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Risk Adjustments Can Be a Risky Proposition!

Setting risk adjustments can be a risky game when it comes to Fair Lending.
A quick glance of your risk adjustments can give an examiner a lot of ammunition if they suspect that consumers or types of consumers are being treated unfairly. A good technique for evaluating your risk level as it relates to your risk adjustments is as follows:

1.  If the risk adjustment is coming from the GSE or Investor, then you have less to worry about because it is their risk adjustment overlay, and not one that your company imposed.
2.  If your product line is not diverse or competitive in both well-served and under-served areas of your MSA, you may want to research more options for program offerings. One of the first issues a fair lending examiner will pick up on is do you have other viable options. Finding those options means that you took a look at your markets to see what the financing needs are of those buying property and then compared that with what you offer. If there is a viable option you may want to consider it. So, if the lenders you presently use have strong risk adjustments, it may be wise to research what other lender’s finance in those markets. This will help to make your offerings more competitive in the geographical areas you target as under-served.
3.  If your company imposes the risk adjustment, then you will need to offer a business justification for that adjustment. Using phrases to justify the adjustment such as “it takes more time to do those loans” will not get you where you want to be with the examiner. One lender that I know of had to do a “time-study analysis” because of this claim, and that was very costly. Business justifications are complex and require empirical data to back it up. And even then, they still may not be acceptable so approach them conservatively.
4.  Is the risk adjustment causing Disparate Impact or Redlining? For instance, a lender in California had a 300bps mark-up for any mortgage that used a grant or subsidy program from the state. If you are familiar with the California market, these programs are available for many types of clients due to the cost of real estate (not just under-served, but Teachers, Fireman, & Policemen). The lender said that the risk adjustment was warranted because those loans affected their FHA Compare Ratios negatively. The next question was where is the empirical data to back up that claim? An adjustment that severe is a red flag and most likely causes an examiner to explore it in further detail. To make a long story short, the lender was forced to change that mark-up to a more reasonable adjustment and remediate anyone who may have financed those loans with them. They also have to report compare ratio data to justify the correlation between the risk and the effect on the compare ratio. That’s a lot of work!!

Remember, in today’s world you’ve got to have a reason to charge one person more than another. Those reasons need to be backed by data analysis and the use of statisticians who can accumulate what you need. Even then, it may still not fly as a business justification, but it will prove that you did your due diligence. I’m just waiting on the day when the GSE’s have to back up their overlays with empirical data. Now that will be interesting!!

Tammy Butler, Master CMB

Author Tammy Butler, Master CMB

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