination game.

The article does make some good points in to the problems that are driven by the use of AUS:

The software itself, of course, cannot be blamed for lowered lending standards or lax controls. But critics say the push for speed influenced some lenders to take shortcuts, ignore warning signs or focus entirely on credit scores.

AUS placed excessive priority on the FICO score while dismissing some of the more "human-based" granular review of the components of that score. That was probably a function of the computer’s inability to decision consistently on the detail. Now, in this market meltdown we are seeing major problems in markets typified by good/excellent credit.

â??Automated underwriting put the credit score on such a pedestal that it obscured the other important things, like is the income actually there,â?? said Professor Retsinas of Harvard. â??Before there was A.U., down payment mattered a lot. Where weâ??ve crossed the line in recent years is to say, we donâ??t need down payment.â??

Michael Perna, Arc Systemsâ?? marketing director, said that income â??is supposed to be verified by a person.â??

This review "by a person" became less and less of a factor as loans were pushed through the door in an effort to boost productivity and profits. This was a key element to the degredation of the loan quality in originations.

The article is an interesting look at the impact of AUS on lending; but as I mentioned above, it can hardly be blamed for the problems in subprime and the overall mortgage market. The "boom" was not due to a technological advance – it was due to too much money that was too easy to borrower and use.