counter party credit risk

Counter Party Credit Risk: Follow the Money

A term that is starting to be mentioned with greater frequency in the mortgage industry is counterparty risk. When does this term arise and what effect does it have on a real estate transaction?

Example of Counterparty Credit Risk

At last, your home buying process is in the final stages. The underwriting, mountains of paperwork and closing are finally complete and you’re given the keys to your new home. All the worries that you’ve had throughout the transaction are over.

But, should you really stop worrying?

Once the paperwork is signed and the closing has been completed, the money begins to move. The new lender (assuming it’s a “wet” closing) has already sent money to the title agent, who is a third party vendor, acting as the escrow or settlement agent. At this point, the title agent needs to disburse the money to the old lender, the other vendors and the creditors on the settlement statement.

However, once the new lender has sent the money, it is released into the title agent’s bank account — now a counter credit party. The new lender receives no collateral, just the title agent’s documentation and assurance. This assurance is typically good, and they get the money to the old lender and other creditors as promised.

This period usually lasts for a small window of time but, unfortunately, it is one in which corrupt title agents can and do take advantage of. An auditor ATS Secured has spoken with referred to this time period as the “black hole.” The above scenario is just one example of counterparty credit risk.

Counterparty credit risk has always been a major problem in the mortgage industry; however, in recent years this type of defalcation has skyrocketed. Monday, word broke that a large title company in Georgia has had a substantial defalcation. The company has had to take serious action to save their business—selling 70% of their title company.

Even worse, this “black hole” can create a ripple effect of unintended consequences. These defalcations typically go on for extended periods of time before they are discovered. While these don’t happen frequently, the magnitude of when they do happen can amount to millions and occasionally into the tens of millions. If person A owes money to person B, but takes the money for themselves and leaves the country, then Person B can’t pay the money back he owes to Person C, who in turn can’t pay what they owe.

In 2008 this ripple effect spread even further. It is part of what shredded the economy and led to the Dodd-Frank Act and the CFPB. Recent bulletins by the CFPB and all the Prudential Regulators have all introduced, or reaffirmed, guidelines for banks to scrutinize their third party vendors.
In spite of all this, counterparty credit risk still remains a significant issue. Simply looking at a vendor’s past history isn’t enough to tell if they are part of a fraud scheme today.

Preventing Counterparty Credit Risk

The industry needs a secure method that follows the money with the ability to lockdown payments and track them end-to-end. The mortgage closing process needs transparency so that, in the above example, the new lender would have end-to-end payment verification, ensuring that their money was going exactly to its intended recipient.

Even with this process in place, to truly seal up the black hole of counterparty credit risk, indemnification would ensure that any possible fraud would be covered. It all revolves around following the money.

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