Mortgage Brokers

The mortgage broker is the middleman between the applicant and the rest of the mortgage industry. As banks and lenders grew in size, they lost personal contact with their applicants. This, in addition to the increasing complexities associated with financing a property, a need developed for a service that would help the applicant. This service gives the applicant the tools needed to make intelligent decisions when applying for a mortgage. The mortgage broker fills this need.

The lenders quickly realized that is was cost effective to deal with mortgage brokers. The manpower they required to deal directly with the consumer was large and the demand for mortgages was different year to year. If the lender didn’t hire additional personnel during periods of high volume, their staff would be overworked, errors would occur and they wouldn’t be able to capitalize on the increased volume of originations. If they increased their staff during periods of high volume, they would have too many people on their payroll when the market corrected, thus forcing them to lay off staff. This didn’t make for a healthy work environment.

The support staff that a lender needs to service a mortgage broker is far less than when dealing directly with the public for several reasons. To begin with, lenders can make demands on the broker that they can’t impose on the general public. Packages being submitted by a broker must be complete. If they are not, the lender is under no obligation to accept the package. The lender can demand that most of the application packages submitted not only meet the lender’s standards, but that they will also close. Typically, only 40% of the applications submitted directly to a lender by consumers, actually close. A lender will expect at least 80% of the applications submitted by a broker will close. All the “hand holding” that is an important part of customer service is passed onto the broker. A lender has better control of their manpower requirements over time, making for a stronger company because their employees feel secure in their positions.

The discounted pricing that a lender gives to a broker costs them less than it would cost the lender to originate the same total value of closed mortgages. This makes dealing with a mortgage broker a sound business decision for the lender.

Most mortgage brokers are small businesses. Their staff tends to develop a personal relationship with their clients. This gives the applicant the ability to be in constant communication with the same people over and over throughout the process. Becasue of the discounts provided to the broker from the lender, this personalized level of service comes with little or no cost to the consumer, making it a win-win situation for the applicant. This is the reason that the market share of broker originated mortgages reached nearly 70% a couple of years ago. An impressive number, when you consider residential mortgage brokers have been in existence for less than 20 years.

As efficient as this system was, it was missing one thing- accountability. Lenders were not as careful in deciding which brokers they wanted to deal with. A lender may have been negligent in their due diligence prior to working with a broker; they may have been afraid of losing market share if their standards were too high; they may have over-estimated their staff’s ability to underwrite mortgages; they may have under-estimated the greed of many brokers, etc. This resulted in the inferior quality of mortgages that were being closed on. Lower quality mortgages yield higher default rates, which lead to higher foreclosure rates, which lead to decreasing values of Mortgage Backed Securities, which in turn yields losses to investors.

The common element that we’ve seen, in all the businesses involved in the mortgage market, is that everyone was assuming that all other entities were doing their job properly. The lender assumed the broker was doing the right thing, the wholesaler assumed the lender had properly underwritten all mortgages, the investor had confidence in the rating agencies, the broker assumed that the lender’s interpretation of underwriting standards was valid, etc.

None of the industry players were doing their job as thoroughly as they should have. Something was bound to give. The spark that initiated the problems in the mortgage market was that the housing market began to slow down. Once appreciating housing prices could no longer be relied on and the entire mortgage marketplace gradually became stressed. The sloppiness of all the industry participants quickly became apparent and the downward spiral accelerated.

The access the industry has to the applicant is through the lender and the mortgage broker. The mortgage broker’s role is pure; he is only working as the middleman between the public and the industry. The lender, as we noted earlier, plays a duel role. He is not only dealing with the consumer but also has a responsibility to write profitable mortgages. Of all the industry players, I feel the broker had the greater degree of responsibility to the applicant and therefore was in the position to minimize the damage of the mortgage meltdown. Unfortunately, too many brokers did not live up to this responsibility. Far too many brokers were putting their own interests over the interests of their clients. There were three general reasons for this: greed, incompetence and the lack of respect for their clients. I don’t want you to conclude that all mortgage brokers failed to do their jobs properly. As a mortgage broker and being active in the various broker associations, I can say with confidence that many of us do our job right. It’s just unfortunate that not all brokers fall into this category.

From the consumer’s prospective I feel that using the right mortgage broker is the best way to finance a home. I also feel that with additional government regulations and improved due diligence from the wholesalers’ and lenders’ prospective, that finding the right mortgage broker will get easier every day.

Let’s look at each of the reasons. Greed is the easiest one, so we’ll start there. There has never been any regulatory limit on the fees charged by mortgage brokers or any other business involved in the mortgage process. The government’s position is to allow for the competitive marketplace do its job. For the most part it has. In most areas of the country there are numerous sources of financing and the free market works. Wholesalers and lenders were historically cautious in limiting broker compensation, although over the last few years this has been changing. This system fails when high-pressure selling tactics are employed or access to mortgages is limited in a community. Greed, in any profession, will never be eliminated. All we can hope to do is to minimize it. Lenders and wholesalers are now recognizing they need to be more proactive in this regard as well as becoming more particular in choosing the brokers they want to deal with.

Regulators are finally addressing the incompetency issue. Someone looking to become a mortgage broker needed little or no education or work experience. For example, in New York State, there was never an educational requirement to become a mortgage broker. This changed on January 1, 2008, but it took 20 years of fighting with State government and a mortgage meltdown, before any education requirement was imposed on a mortgage broker. There is no worse combination; incompetent professionals in a field that the public assumes has at least minimum standards. This low standard literally invites criminals in. This is why the FBI has identified mortgage fraud as the fastest growing white collar crime in the country.

The most ethical person can be incompetent. If the owner doesn’t take the time to teach his originators all the details of the various mortgage programs and underwriting standards, how competent can the originator be? This has been a big problem in the industry. The standard to become an originator is lower than the standard to become a mortgage broker. This puts a high level of responsibility on the mortgage broker regarding the education of his staff. Many mortgage brokers are more interested in hiring salesmen, not financial consultants. A large number of applicants were put into mortgages that were not in the applicants best interest, simply because the originator didn’t know any better.

Regulations are being passed by each State that will not only add an education requirement for originators and a criminal background check but will also assign an identification number to the originator. The number will be put on every application taken by the originator. Now a mortgage can at any time, be tracked ,creating accountability.

The final reason is the most important, lack of respect for the client. If you have respect for your client, regardless of your quality of education or experience level, you will be an asset to your client. Respect requires you to find the answer to a question that is posed to you instead of making something up. Respect requires you to ask enough questions of your client to get a complete picture of their needs and goals. Respect prevents you from charging more for your service than is fair. The most important quality, respect for your client, is the easiest standard to meet. You just need to be a professional.

The easy lending standards we’ve been working with over the last few years have been a powerful set of tools for a mortgage broker to work with. But like all power tools they need to be used intelligently. A chain saw in the right hands takes all the work out of cutting trees, in the wrong hands you are left with a bloody mess. The mortgage meltdown we are currently experiencing is the bloody mess when powerful tools were misused.

Where the Lender Fits In

The Lender is the entity that deals directly with the customer in originating a mortgage, commits to fund and then closes on the mortgage. It can use its own money to fund mortgage, use an investor’s money or broker the mortgage out to another funding source. Every lender operates in a way that best suits its needs. A large lender with substantial cash reserves may be closing the majority of mortgages with its own money whereas a small lender will elect to close most of its mortgages using investor’s money. A savings bank would be an example of a large lender. They have a depositor base supplying the cash needed to fund its own mortgages. A mortgage banker would be an example of a small lender. Not having access to a depositor base it will need to depend on investors to fund mortgages.

A lender utilizing its own funds writes its own underwriting standards and sets its own pricing. A lender that uses investor funds will be using the investor’s underwriting standards and is more limited in setting pricing. Now let’s look at the impact each style of operation has on the mortgage market in general.

A lender that uses its own capital to fund mortgages is called a portfolio lender. As the name implies, this lender is holding all their mortgages in their own portfolio. The underwriting standards they use will directly influence the performance of the portfolio. If they are too conservative, they may not be writing enough mortgages to generate the profits needed. If they are too liberal, the performance of the portfolio will be poor due to a higher than expected default rate. The portfolio lenders suffered the same problems that the wholesalers faced in this market. The combination of a desire to increase their volume of originations and turning a blind eye to the risk exposure of their underwriting standards, leads them down the path to a non-performing portfolio.

It’s a little different with the smaller lender. Here, thier wholesalers and investors are dictating the underwriting standards. A mortgage banker is interpreting those guidelines that have been given to him. The act of underwriting the mortgage application is one of matching the attributes of the applicant to the underwriting standards. The mortgage banker’s contribution to our current problems is their liberal interpretation of the underwriting standards. They were closing on mortgages that they should not have closed on. Common sense was ignored, in order to keep the volume of closed mortgages as high as possible. The moertgage banker didn’t feel responsible since they were following the guidelines of their investors. The investors, however, saw it differently and quickly stopped funding their mortgages with an end result of driving the mortgage banker into bankruptcy.

In theory, lenders could have prevented a lot of our current problems. Using a common sense interpretation of underwriting standards, a more diligent investigation of the details of the purchase transaction and the financial profile of the applicant, our problems would be much less severe. Few lenders took this approach, preferring to “go with the pack” and do the same thing their competitors were doing. This seemed to be the safer path. Investors were looking to buy high yielding mortgages, the rating agencies gave these pools of mortgages high marks, the population was demanding that they be given mortgages and the Federal government was praising the high percentage of Americans who now owned their own homes. Additionally, the expanding mortgage market was keeping the country’s economy strong. In such an environment, it’s extremely difficult for any person or company to break away from the pack.

This, in no way, is meant to minimize the responsibilities of the lenders for this mortgage market nightmare. It is being presented to give you an overall prospective of how we’ve gotten to where we are. They only way we can avoid making the same mistakes again, is to identify the underlying factors that caused the problem in the first place.

The Responsibility of the Wholesaler

Before we can discuss the responsibility of the Wholesaler in this mortgage market, we first need to define what the wholesaler does. We know that once a mortgage is originated and closed, it will eventually wind up in the secondary market. It will become part of the portfolios of the GSEs or a MBS on Wall Street. The mortgage will move from the originating entity though an intermediate entity until it finally makes its way to the investor. An entity whose primary job is that of an intermediary, is called the wholesaler.

The wholesaler doesn’t deal with the consumer; the broker or banker does that. The wholesaler bundles mortgages and sells them to either a GSE or Wall Street firm who will then proceed with the securitization. The wholesaler is obligated to pool mortgages to meet the specific standards of the company. They pass on these same specifications to the originating entities they work with.

Wholesalers will buy closed mortgages from bankers or they will underwriter mortgages for brokers. A banker will use a wholesaler for an expanded product line. They may not originate enough of a particular mortgage type to warrant selling to them directly, so they will utilize a wholesaler instead. Or they may use a wholesaler during times of heavy volume of originations. A broker needs a wholesaler to place his mortgages since he doesn’t have direct access to the GSEs or Wall Street.

The long-term success of a wholesaler is dependant on how accurate they are in writing their underwriting specifications and how diligently their staff follows their investors’ guidelines. If the investor’s requirements are interpreted liberally, the quality of the pools of mortgages will suffer. If their staff isn’t kept informed of changing standards, they can easily be approving mortgages that cannot be pooled. If the staff is overworked or additional manpower is brought in that isn’t properly qualified, the wholesaler’s ability to function suffers.

While the mortgage market was rapidly expanding and Wall Street grew more hungry for mortgages they could securitize, the wholesalers got caught up in the momentum. To meet the record setting volume of business, additional personnel needed to be hired and current employees were working longer hours. This caused the quality of the mortgages to suffer. As commonly happens in industry, the production volume became more important than the quality of the finished product. As the quality of mortgages quickly began to fall, the wholesalers found themselves holding mortgages they couldn't sell. This forced many out of business.

These issues can easily be addressed. Internal communications improve, new employees gain experience and the workload for all employees becomes more manageable. The increased workload was responsible for only a portion of the problems we see.

If the wholesalers were doing their job properly, the problems we’re realizing today would be much less severe. We keep hearing that the originators placed people into mortgages they couldn’t afford. Wall Street was buying mortgages at such a rapid rate, they didn’t care what they were buying. Originators wanted their commissions by hook or by crook and Wall Street needed product to securitize. I have no argument with these statements. I only question the magnitude of the impact of bad originators and greed on the Street.

Wall Street needed mortgages; there is no question about it. They wrote underwriting standards that were generous; again, no argument. The wholesalers were in the position to maintain a narrow interpretation of those standards and should have. The perfect example of this is the "stated income" mortgage, which has now been dubbed the “liar’s loan”. When this product was originally designed, it was meant for business owners, individuals whose financials are not consistent from year to year, thereby making it difficult for them to qualify for a loan under traditional underwriting standards. In an effort to minimize the risk associated with mortgages of this type, a higher down payment was required. This higher down payment not only put more of the borrower’s personal funds ito the transaction, it was also a way to confirm that the borrower has proven fiscal responsibility by saving up the required assets.

In their drive to increase volume, Wall Street began to work with lower down payment requirements and began accepting salaried employees under a stated income program. Here’s where the wholesaler’s responsibility is. An applicant who is putting a small down payment on his purchase and is working in a fast food restaurant probably isn’t making the $100,000 a year that is "stated" on the application. The wholesaler needed to be responsible and use good judgment by not approving this applicant. The mortgage may have technically met the standards but the wholesaler wasn’t doing his job. The standard wasn’t written for mortgages to be granted to individuals that have no ability to make the payments.

Now let’s look at it from the originator’s position. Let’s assume that the originator didn’t care about the applicant and was only interested in making his commission on the mortgage. The application is taken and then submitted to the wholesaler. If the wholesaler were doing his job responsibly, the application would be declined.

Bottom line is that wholesalers were not doing their jobs. They were solely concerned with production figures. Refering back to my example, a wholesaler would have been afraid to decline this loan for two reasons. First, the fear that the wholesaler down the block would close on it anyway. Second, fear that the originator would no longer submit mortgages to them. This logic is the reason so many wholesalers are now out of business.

The Problems on Wall Street

Wall Street is where Mortgages are pooled, securities are created and then sold to investors. Basically it’s the marketplace. This is a world of alphabet soup. RMBS, CDOs, SIVs, etc. is the language of this market place. For the rest of us they are referring to residential mortgage backed securities, collateralized debt obligations and structured investment vehicles.

The brokerage houses role in the mortgage market is to take a pool of mortgages and create securities with various yields. The best way to gain an understanding of what they do is with an example. Let’s say we have a pool of mortgages with an average interest rate of 8%. Not all mortgage are going to perform as expected. A series of tranches, securities yielding a specific rate of return, are created. For our example we use 3, one yielding 6%, one yielding 8% and one yielding 10%. As the borrowers make mortgage payments the investors who purchased the securities yielding 6% are paid first. Once all those obligations are met then the next group of investors, those expecting 8%, is paid. Only after the obligation to these securities are satisfied can the investors who purchased the securities yielding 10% see any money. As this example illustrates, the higher the yield, the higher the risk of the investment.

These securities can then be pooled with other securities, creating new tranches that are also sold. Mortgage backed securities can be pooled with credit card receivables, personal loans, car loans, etc. The brokerage houses of Wall Street create complicated investment vehicles that are designed to meet the goals of all the various investors. This system is totally dependant on the ability to accurately predict the performance of the underlying mortgages and promissory notes. The current problem in the mortgage market today is because the predictions were very wrong.

How could all these experts be so wrong? There are several reasons, all of which have contributed to the problem. We’ll probably never know for sure the magnitude each reason played but we do know the results, today’s mortgage meltdown.

The first reason is both the investor as well as Wall Street depend on the rating agencies to analyse the risk of each security offered. As discussed earlier, the rating agencies miscalculated the risk of the securities. The Wall Street firms, as well as all investors, use the rating of a security as a starting point. They will then do their own calculations to determine risk. It’s obvious now that those calculations were no better that those performed by the rating agencies.

The next issue is the magnitude of the complication of the securities being offered. It’s being discovered only now that the securities that have been offered are so intertwined with each other that, every missed mortgage payments is magnified a hundred times over. It seems that the people who designed the securities didn’t have a full understanding of this. To make matters worse, the investors that were purchasing these securities also had no clue about all these inter-dependencies.

This brings us to the most important question. Were the people involved in this market aware of these shortcomings and just ignored them? Millions of dollars were made, both by the company as well as the individuals working in the industry. Did the money they were making blind them all or were they ignorant to what they were doing?

Whatever the reason, it is clear that Wall Street is not living up to its obligation to maintain a marketplace where investors can depend on the data provided. Investors need to be able to make informed decisions. Wall Street can only function if it has the confidence of the investment community. We live in a global economy; Wall Street isn’t the only marketplace for investors. Once investors lose faith in Wall Street, they will simply invest in other markets. Should this occur, we will no longer be a leader in world economics; we will become a second rate country. The current state of our economy isn’t as strong as it should be; what state of economic health will we be in, when investors begin to put their money elsewhere?

Wall Street needs to regain its international creditability before we can hope to re-ignite our economy. The mortgage market is only one piece of a large security market; yet when it went bad, the effects were and stil are, being felt around the world. Imagine what will happen if another component of the market was to go bad.

The Investor's Role

The process of pooling mortgages and selling shares to investors is called securitization. Without investors willing to buy these shares, there would be no way for lenders to convert closed mortgages into fresh capital to lend out. This is the basic problem we are facing today. Investors have lost their desire to purchase these securities and when there are no buyers in a market sellers are forced to hold onto their wares.

Investors are extremely important to the mortgage market, because without them there is simply no market. The class of investors purchasing these securities is made up of individuals, companies, mutual funds, pension funds and government entities, both domestic as well as foreign. The spread of these securities is amazing, they seem to be held in every investor’s portfolio regardless of how large or small the investor is.

The world economy has been awash with available cash for some time now and there seems to be no end in sight. Countries that were once seen as “third world” have developed thriving economies and are responsible for generating new wealth. Their economy can be based on modernization; such as we’ve seen happen in China and India. It could be based on the development of a country’s national resource; such as we’re seeing in Nigeria and Venezuela. Whatever the source, new wealth is being created at a record pace.

What this means is there has been and still is a tremendous amount of capital throughout the world looking to be invested somewhere. This has resulted in lower yields than have been historically available. It’s basic economics, the law of supply and demand. In this case, the commodity or “supply” is money and the user or “demand” is companies needing cash to run their businesses. In the case of the mortgage market, lenders need to sell off closed mortgages in order to free up capital to close fresh mortgages. The avenue used is securitization. Investors will typically want to diversify their investments. Some money will be invested in more speculative and therefore higher yielding ventures; other money will be invested conservatively with the appropriate low yield that accompanies a safer investment.

In looking at the different levels of risk an investor is involved in, he will try to get the highest yield possible in each investment made. This includes whatever money he is investing in secure ways. Mortgage Backed Securities have traditionally been considered a safe investment while giving a slightly higher yield than, say, US Treasuries.

As investors pushed for higher yields, the lenders were encouraged to originate mortgages that were at a higher interest rate. The only way for a lender to close loans at higher interest rates was to attract less qualified borrowers, who would be willing to pay the higher rates. This cycle of investors looking for higher yields and the lenders responding by lowering their lending standards brought us to today’s problems in the mortgage market.

What went wrong? The obvious answer is, greed. In the drive for higher profits, the investors destroyed the money making machine know as the mortgage market. I’m not satisfied that investor greed is the only issue in play here. We assume that investors are number-crunching businessmen and all decisions are calculated with nothing else influencing the decision. Humans make investment decisions and all humans have a set of consistent qualities that may vary in intensity from person to person but are always present. The attribute that’s important to this discussion is the desire to be part of the group. The comfort zone we have of running with the pack, the uncomfortable feeling we have in being different, and the fear of jeopardizing our income or reputation by disagreeing with the opinions of our company or the general assumptions of the industry we’re in.

When you combine greed with a pack mentality, the result is always a severe market correction. We’re seeing it right now in the mortgage market, we experienced it with the dot com market and I’m sure 10 years from now we’ll be experiencing yet another speculative bubble burst. Until investors develop the strength to think independently and the confidence to base their decisions on their personal analysis, we are destined to move from bubble to bubble.

Investors have no one to blame their losses on but themselves. Today’s troubled mortgage market is going to prove to be one of the most lucrative investment opportunities for independent thinking investors. One by one we are going to see major investors, hedge funds, companies, high net worth individuals and even foreign governments making selective purchases that will prove to be brilliant investment decisions over the next few years.

We all need to be more independent in our thought process. If we continue to hide in the pack we are destined to eventual failure.

The Rating Agencies

The rating agencies play an important role in the financial marketplace. Their job is to evaluate publicly traded securities and estimate the risk an investor exposes himself to when purchasing the securities. The agencies review past performance of the type of security they are evaluating, the history of the particular security, current overall market conditions and future trends of the market.

Reviewing the historical performance of the market or a particular security is straightforward. The data is readily available and it is simply a mathematical analysis. The tough part is developing future market trends. This is where the rating agencies earn their money. By studying historical market trends and evaluating current market conditions they then attempt to predict the future. In the case of rating Mortgage Backed Securities (MBS) it is now obvious that the predictions were wrong. Not a day goes by that we don’t see a rating agency lowering the credit grade on some MBS.

How could they be so wrong? Until I see some solid evidence, I’m not buying the conspiracy theory. On the surface it seems to me that the agencies have far too much to lose in jeopardizing their creditability by misclassifying the bond ratings. I feel the problem lies within the combination of two issues. To begin with, there is not a long history of subprime mortgages and whatever history that is available only covers a timeframe of rapidly appreciating home values in a strong economy. In addition, the volume of subprime mortgages originated was increasing on a monthly basis. Without a dependable history to work with, the reliability of future projections becomes questionable.

Should this short history have impacted the rating? After all, they certainly must have seen this? I believe they did recognize the limitations of the data they were working with and concluded that it wasn’t a big enough issue to negatively affect their rating. In hindsight this proved to be a bad decision and became a major component in the mortgage meltdown.

Investors make money by finding abnormalities in a market. They search for opportunities where they feel the yield on a particular investment is not in line with its level of risk. If the investor is right, he makes money. If he’s wrong, he loses money. Investors were seeing high rated MBSs carrying a higher yield than other investments with the same rating. Many investors focused on this imbalance and bought. They were betting on the credit rating being a better barometer of risk that the actual yield on the security. The bet proved to be wrong, the market yield proved to be a better representation of the risk of the mortgages.

Under normal market conditions, securities are bought and sold on an ongoing basis. This provides investors the opportunity to sell when they feel the investment is becoming riskier, or buy when they feel the timing is right. This results in small market fluctuations day-to-day as investors adjust their portfolios.

The problem the market faced in August is that, almost overnight, there were no buyers for MBSs. With no buyers there is no market and therefore a market price couldn’t be determined. This started a cascading effect throughout the mortgage market, the domestic security markets as well as the foreign security markets. The end result has been massive writedowns of the values of the securities held by investors, mortgage companies going out of business, consumers finding mortgage money harder to find with a resulting increase in foreclosures and real estate depreciation.

Just as the value of MBSs got too high before investors responded, we are currently seeing the value being too low. Buried in all the bad news we’ve been reading, there are some positives things happening. As investors begin to look closely at the financial institutions and MBSs, they are finding buying opportunities. It started with the $7.5 billion investment in Citicorp by Abu Dhabia. They saw a buying opportunity and took advantage. Goldman Sachs is on the verge of buying Litton Loan Servicing, another example of an experienced investor taking advantage of an undervalued asset. Investors from Singapore and the Middle East purchased a 10% ownership of UBS. We are going to see more and more of this as the weeks go on.

The market is slowly re-establishing. Many investors, both large and small, have taken huge loses in the meltdown of the mortgage industry. This has created a buying opportunity for other investors and they will be taking advantage of this.

Will investors lose faith in the ratings given by the agencies? Will investors look to other avenues for risk evaluation? Only time will give us answers. There is one thing we all can re-learn from this situation. There are no sure things in life; every investment is a gamble. In any market there will be winners and there will be losers. Winners are quick to take credit for their wise decisions and losers are just as quick to try to find someone to blame for their losses.

Government Sponsored Enterprises

The Government Sponsored Enterprises (GSE) play an important role in the mortgage market. Fannie Mae and Freddie Mac contribute to the increase of homeowners in the country through the symbiotic relationship they have with government.

The GSEs develop programs specifically targeted to first-time homebuyers and operate under the supervision of the Office of Federal Housing Enterprise Oversight (OFHEO). The government’s contribution is granting them access to a credit line from the US Treasury and allowing them to operate with lower cash reserves than the private industry is required to have. This lower cost of operation is then passed onto the marketplace. That’s why mortgages that are underwritten to conform to Fannie or Freddie standards carry a lower interest rate.

Before we see how the GSEs impact today’s mortgage market we need to take a look at how they evolved. Fannie Mae website will supply you with a more detailed history but this brief summary will give us all we need right now.

The FHA Administrator chartered Fannie Mae on February 10, 1938. The impetus for creation of Fannie Mae was twofold: the national commitment to housing and the inability or unwillingness of private lenders to ensure a reliable supply of mortgage credit throughout the country. The primary purpose of Fannie Mae was to purchase, hold, or sell FHA-insured mortgage loans that had been originated by private lenders. After World War II, Fannie Mae's authority was expanded to include VA-guaranteed home mortgages.

The 1968 Charter Act split Fannie Mae into two parts: Ginnie Mae and a reconstituted Fannie Mae. Ginnie Mae would continue as a federal agency and be responsible for the then-existing special assistance programs, and Fannie Mae would be transformed into a "government-sponsored private corporation" responsible for the self-supporting secondary market operations. The reconstituted Fannie Mae was to be stockholder-owned and managed. Fannie Mae retired the last of its government stock on September 30, 1968, and transformation to a government-sponsored private corporation was completed in 1970. The 1968 Act provided the authority to issue Mortgage-Backed Securities (MBS).The Act also established a regulatory structure to ensure Fannie Mae's adherence to its public purpose. It provided for continuing HUD oversight of Fannie Mae, granting "general regulatory power ... to insure that the purposes of this Title are accomplished."

The Emergency Home Finance Act of 1970 created Freddie Mac and authorized it to create a secondary market for conventional mortgages. Parallel authority and limitations to deal in conventional mortgages were given to Fannie Mae.The Federal Housing Enterprises Financial Safety and Soundness Act ("FHEFSSA") of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac. It created the Office of Federal Housing Enterprise Oversight ("OFHEO") as a new regulatory office within HUD with the responsibility to "ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely."

OFHEO is funded by assessments on Fannie Mae and Freddie Mac and is authorized to act without HUD oversight on a range of regulatory issues enumerated in the statute. FHEFSSA established risk-based and minimum capital standards for Fannie Mae and Freddie Mac. And, it established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas.

Fannie Mae and Freddie Mac purchase over 50% of the mortgages originated in the country. Because of their market share they essentially wrote the underwriting standards for the industry as well as developed nearly all of the standard documents that the industry uses. The public purpose component of their mission is to maintain an orderly mortgage market, encourage homeownership to as many consumers as possible and to keep the cost of mortgage financing as low as possible.

Roughly 2 years ago both agencies were involved in accounting scandals. There were several companies involved in accounting scandals at the time but the GSEs issues were different. Companies typically try to make their financial statements look as profitable as possible. A more profitable company yields higher stock prices and that makes shareholders happy. When accountants get too creative in their jobs they find themselves crossing the line and break the law, this creates the scandal.

The GSEs were caught declaring less income than they actually made that year. Their reason was they were smoothing out their income over the years. They felt that consistency in year-to-year profits made for a better public image. It doesn’t matter if their intentions were good or bad. It was not an accepted practice, it was unlawful and they were forced to reissue their financial statements for several years. Coming off the boom years their profits, as you would have expected, were extremely high.

Combine record high profits with their government mandates and you have the foundation for a problem. The government, seeing the record profits, pushed the GSE’s to purchase mortgages with a lower credit grade than they historically did. The feeling was that the profits weren’t due to an overactive housing market but due to underwriting standards that were too conservative.

Not all mortgages perform perfectly. They is always a percentage of borrowers that don’t live up to their contractual obligations with their lenders. The reasons that borrowers can’t keep their mortgages current are numerous. There could be a job loss, a medical emergency, a natural disaster, a divorce, etc. Things happen in lifenand they aren’t always good things.

A lender, or an investor in mortgages, tries to predict the percentage of mortgages that are not going to perform before pricing the mortgage or pools of mortgages. This is a very important piece of information because that is the largest factor in the profitability of the final decision. If the prediction is more than the actual number of defaults, the investor finds himself making more money that he expected. If the prediction is too low, meaning that more mortgages go into default than planned, the profit seen by the investor is less than expected or could even become a loss.

In an attempt to maintain the growing percentage of people becoming homeowners in the country and to offer lower cost financing to more people, the government made the GSEs revise their lending standards. Their profits were high because the rate of defaults were lower than anticipated. This was viewed as justification in requiring the underwriting standards to be lowered. The GSEs were now purchasing mortgages that were considered Alt-A or Subprime previously.

What’s been happening over the last 6 months is that the portfolio of mortgages held by the GSEs were no longer performing as well as they had been. Not only were the newer mortgages not performing as well as they were expected to but the default rate of the entire portfolio was increasing. The net result is that both agencies are no longer in a strong financial position. Their stock prices have suffered and they are raising their cash reserves to handle the higher level of defaults. This will prove to be a manageable problem for the GSEs. They are large enough and financially strong enough to weather this.

The biggest problem is that the public is losing confidence in the GSEs and this is fueling their negative attitude to the housing market. The average person is seeing the large drop in profitability from last year to this year but they are not taking into account that last year was a record year. Once the financials of Fannie and Freddie are looked at over a several year period, a different conclusion becomes evident. Yes, this is a bad year for both GSEs, there is no argument there. A longer historical prospective will yield a more accurate evaluation of the magnitude of the situation.

The facts are that the more liberal underwriting standards that the GSEs used, made a substantial contribution to the problems in the housing market today. Both the GSEs and the government had the best of intentions; more people becoming homeowners and at a lower cost. Unfortunately, it encouraged some people to take on more debt than they were financially ready for resulting in a mortgage default that could quickly become a foreclosure statistic.

We shouldn’t condemn the GSEs for lowering their standards. Not every mortgage closed under these standards went into default. We need to encourage Fannie and Freddie to review their standards and make revisions as needed, that will allow them to continue to fulfill their government mandates and at the same time maintain adequate profits.

The GSEs share responsibility for the mortgage crisis in yet another way. We’ve just shown that one of the consequences of lowering their underwriting standards was an increase in their default rate. An increase that was larger than they anticipated. In lowering their standards, they began funding the better-qualified Alt-A and Subprime borrowers. The lenders who specialized in Alt-A and Subprime were now loosing their better borrowers. This meant that these lenders would now be exposed to a higher rate of default because the better quality mortgages that were adding stability to their portfolio were now elsewhere.

The problems in the mortgage market caused by the aggressive lending policies of the Subprime lenders were now being magnified. Less qualified borrowers were being given mortgages which resulted in higher defaults and at the same time, their better-qualified borrowers were leaving the Subpirme marketplace. The default rate was now being pushed up from both sides.

The GSEs need to avoid fast changes in their underwriting standards no matter how much they are pushed by the government. Revisions need to be done slowly so as not to shock the marketplace. They need to be careful now and not tighten their standards too much, too quickly, in response to the current market. An overreaction now will cause serious damage and only make matter worse.

The Goverment's Influence

What role does the government play in the mortgage market? All levels of government impact the mortgage market each through a different avenue.

The local level, county or city, influences the inventory of housing and job creation. Utilizing zoning laws, local municipalities can increase or decrease the rate at which additional housing units come on the market. By creating tax incentives they can attract or hold onto businesses, with the result of increasing the desirability of the community. Local government directly influences the supply/demand equation for housing inventory. This has a direct impact on house values.

Home resale values determine the amount of equity one has in his home and therefore the security of a lender. Mortgage defaults tend to increase in regions with flat or declining real estate value and tend to reduce during times of appreciation. We’re seeing this occurring right now. The areas with the greater defaults are also the areas with the greater depreciation in sale prices.

The State level and to a lesser degree, the local level, sees the housing and mortgage markets as a source of revenue. Government on all levels need funds in order to supply services to the communities. Generally speaking our elected officials prefer to collect the most amount of money from the smallest set of voters. For example, an increase in a sales tax impacts everyone. Those in office run the risk of not being re-elected if too many voters blame them for taking their hard earned money away from them. Collecting money through a real estate transfer tax or a mortgage tax only effects the voters who are conducting a real estate transaction. The set of voters in this category is only a small percentage of the voter population. An elected official stands exposed to lose a lot less votes in this case.

By increasing the cost of executing a real estate transaction the State, government effectively discourages sales. At this level the mortgage market is influenced through a reduction in transactions that results in a lower rate of appreciation or worse, acceleration in the rate of depreciation in a declining market.

For example, let’s look at a property being sold in New York City. The seller will pay a transfer tax to the State of approximately 0.4% of the sales price as well as an additional tax to the City of 1.0 to 2.625% (depending on the type of property) of the sales price. The buyer will be giving the State a mortgage tax of 0.8% of the mortgage amount and an additional 1.0 to 1.8% to the City. If the purchase price is $1 million or greater the buyer will be paying an additional 1.0% of the sales price to the State. These taxes provide a windfall of revenue during a rapidly appreciating market but can discourage sales in a down market. It’s easy to see how large an influence State and local governments can have on a local housing market.

The Federal Government has the largest direct impact on the mortgage market. Washington is constantly searching for the proper balance of taking as many people from being renters to being owners, maintain the integrity of the banking industry, keeping the cost of financing as low as possible for every American and at the same time allow the free market to do its job.

Until The late seventies, the Federal Government set mortgage rates nationwide. This provided a consistency that everyone looking to purchase a home would be facing a 30 year fixed rate mortgage at 8.75% (or whatever the rate at the time was) with 0 points. The downside to this approach was that a lender would only allocate capital to mortgages if they couldn’t get a better return than 8.75% on their money elsewhere. The availability of mortgages would vary over time, reflecting market conditions. It was decided that this was not a healthy situation, especially during a period of high inflation, which was the case at that time. The government decided it was better that mortgage money consistently be available to everyone and allowed mortgage rates to vary, based on market conditions. This created a situation where there would always be mortgage money available but the cost of the money would now reflect market conditions. This decision opened up various options to the borrower. He could now elect to pay points upfront in order to get a lower rate for the duration of the mortgage term. He could borrower money on an adjustable rate to lower the initial payments, etc. This free market of mortgage rates gave the consumer a multitude of choices and gave the industry the opportunity to create products to accommodate the different needs of the borrower giving him even more options. The downside here is that the borrower needed to develop the skill set necessary to make a proper & informed decision.

The bigger problem this created for the mortgage market was that this freedom of pricing combinations and types of mortgage products, could be used by criminals. The same tools that an applicant used to get the best mortgage for his needs could be used by the crimminal to confuse the applicant and take advantge of that confusion. White-collar crime comes in all shapes and sizes, from the lender looking to steal homes out from under an innocent borrower to the thief looking to rip off a lender. The industry, law enforcement and all levels of government are in a constant battle to minimize the criminal activities.

The conclusion here is that the positive effects of a free market mortgage rate environment gives the consumer greater access to mortgages and the ability to capitalize on a low mortgage rate when the time is right. The negative effect is that obtaining a mortgage has become more complicated for the consumer and both the consumer as well as the industry, needs to be diligent in protecting themselves from the criminal element.

The Federal government has had an ongoing goal to increase the number of homeowners in the country. The basis of this focus on homeownership, is the wealth of most American families found in the equity that is built up in their home. The thinking goes that as more people own homes, there will be more families building up equity and therefore, personal wealth. Various government departments and agencies are constantly looking to design programs to aid the first time homebuyer. It’s because of this effort the FHA program was developed. A government insured program that helps people purchase homes with little or no money down, less than perfect credit and/or need more generous qualifying ratios. The government has also encouraged the GSEs as well as the rest of private industry, to create programs to accommodate the needs of first time homebuyers.

It doesn’t matter what industry we talk about, you won’t know that you pushed a standard too far until problems arise. An engineer can’t tell you how much weight a piece of steel can hold without first taking a sample and placing increasing weights on it until it finally breaks. We have pushed the underwriting standards of the mortgage industry to its limits. We know this because we are currently suffering the consequences, increasing number of defaults, foreclosures and depreciation of home values.

The best example of the negative impact of government pressure is what’s currently going on with the GSEs (Fannie Mae and Freddie Mac). They had record profits a year ago. The government reminded them that they have certain obligations, one of which is to keep the cost of mortgages down for as many consumers as possible. The GSEs responded by cautiously loosening their credit standards to permit the better quality Alt-A and subprime borrowers to be eligible for their loan products. This had the positive effect of lowering the cost of financing for these individuals. It also has the negative effect that the GSEs are currently suffering huge loses. In hindsight we can see that the standards shouldn’t have been made as liberal as they were. There was no way of knowing how far they could go without suffering the consequences of going too far.

The current market conditions are leading many to conclude that we should go back to the old ways of lending. Banks holding all mortgages in their portfolio, only lend to individuals with the best of credit, require substantial down payments and don’t let a borrower spend too much of his income on housing expenses. It’s believed that these standards need to be written into law by the government. This would be the worst possible path for the government to take. It would be an over-reaction to the current situation and by putting the standard into law, make it extremely difficult to correct the new problems that this would cause.

The government needs to concentrate on keeping the criminal out of the industry. This is done though mandating accountability of all individuals and entities in the mortgage process and creating monitoring systems that are capable of identifying every company and person that was involved in a particular mortgage. This way when problems arise, patterns will be found and the people and entities responsible for the damage become exposed. Any other government intervention needs to be kept to a minimum.

Overview of The Mortgage Market

With all that’s been written over the last few months about the mortgage market we need to step back and look at all the workings of this market. One obvious conclusion that can be made from what we’re reading is that the market is much more complicated than anyone ever imagined. In this respect the news media has done a fine job. On the other hand, by focusing on one or two issues, the media is creating the condition that will draw the reader to conclusions that may not be valid.

What I want to accomplish over the next few weeks is to give you an overview of how each player fits into the mortgage market and how the actions of each player impact the actions of all the other players.

The financial marketplace, which includes the mortgage market, can be best described as an ecosystem. Just as we now recognize that driving a car not only depletes the world’s oil supply is also impacts the temperature in Antarctica which in turns impacts the temperature of the oceans which in turn has an impact on the seacoasts around the world. As in the global climate, the decisions made by every player in the mortgage process, from the applicant, through the banks, the government and every step in between will have an effect on the overall process.

When a scientist or engineer looks to address a complex interaction such as what I’m describing here they will start by analyzing each component by itself. From there they will determine how the components impact the others with the ultimate goal of building as complete a model of the workings of the system as possible. This method of analysis is what I will be using in this study of the mortgage market.

I am going to begin with identifying each player in the process. From there, I will describe the problems each faces and the directions that can be chosen. I will be identifying the pros and cons of the various choices and the motivations that are behind each decision. This is not a witch-hunt; I’m not looking to accuse any one player as the cause of the mortgage meltdown we are now dealing with. The goal here is to gain a better understanding of how decisions are made at each step.

The players in the mortgage market are:
The applicant – the person looking for a mortgage.
The originator – the individual working for a broker or lender who is the source of information for the applicant.
The broker – a middleman that works with the applicant to find a lender that will commit and fund the mortgage.
The lender – the entity who commits to and funds the mortgage.
The wholesaler – an entity that doesn’t deal directly with the applicant but funds mortgages for the lender or broker.
Wall Street – we will use this term to encompass all the entities that package mortgages, securitize the package and then sell securities to investors.
The investors – an entity that invest money in order to get a return that is reflective of the amount of risk it is taking.
The Rating Agency – An entity that is in the business of evaluating the risk that a particular investment has. The investor looks to this rating as an aid in determining what investment to make.
The GSE – Government Sponsored Entity, chartered by the Federal Government for the purpose of supply liquidity to the mortgage market and to help more Americans become homeowners.
The Government – All levels of elected leadership whose purpose is to increase the well being of each citizen they govern.

Entities can play multiple roles in the mortgage market. For instance a commercial bank can be a lender (writing mortgages directly), a wholesaler (taking applications through mortgage brokers and other lenders), a broker (by placing mortgages that do not fit their standards with other lenders), a wall street firm (handling securitization) and at the same time act as an investor (through purchasing securities).

When I am discussing players I will not be talking about specific entities but positions in the industry. Each player has a different prospective on the market. For example, the applicant simply wants to borrow money at the lowest cost that fits his needs whereas the investor is looking for highest rate of return with the lowest risk. No decision is pure, that is, every decision will have both positive and negative results. A decision made with the best of intentions can suffer from the law “of unexpected consequences” turning a good idea terribly bad. The mortgage industry has felt the effects of this law more times than anyone wants to count.

You’ll see several examples as you continue to read this blog.

Subprime Meltdown - How widespread is it?

I've been having an ongoing discussion of the mortgage market with a client of mine (Bill) for some time now. I thought our latest series of e-mails were very interesting so I thought I would post them here for your comments.

Yesterday Bill wrote, "Don, It seems the big banks have pretty heavy exposure to the debt they enabled. Economic rule number one is when there's easy money to be made, pigs will wallow in mud and in this case their own excrement as Merrill has done. They say humans and pigs share 97% of the same genes. Too bad the 3% aren't all the undesirable ones. Human greed is reliable, and it is always the setup for the crisis. Let's see how bad this gets. I was relying on this aspect of human nature in my assessment of the crisis that is unfolding. It looks bad from everything I read."

I responded with, " There's no question that Merrill made some bad business decisions. I do find it interesting the brokerage houses such as Merrill are now regularly being identified as banks, but that's a different issue. As bad as Merrill played the market, Goldman represents the other end of the spectrum; look at today's Times. Every so often you read about some investor or hedge fund looking at buying heavily discounted securities and/or insolvent mortgage companies. The market is bad right now and it may get worse before it gets better but there is a lot of money sitting on the sidelines positioned to take advantage of buying opportunities. We can't lose sight of the fact that the high foreclosure rate in the subprime arena represents a small percentage of the mortgages in the MBS market. The entire world of MBS has suffered in price yet the majority of the mortgages in the pool are performing. It's only a matter of time before the investor community takes advantage of this."

"I agree with what you say that it's probably a small percentage, but other stories also indicate that people overextending themselves straddled all income classes. Let's agree that the nonperforming percentage is small, the accelerant is the amount of leverage that was taken on by the holders of those assets. When the stock market crashed in 2000, the investors that used leverage to purchase securities exacerbated the natural downturn. That's why the hedge funds are blowing up over this. Then you have Merrill that did what Lucent did during the .com craze, they funded their own sales. Chaos theory says that small events when they weave themselves through a system, have profound effects on the overall system. I tend to believe in that science, and currently there's a lot of evidence supporting that position. I have been reading about Goldman Sachs, but think about if a second. If they only concluded the problem was small, they wouldn't have taken the contrarian position and they wouldn't be so exemplary. It's the fact that the problem is bigger than everyone thought makes them so uncommon because they had good acumen when others didn't." - Bill

I ended the day with, "Yes, people overextending themselves throughout all income classes. You need to look at 2 things. First, the number of people overextended is relatively small compared to the total population of homeowners. Then secondly, not everyone that is currently overextended is going to go into default. For example, someone who is temporarily unemployed is overextended but living off of saving or additional borrowing. He will work his way through this situation without going into default.
It's not a good comparison when you compare housing to the stock market. Stocks can be bought or sold on a phone call, there is mob psychology as well as panic thinking that influences the market moment to moment. The housing market operates on a much longer timeline and current market value is not something you can open to a newspaper section and get today's price on your home. This creates a buffering effect that forces people to cool down before reacting.
This is both a positive as well as a negative but in the end, you don't see the equity of your home moving up and down on a daily basis as you see your stock portfolio move. We're not even considering the fact that your home serves the duel purpose of a shelter as well as an investment, something that does play an important role.
I don't think Goldman realized the magnitude of the decision they made. The impression I got from the article was that they made a business decision that the risk outweighed the reward when looking at MBS and they invested accordingly. In hindsight the risk proved to be substantially larger that they anticipated. Instead of making a prudent business decision it turned out to be a brilliant business decision.
There is no question things are not good in this economy. The question is how bad is the economy and how large an influence has the housing market had. There is a layering of influences going on and housing is just one of them. It's a long list: oil prices, the Iraq war, the trade deficit, the ongoing cost of terrorism, etc. When you begin to identify all the ongoing issues you can't help coming to the conclusion that it's amazing the economy is as healthy as it is.
This housing problem is going to nowhere near the magnitude of the dot com collapse. It's just not that far reaching."

What's your opinion? We all see events differently. By sharing our views we can each develop a better viewpoint and therefore be better equipped to make decisions.

Housing Fundamentals

In an article written by Floyd Norris in the New York Times on Nov 9, 2007 entitled
"Blame for Poor Home Sales? It’s the Press, a Builder Says" there are some interesting observations on our housing market from a builder that builds homes all over the country.

The news media is extremely effective at keeping the public informed. Unfortunately in their quest to distribute information there is a magnifying effect. When housing values were growing non-stop a few years ago, all we read about was how people were getting rich in real estate. There was praise for the wealth created in the economy due to the rising home values. The mortgage industry's creativity in developing programs that allowed renters to buy homes with little or no money down was credited for the increases in the percentage of homeowners in the country. The combination of easy lending, low interest rates and raising home values was the perfect storm to keep the economy humming along. This helped fuel the real estate boom.

Today we are dealing with a different picture. Home values have been dropping, lending standards have tightened and the attitude that every American should own their own home has changed to home ownership in not for everyone. The industry has given mortgages to people that couldn't afford them and the industry professionals should have known better.

The magnifying effect of the news media is now working in reverse. Instead of inflating a hot real estate market it is now taking a bad situation and making it worse. "The housing market is horrible in most parts of the country, says the chief executive of the luxury home builder Toll Brothers, and he fears it will not get better until the newspapers stop saying how bad it is."

Robert I. Toll, the chief executive, studied the markets his company is involved in and handed out grades. Most got a mark of "F" or worse. "The fact that I differentiate between F, F-minus and F-minus-minus" shows just how bad things are, he told analysts during a conference call. He said those grades go from miserable to outright purgatory."

Toll Brothers is not building in every area of the country so this study is not very scientific but it does have its use. Mr. Toll goes on to say, " Nearly all the decent grades went to markets in and around New York City."

What makes our region different? There are certain things that cannot be questioned. One is the law of gravity & another is the concept of supply and demand. If you look at the regions of the country that have the largest declines in home values, you will find they typically have one thing in common. That is, too much available housing. Inventory increases for one of two reasons or both. There is too much new construction with the result that supply is out of balance with demand or the area is suffering from a decline in population that again is destroying the balance.

There will always be certain cities or regions that suffer an economic downturn. Typically they are cities that depends on one specific business or industry for employment. When that company or industry suffers problems and is forced to reduce the number of people they employ, the ecomony of that city suffers. With fewer jobs, people are forced to relocate elsewhere. The city is ecomonically weakened and there is no reason for anyone to move into the homes that have been left vacant, therefore, resulting in a drop in home prices. Even during the growth years of the housing market, there were areas of the country where prices came down.

The more common reason however, is over building. If you look at the cities with the largest drop in home values, you will find they have been over-developed. Even in a region with a growing population, it is possible to build faster than the rate of population growth. If the rate of increase in residents begins to drop that only makes things worse.

Now let's take a look at our region, New York City and its surrounding areas. What are the two obvious problems that we deal with? First, there is a scarcity of apartments. This is due to a constant increase in the population. Second, it's extremely expensive, if not impossible in many parts, to build additional housing. "Buildable" vacant land is virtually non-existent. To build new housing, a builder usually needs to purchase an existing structure, tear it down and then build something new. We don't have the ability to increase our housing stock by any significant number. This combination of population growth and restrictions on building creates a buffer from house values taking a serious drop.

The cost of a commodity will not decrease as long as the demand for that commodity is increasing. No matter how out of hand a market gets, eventually the laws of supply and demand will bring things back to normal.

If you're thinking about buying a home but you're waiting for prices to collapse, you may want to rethink that position. Local housing demand is going to prevent any serious drop in prices. Although lending standards have tightened, mortgages are still being granted and at historically low interest rates. If inflation becomes a problem, cheap money will disappear, thus making owning a home more & more expensive.

No one can predict the future. Don't let the "magnifying effect" of the news media determine the decisions you make. Look at all the facts as objectively as possible, draw you own conclusions and make the decision from there. If nothing else, it will be your decision!

Impact of a Fed Rate Cut

What will happen if the Fed cuts the rate tomorrow? We've read about the overall effects. Lower short term rates may bring some stability to the bond market and lower long term rates will bring the cost of mortgage money down. It will further devalue our dollar making our exports cheaper around the world. By the same token, it will make imports more expensive and should encourage Americans to buy domestically produced products. It's generally hoped to stimulate the economy somewhat.

I want to look at the effects of a rate cut from the consumer's position. What is the impact of a cut in the Discount Rate to the average consumer? Most credit line mortgages as well as nearly all credit card interest rates are adjustable and are controlled by the Prime Rate. The Prime Rate moves in tandem with the Discount Rate. A rate cut by the Feds, as we had in September, has the immediate effect of reducing the minimum payments on nearly all credit line mortgages and credit cards. Since the average American carries a substantial amount debt, this increases the amount of disposable money available to most families at the end of the month. Americans have shown that given additional money, they are more likely to spend it than to save it, so this will encourage an increase in consumer spending. For the last few years our economy has been surviving on consumer spending and this helped keep the economy on track.

The downside of a rate cut is that it can fuel inflation. If you think back 20 to 25 years ago you will remember the problems we faced as a nation, because of inflation. We even went through a period of national price controls as a means to reduce the inflation rate. Double digit inflation was the norm and the goal was to force it into single digits. We've now gotten so accustom to a low inflation rate that the thought of inflation moving up to 4% is frightening.

Inflation erodes buying power but it does have a positive impact on people, companies or nations in debt. With the amount of outstanding debt in this country being so high, an argument can be made that inflation may actually be a good thing. I'm not suggesting that we develop a policy to encourage inflation, I'm just pointing out that if we begin to lose control of inflation there will be some positive effects in addition to all the negative ones.

There are no easy fixes to the financial problems we are facing. Until we all individually curb our spending habits and begin to take a long term view of our personal finances, we will always be in financial trouble. No government intervention will be able to get this economy back onto a strong foundation unless all Americans change their ways. There is no excuse for a negative saving rate for the citizens of the largest economy in the world.

The Basis of Today's Problems

We are now witnessing the convergence of three economic circumstances. First, the subprime meltdown woke investors up to the real risk in low-grade paper. This sent the financial markets into turmoil. Housing markets such as Las Vegas and Miami had already laid the foundation for a disaster, by over building and excessive investor speculation. Even without the problems in the financial markets, these housing markets were headed for trouble. Prices in both these markets have been softening since last year.

Secondly, the unemployment numbers in the real estate field will get much worse before teh situation begins to get better. Layoffs in this industry impact communities to a lesser extent than other industries. When GM or Ford cut back, the economies of entire cities collapse. The real estate/mortgage industry is spread out all over the country; there are no “company towns” in this field. People that have been laid off can move into other fields without much, if any, retraining. Real Estate agents and mortgage originators are essentially salespeople. They will move into selling some other product. Even the back-office personnel can be more readily absorbed into the workforce. I’m not trying to minimize the difficulty of these transitions but I want to point out that, for these employees it’s a less stressful transition than it would be for employees of a manufacturing plant or a research facility that had to shut down.

Thirdly, and perhaps most signigicantly, today’s economy is forcing America into finally facing its day of reckoning. Deficit spending on both the governmental and personal levels have reached the breaking point. People have been supporting their lifestyles with the equity of their homes and their credit cards. The housing market wouldn’t be in crisis if people weren’t using their homes as ATM machines. Whatever programs are developed to address the problems in today’s economy will be just band-aid solutions. Until the basic spending habits of Americans and their elected leaders become more realistic, we are going to move from one economic crisis to another. You can spend more than you make for only so long.

Laws need to be thought through

NY Times WASHINGTON, Oct. 22 — "House Democrats introduced legislation on Monday that would for the first time let homeowners sue Wall Street firms for relief from mortgages that the borrowers never had a realistic chance of repaying."

I don’t disapprove of the concept of holding people in the industry accountable for their actions. I do, however, have a problem with giving the consumer too much wiggle room.

I don’t have a lot of respect for subprime originators. I truly believe that the bad apples out-number the good by a large margin in this particular segment of the mortgage industry. I have a friend, Jim, who is a mortgage broker in Ohio, working exclusively in the subprime market. He started out working for a bank, eventually went out on his own and another bank bought his operation. I don’t know much about the way he conducts business but he did make an interesting point one day over dinner.

He raised the question, “When do you know a loan is a predatory mortgage?” Answer, “When the borrower misses his first payment!” His point is this. In most cases, the consumer is fully aware of the loan and it's terms and uses the loan specifically for a "bail out" scenario. As long as everything goes according to plan, the borrower moves towards getting back on his feet and repairing his financial situation. The borrower is satisfied with the mortgage, uses it for as long as it suits his needs and then as his situation improves, can refinance with better terms & rate, or sell the property and move on with his life.

But what happens when things don’t go as planned? The new job position that the borrower just took is eliminated or his marriage breaks up or a medical problem arises. The borrower can’t make his mortgage payment. The words "predatory mortgage" become the exit strategy for him to use to get out of a bad financial situation. People never blame themselves for their actions, it’s always someone else’s fault. A deep pocket lender then becomes an excellent target. "The broker should never have arranged for that loan," or "the broker should have known better."

You see my point. A law written that would be as one-sided as this one is, doesn’t do anyone any good. What needs to be written is a law that gets the thieves out of the mortgage business and at the same time permits a borrower to make a bad decision and deal with the consequences. Enacting a law that punishes the industry for all bad decisions does more harm than good. The net effect would be that there would be fewer options available for an individual to help himself out. This would not good public policy. We need to encourage the industry to develop mortgage programs and underwriting standards that would be difficult to abuse by originators as well as consumers, and at the same time afford consumers the tools needed to help them through bad financial periods in their lives.

We need to increase the level of quality of originator as well as hold him accountable for his advice. We also need to develop a means to verify that the consumer understands the potential consequences of his actions and is making an informed decision. We can't demand the industry prove that a borrower is making the right decision, especially in hindsight. The "right" choice is a subjective opinion. All we can hope to do is equip the applicant with the tools needed to make the decision that is "right" for them.

Be Careful What you Wish For

I'm hearing more and more industry commentaries, wishing for the days of old when mortgages were written by the local bank. The friendly banker knew the customer, gave the customer a mortgage and collected the mortgage payments until the mortgage was paid off. The concept being that in the event the borrower ran into financial trouble, the banker would be in a position to work something out with the borrower so the borrower didn't lose his home.

Most mortgages today are written by lenders that will then sell the mortgage into the secondary market. The job of the secondary market is to pool large numbers of mortgages together to create a diverse group of credit grades, geographical regions, interest rates and loan-to-values. This pool in then securitized. That is, bonds are then issued at various interest rates that represent the level of risk the buyer is taking on. A simple example would look like this. A pool of mortgages having an average interest rate of 8.0% is assembled. The servicer of the pool collects the interest payments from each borrower. Bonds, called Mortgage Backed Securities (MBS), are issued yielding 3 different interest rates; 6.0%, 8.0% & 10.0%. As the mortgage payments come in, the buyer of the 6.0% MBS gets paid first. Once that obligation is satisfied then the holder of the 8.0% security is paid. Only then is the holder of the 10% note receiving any money. The investor willing to take the highest risk (the last in line to get paid) is entitled to get the highest return on his money (in this example 10.0%).

The problem in the mortgage market right now is because the actual default rate of mortgages is higher than expected, so not only is the investor who bought the highest yielding securities not getting paid, the more conservative investors are not getting paid what they expected. This is the basis of all the turmoil we are now seeing in the mortgage market.
There is no direct contact with the investor who purchased the MBS and the borrower. To make matters worse, pooling by its very nature makes it impossible to create a link from any one borrower to any one investor. This makes any form of a workout with a borrower that's in trouble, impossible. It's from here that the desire to go back to the "good old days" of lending seems appealing.

Securitization of mortgages was not only encouraged by the federal government, they created the first organization to implement it, Fannie Mae. The reason for the creation of securitization is being overlooked in these recent media commentaries. To begin with, securitization allows consumers to borrow money at a lower rate. A banker who expects to hold a mortgage for 30 years, at a fixed interest rate, will need to charge a rate high enough to cover his long term cost of money as well as the long term effects of inflation. A banker today can close on a mortgage and keep it on his books only for as long as he wants to. He can sell the mortgage into the secondary market any time he feels it make good business sense for the bank.

The other big advantage of securitization is that it allows for more liquidity in the marketplace. A banker holding every mortgage he closes is limited in the actual number of mortgages he can write. His total amount of outstanding mortgages can't exceed the total amount of money that has been deposited in his bank. By selling closed mortgages into the secondary market he is able to continue to write mortgages well in excess of his depository base. This gives him the tools he needs to continue writing loans into the community he is serving, supporting all levels of the local economy.

Nothing in life is perfect. For every positive there is a negative and the mortgage market is no different. The mortgage model of the "good old days" had the advantage of personal interaction between the borrower and the banker, yet was limited in the number of people it could serve. Securitization enables the industry to service a greater percentage of the population and at a lower cost. Its drawback is that when trouble arises it doesn't have the flexibility to address the problems facing each individual borrower.

So be careful what you wish for. You will regret having your wish for the "good old day" granted if you find yourself seeking a mortgage and can't get one. Being turned down because you've harmed your credit or don't earn enough money is one thing. Being turned down because the bank has no money to lend is a totally different problem, one this country hasn't had to face for many decades. Hopefully we'll never go back to the "good old days."

The Piggyback Risk

Ever since the first FHA mortgage was written, lenders required an added level of insurance when writing a mortgage on a property that the owner had less than a 20% equity participation. FHA called this insurance MIP (Mortgage Insurance Premium). From the borrower's prospective, this required him to pay an additional upfront insurance payment in additional to the customary closing costs and an additional monthly insurance premium in addition to his normal housing expenses. From the lender's prospective, they could close on a mortgage in which the borrower had little or no cash investment in the property knowing that in the event of a default there was insurance available to absorb a portion of the lender's loses.

Learning from this government program, the insurance industry developed policies that lenders could use on non-government mortgages. Mortgage Insurance (MI) was offered to borrowers to enable them to purchase a home without investing 20% of of the purchase price. These MI policies have more flexibility than FHA's MIP. A borrower could elect to pay based on an annual policy, a monthly policy or can even elect to pay a higher interest rate on his mortgage and have the lender pay for the insurance. Instead of dealing with a flat rate for all mortgages , as in the case of MIP, private MI companies price the premium base on the risk profile of the borrower. For example, a borrower investing 15% of the purchase price carries less risk of default than a borrower investing 3% and is therefore entitled to pay a lower premium.

In addition to reducing the risk to the lender, MI also added one more level of underwriting approval on a mortgage application. Not only does the lender's staff investigate the details of the transaction and of the borrower's qualifications but the MI company also underwrites the application and is a second set of eyes looking over everything prior to a mortgage being committed.
In an attempt to offer borrowers more options in mortgage financing the industry developed a new program known as the piggyback. The piggyback is the utilization of 2 mortgages instead of one when financing a property. Although there are numerous reasons to do this, we are only going to look at one in particular. That is, using a combination of 2 mortgages to replace the need for MI. On the surface, there shouldn't be a problem here. The first mortgage is typically written as an 80% loan-to-value (LTV) and priced as a first mortgage should be. A second mortgage is then underwritten and priced as a higher risk loan. From the borrower's prospective this usually meant that the overall cost of the financing would be less that when MI is added onto a high LTV first mortgage. Saving a consumer money is a good thing so this became a popular mortgage program to be recommended by originators.

Unfortunately, the default rate on piggyback mortgages is proving to be higher than on first mortgages written with MI. Since there is no insurance company involved, the lender is exposed to all losses in the event of foreclosure.

The reason for this stems from the fact that insurance companies are better equipped to identify the magnitude of risk associated with an event and price the premium to suit. A mortgage written with MI added onto it wasn't generating more profits for the investors than a piggyback it was more accurately priced to reflect the risk of default. When lenders developed the piggyback, their analysis concluded that the higher interest rate they were receiving on the 2nd mortgage was adequate coverage for the projected performance of the mortgages. For a few years, their analysis proved correct. Market conditions changed and the default rate grew.
This is why we will be seeing tighter underwriting standards, as well as higher pricing, on piggyback mortgages going forward. Many lenders will likely stop accepting applications for piggybacks in response to the miscalculation of the risk associated with this form of financing.

Like most industries, the mortgage industry mirrors a pendulum motion. It swings towards more liberal underwriting standards until it goes too far. It then swings back to a more conservative period until is moves too far in that direction. It then begins the cycle all over again.