Richard W. Shepherd
Marketing & Symposium Editor
Loyola University Chicago, J.D. 2019
Compliance failures in banking can often result in real harm to borrowers. In the case of Wells Fargo, a compliance error resulted in 400 of the bank’s customers losing their homes. Due to an issue in the bank’s software system, the institution denied loan modifications to borrowers who should have qualified. This latest failure adds to the myriad of issues Wells Fargo bungled over the past several months. For compliance professionals, the failure demonstrates the risks of automation in compliance, the importance of technical expertise, and the risks of decision-making without putting the interests of the customer first.
What Happened at Wells Fargo
The bank initially disclosed the error in a regulatory filing. In itsQ-10 filing with the Securities & Exchange Commission, the bank disclosed the fact that they were setting aside $8 million to compensate borrowers who were incorrectly denied mortgage modifications ($12,800 per customer). The modifications were made available to borrowers under the Treasury Department’s Home Affordable Modification Program, a 2009 program enacted to help Americans make their mortgage payments during the housing crisis. The error resulted in 625 customers in foreclosure to be denied mortgage modifications, 400 of which eventually lost their homes.
In their Q-10 filing, Wells Fargo stated: “This error in the modification tool caused an automated miscalculation of attorneys’ fees that were included for purposes of determining whether a customer qualified for a mortgage loan modification.” Essentially, a calculation error in software developed by the bank resulted in the foreclosures.
In a mortgage loan modification, the borrower can change the terms of their loan to make it easier to repay. Modifications may extend the term of the loan, reduce the interest rate, or forbear the principal balance. During a modification, the bank can also roll other fees such as insurance and attorneys’ fees into the new loan balance. A modification can be a part of a federal program such as the Home Affordable Modification program, under which the government would provide the bank with an incentive to modify the loan, so the borrower can stay in their home. In a foreclosure context, modification is a type of loss mitigation. During foreclosure, banks are required to attempt loss mitigation by working with the borrower to resolve the issue before the court decides how to rule.
When a borrower applies for modification, the bank performs underwriting to determine whether or not to approve the application. Under federal programs, the target amount for the modified mortgage payment is 31% of the borrower’s income. The bank also has to calculate whether or not the new loan would make them as much money as the old loan. If that’s the case, and the borrower’s debt-to-income ratio is within an acceptable range, the modification should be approved.
To make these calculations, Wells Fargo developed software called the automated-decisioning tool. The tool analyzes the individual borrower and their loan, and uses various constraints, including an incorrect calculation of attorneys’ fees, to decide whether or not to approve the loan. The software generates a yes or no decision. Only the decision, and not the actual calculations, are exported to different parts of the bank, meaning the error was not noticed for five years. Because attorneys’ fees were being calculated incorrectly, 625 borrowers who qualified for modification were denied. Overall, Wells Fargo approved 28% of modification requests, below average for the nation’s largest mortgage servicers.
Lessons for Compliance Professionals
For compliance professionals, this episode provides multiple take-aways. The failures at Wells Fargo demonstrate the risks of automation in compliance, the importance of technical expertise, and the risk of decision-making without putting the consumer and ultimately the reputation of the enterprise first.
Banking compliance is often complex, especially for institutions with thousands of loans and customers. Software systems can provide a useful solution in managing a bank’s day-to-day operations. Further, consumer’s desire for online and mobile banking services provides additional incentive to automate decision-making. An individual can easily apply for a mortgage, credit card, or in this case a loan modification online or through a smart phone app. The bank can create a system to analyze the borrower and determine whether or not to approve the loan within seconds. Doing so provides an efficient solution to a complex workload. However, in creating software, banks need to be sure the assumptions and overall framework utilized by the bank are correct. Further, an effective auditing system must be implemented to continually analyze whether the system is working correctly. As this case demonstrates, using incorrect assumptions or constraints can result in catastrophic consequences to a borrower.
The case of Wells Fargo also demonstrates the importance of technical expertise, both in information technology and financial regulation. Wells Fargo did not notice the software error for five years. Thus, no internal audit, board oversight, or regulatory examination revealed the issue for five years. This demonstrates the need for more technical expertise in banking. As the industry becomes more technology-based, it’s paramount that institutions and regulators employ more individuals with information technology backgrounds, and better educate their existing employees on the intricacies of information technology.
Finally, this demonstrates the importance of putting the needs of the customer first. In comparison to the financial and housing crises of the past decade, this episode is a drop in the bucket. However, for the 400 families who lost their homes, their lives are changed forever. The decisioning tool developed by Wells Fargo offered efficiency, but cost the bank reputational and legal damage, and costs borrowers their homes. It’s hard to imagine George Bailey making an incorrect calculation resulting in a foreclosure. When making decisions, institutions need to think more like George Bailey and less like Mr. Potter.
Looking Forward
Both Congress and regulators have begun looking into this episode further. Several questions hang over the investigation including the role of regulators while the error was ongoing at Wells Fargo. Specifically, whether a lack of regulatory due diligence allowed the error to continue. Additionally, what further issues arising from the immediate aftermath of the financial and housing crises could become apparent over time. Finally, with an administration determined to deregulate financial services, what consequences will institutions actually face for failures like this.