What is the Law of Unintended Consequences?
In short it means that a particular action or decision may produce an outcome or consequence that may be unintended. An example might be a decision to release a product to the marketplace before it was truly tested. The decision might have been predicated on fears that the company’s competition was about to release a similar product. However, if the product was faulty it would create a negative experience with customers and result in bad press for the company. The unintended consequence may be that the company’s market share in other product lines might decline because of the bad press received on one product.
A good example in our business is the results of originating and selling subprime and stated income loans. In the mid-2000s, secondary market investors were buying loans as long as the borrower had a pulse. Income verification was not required, FICO scores could be ignored, the borrower might not have been a permanent citizen. However, the investor purchase agreements had a killer clause that said if “a loan had any misrepresentation the investor had the right to put the loan back to the mortgage banker". Unfortunately many stated income loans were “liar loans” with income misrepresentation. The unintended consequence was loans were sold with recourse, creating repurchase risk for the life of the loan.
Most mortgage bankers today understand the Law of Unintended Consequences as it relates to loan repurchase risk. They understand the potential results of their past actions and are sure to prepare for the outcome of their present decisions. Essentially, everyone knows a mortgage banker has and will continue to have loan repurchase risk.
There are many pro-active approaches to mitigate repurchase risk such as stringent control quality control, legal review of agreements, etc.
Another key approach is to set aside a portion of your current earnings to protect against the possibility of future losses. These are called "loan loss reserves". Regulated financial institutions such as banks and credit unions must aside loan loss reserves to protect against unexpected future losses. I called Jeff Spiegel (Spiegel Accountancy Corp.), a CPA in the SF Bay area that conducts audits for mortgage bankers, for color on setting aside reserves for unanticipated l loan losses. There are two types of reserve accounts:
- Specific Reserves: These reserves will be set up for identifiable losses. These potential losses could be the result of loans already on your books that are nonperforming, EPDs, etc.
- General Reserves: These reserves are set up for unidentifiable losses. These unidentifiable losses would be potential results of buy backs, EPDs, etc. that are not yet known. The loan loss reserve amount would be determined by reviewing your history of losses from previous years.
These loan loss reserves are expensed on your financial statement, but are not tax deductable until the actual loss is realized.
If a mortgage banker has been originating and selling loans to investors, it should it should prepare for The Law of Unintended Consequences. One does not intend on repurchasing loans from investors, but it has become part of being a mortgage banker. One should expect it and set a strategy in place to prepare for them. Setting up specific and general reserves is a strategy that makes sense.