Why are we changing the FHA MIP?
Ok, I’m the first to admit that I’m not a mathematical genus. I’ve said for years that it only takes 3rd grade math to be a lender, which suites me perfectly. So when I heard that FHA’s changing their mortgage insurance to increase their MIP reserves (scheduled to go into effect October 4th of this year) I just assumed that they would take steps to increase the amount collected to accomplish their goal. I’ve run the numbers and for a typical FHA borrower the monthly payment will go up by about $23 per $100,000 in sales price at today’s rates.
I can understand HUD’s concerns. FHA is a major player in today’s housing arena. It provides financing for people with less than perfect credit, and who do not have as much money for a down payment. Increasing the MIP fund’s health is in everyone’s best interest. Here’ the problem. THE NEW SYSTEM WILL DRAMATICALY DECREASE DEPOSITS INTO THE MIP INSURANCE FUND! No, really, it’s true. This is because they DECREASED the amount they are collecting up front – money that goes directly into the MIP insurance fund at close of escrow, and raised the annual premium. Based on my ability to do basic 3rd grade math, I’ve calculated that it will take almost 4 years before the increase in annual premiums will give HUD more money than they would have under the current plan from a loan done TODAY. That’s assuming that the loan does not go into default, or that the borrower doesn’t sell or refinance out of FHA before then.
Here’s how it works. Currently FHA collects 2.25% up-front MIP that is added to the loan amount, and charges monthly MMI at .55% per year. That 2.25% goes directly into the MIP fund when the loan is insured and then collects monthly MMI premiums at a .55% annual rate. The new factors call for a 1% up-front MIP and monthly MMI to be between .80 and .90 – depending on who you listen to. I used the .90 MMI – which is the highest annual premium I’ve heard – in my example below. These numbers are based on a $100,000 base loan, maximum loan-to-value. Amounts deposited decrease because the monthly MMI is based on the loan balance.
Old Method New Method
Deposited Total to Fund Deposited Total to Fund Difference
At close $2,250 $2,250 $1,000 $1,000 $1,250 less
After 1 year $ 550 $2,800 $ 900 $1,900 $ 900 less
After 2 years $ 541 $3,341 $ 885 $2,785 $ 556 less
After 3 years $ 531 $3,871 $ 870 $3,655 $ 217 less
After 4 years $ 522 $4,394 $ 854 $4,509 $ 115 more
I’m not taking into account the present value of money that would probably show that the MIP fund is still not even after 4 years; that’s too much and I’m trying to keep this to 3rd grade math. I’m also not calculating how long it will take for the MIP Insurance fund to actually see a benefit – if it ever will! There are way too many factors to consider, but I really don’t see any way the fund’s reserves increase under the new plan – ever!
So what am I missing? I really can’t see any benefit to the MIP fund – in fact deposits to the MIP fund will immediately go down – and the buyers will be paying a higher payment. It appears to me to be a lose-lose proposition. Can they really be that stupid, or am I missing some significant fact? I would really like to know where my logic is flawed. Really! I hope I’m absolutely wrong on this, but I can’t figure out how.
The Role of the In-house Lender
In the interest of full disclosure, I have worked as an in-house lender owned by a large real estate company, I have worked for and owned part of a mortgage company where my partner also owned a real estate company in the same building, and I have also been a preferred lender in a subdivision on more than one occasion. I’m not saying that all such relationships are bad, but they can – and have – lead to situations where the interest of the borrower is not paramount.
There are three basic reasons why real estate companies and builders like to have in-house lending companies or preferred lenders.
The first one is simplicity. It is much easier to deal with one company when trying to manage any sales office. If there is a problem, the builder or real estate company can more effectively communicate with not only the loan officer, but the loan company’s management as well. They can exert leverage to make sure that their transactions move forward and their customers are taken care of.
The second one is power. When a builder or real estate company owns or has an exclusive arrangement with a lending company, they are the ones calling the shots. They can dictate when the loan officers will be there, how they will act, and how they will conduct business.
The third one is profit. Actually not all relationships between lenders and real estate agents or builders are based on making money off of the loan process itself. However, it is an undeniable fact that the only reason that such an arrangement exists is to enhance the profitability of the process for the builder or real estate company, and the lender.
So what does all of this have to do with the mortgage meltdown? The second reason: Power. When the builder or real estate company is calling the shots for the lender, they dictate the relationships. In simple terms, the lender answers to the builder or real estate agent 1st, and sometimes exclusively. Builders and real estate companies want to sell homes – that’s what they do. When a borrower is directed to the lender, the lender’s job is to get the borrower into the home the seller wants to sell them. Period! If a lender has the audacity to tell the borrower that they are not ready to buy, or that they should buy something less expensive, they are very quickly shown the door.
I’m not saying that this always happens every time, but it does happen – and it happened at an alarming rate in the middle of the insanity. It is far more likely to occur when the lender is actually owned by the builder or real estate company, and it is much, much more likely to happen in a builder situation. You can probably guess why this is most likely to occur when a builder owns a mortgage company. The reasons are simple: 1) if the lender is owned by the entity directing the business, that is obviously a stronger position, and 2) a real estate agent is usually more interested in getting the borrower into the right home for them, whereas the builder is only interested in selling the homes that they build.
Just how big a problem this is, or how big a role this played in the overall mortgage meltdown? I honestly don’t know. Personally I have never put the needs of any agent or builder ahead of those of my borrowers – and I can say that with a clear conscience. I believe the same can be said for most of the people I’ve worked for over the years as well. Unfortunately, I also know of several loan officers who had knots in their stomachs every time they went to work (for builder-owned mortgage companies) because they were forced to do what they knew was wrong in order to keep the money coming in for their families. Could this explain why there are subdivisions that are only a few years old with a huge percentage of vacant and vandalized homes?
The fact is these relationships have always existed to some extent, and I don’t see that changing anytime soon. It’s not just about the power. It is legitimate for a builder to not want to deal with a bunch of lenders that they don’t know – and perhaps can’t rely on – with their livelihood on the line. The profit motive is OK so long as it doesn’t violate any laws, and is not done at the borrower’s expense. I just wish in the mist of all of this “regulatory reform” this issue was at least addressed.
Different Loans for Different Needs
As I’ve said before, there are really not any bad loans. If there were, people just wouldn’t take them. There are, of course, lots of bad loan situations. Loan products, like borrowers, are complicated and have different advantages and disadvantages depending on circumstances. What follows is a vary small sampling of loan programs along with my explanation of how they work, who they benefit, and who should probably do something else – or maybe nothing at all.
Fixed-Rate Loans: Yawn… pretty boring loan. Borrower makes the same payment for the term of the loan, and the loan is paid off. The loan balance always goes down; the payment doesn’t change.
Who should get it: Most people. It’s predictable and safe; far-and-away the most popular loan type.
Who should consider something else? There two groups that may want to consider another option: First: People whose income is highly irregular. The problem with this loan is if you can’t make the regular monthly payment, you are in default – even if you can pay it current down the line. People with highly seasonal income, etc. might want to consider a loan that allows a lower payment for periods of time. Second: People who will be making a substantial principle payment. If you borrow $300,000, and six months after you take out the loan you make a $150,000 principle payment, your payment does not go down. Sure you will pay off the loan way before the 30-years is up, but you will be required to make the same payment you originally agreed to regardless of how much you owe.
Adjustable Rate Mortgage: There are lots of types of ARM loans, but the basic principle is the same. The interest rate adjusts at pre-determined times based on the movement of some index. The interesting thing is that historically people that took adjustable rate loans pay less in interest than the people that took the fixed-rate option.
Who should get it: Obviously people that are a bit more risk-tolerant are better suited to adjustable loan products. But also people that expect to make principle payments can benefit from the fact that most adjustable loan programs will adjust the payment based on the combination of rate, remaining term and loan balance. This allows people who make big principle payments to enjoy a lower payment without having to refinance.
Who should consider something else? Anyone who will be adversely affected by having their rate go up should probably avoid loans where this is possible. (Duh.)
Option ARMs: This loan program has been around for a long time, but the 1% teaser is a relatively new twist. This is an adjustable rate loan, usually based on an index that moves slowly. The payments are set on one schedule, while the interest rate changes more frequently – usually every month. The borrower is given the “option” of paying the minimum payment (which is usually based on an artificially low “teaser rate” and is less than the interest payment,) the interest payment (which at least allows the loan balance to stay the same,) or a fully amortized payment. At some point however, the loan payment must be adjusted to a level that pays off the loan within its term; this can result in a very large payment increase (actually a really-really big increase) – especially if the borrower has always taken the lowest payment option.
Who should get it: People that have irregular income most benefit from this type of loan. Self-employed borrowers, professionals who get bonuses annually for a substantial portion of their income, or anyone with a seasonal income flow may like to be able to pay a lower payment during the low cash-flow times and then catch it up when the cash comes in.
Who should consider something else? Anyone who does not understand the consequences of the negative amortization should not take this loan. This is not a loan for the unsophisticated or financially ignorant borrower, and selling it to these borrowers was a recipe for disaster. People who “really need that low payment” should buy less house – not take this loan.
The sub-prime 2/28 or 3/27: This is the loan that is commonly blamed for the whole housing mess. It was an adjustable rate loan that had the interest rate fixed for the first two or three years. After that period it became a basic 6-month adjustable rate loan. Once the fixed-rate period was over, the loan adjusted to a fairly high rate due to the high margin. Other typical features included a pre-payment penalty for the first two years and an interest-only option for the first two years. This loan was intended to be a somewhat unfavorable option for someone who could not get a better loan product. It typically required a 20% to 30% down payment, and allowed for stated income and lower credit scores.
While public opinion seems to be that this is a very bad loan, I believe it was actually too good a loan. The reason people liked the 2/28 or 3/27 loans, was that they had a much lower rate then the fixed rate option (that was almost always available) and had pretty good terms considering the borrower’s profile. The purpose of this loan was to get someone into a house with a loan that was not too bad initially, who could then refinance once their situation improved. What killed this loan – and by extension the housing industry – was when investors began allowing 2nds to replace the buyer’s cash investment. The combination of poor quality borrowers with no investment created disaster.
Who should get it: You probably think that nobody should have ever gotten this loan, and you would be close, but not right. For people who needed to buy, had the cash, and were getting their act together, this was not a bad deal. If they really did get their act together, then they refinanced and were good buyers. If they were still not qualified, then the loan adjusted to what they deserved – and high-rate loan with not-great terms. If they defaulted, they lost their investment and someone else bought the home.
Who should consider something else? My personal opinion was, and still is, that it’s best that people, who are not qualified for conventional or government financing, work on their situation to make themselves better qualified before trying to buy. This should be a last option, so in fact most people should probably not take this loan.
These are just a few examples of different loan programs and – most of which are not now avaible now. This is either because there are no investors willing to buy these loans as investments, or because the have been effectively or actually outlawed by the government. My hope is that as the markets improve that some of these and other programs will again become available. Of course I’m not advocating for the type of insanity that caused all of the problems. I am for informed choices for borrowers who can truly benefit from different programs and program features after consultation with responsible lenders. Time will tell…
What is a Pre-approval?
So you’ve been pre-qualified and are serious about buying a home. Great! Now it’s time to move on to the next step: the pre-approval.
So how does a pre-approval differ from a pre-qualification? A pre-qualification is basically an opinion of what you can do. The pre-qualification goes a step beyond that to actually approve you from a credit perspective. My way of looking at the difference is you get pre-qualified to see what you want to do, and you get pre-approved to be in a position to actually do it.
What does the lender need to do a pre-approval? Lenders need to do two things: gather documents and information, and compare the borrowers’ financial position to the guidelines for the program the borrowers want to use. To do that, they must verify income, verify assets and verify credit. The items needed to accomplish these things will vary depending on the borrower’s individual situation. However, there are a few things that will almost always be required:
1) W-2s from the last two years.
2) The most recent paystubs covering the last 30 days.
3) the most recent bank statements for all accounts that may be used to purchase the home.
In addition to these things, there are a few additional items that it would be good to get to the lender. Some of these items are probably going to be required ultimately anyway, and getting them to the lender at this point my avoid problems down the line. The list of these varies greatly depending on individual circumstances. Among these items are:
1) Full federal tax returns for the last two or three years
2) Retirement account information 401(k,) 403(b,) IRA, Roth IRA, etc.
3) School transcripts (if out of school less than two years)
4) Divorce documents/child support documents, etc.
So is a pre-approval a guarantee of ultimate loan approval? Unfortunately no. There are several reasons for this. The main reason, however, is pretty simple: a pre-approval is based on a snapshot, and if any element in that snapshot changes, the approval is no longer valid. For the borrower this could be: a change in credit standing, a change in employment, a change in debt, or a change in assets. For the lender this could be a change in loan programs, a change in guidelines (this one is especially problematic,) or even a change in interest rates. And this is not even addressing the thing that currently causes the biggest problems: problems with the property – which include more things that I will go into here.
So why even bother? Because it’s far better than not doing anything. Obviously, the more marginally a borrower is qualified, the bigger the issues could be. Someone with a 621 credit score could easily drop below that magic 620 number (the effective minimum score for most loan programs.) The person that barely qualified for $185,000 probably can’t buy at that price if the rates go up even a little bit. That’s why when I pre-approve borrowers I typically use a rate that is about .25% higher than the current market. I will also sometimes assume a higher payment on an obligation than the credit reports indicates – just to have that little safety margin should things change a bit more than expected. (Oh and also – you probably won’t believe this – sometimes buyers that I pre-approve for one price will fall in love with a home, negotiate for that home, and wind-up in contract for more that the amount I pre-approved them for. No… really!) The other reason is really simple – if you don’t have a pre-approval, most agents won’t even present your offer to the seller.
How long is a pre-approval good for? This is an impossible question it accurately answer, but I’ll try. The real answer is that as long as the borrower’s financial situation does not change, and as long as the rates, programs, and guidelines don’t change, the pre-approval will still be valid. That could be for one day, or one year – totally depending on the individual situation
What about the documents, do they expire? Credit reports are only good for 60 days, and the bank statements, paystubs, etc all have to be less than 30-days old when we submit the application for final underwriting. But unless there is a change in status I personally don’t update these items until the borrower identifies a property that they are going to pursue. At that point it may be a good idea to update the file, and perhaps even re-pull the credit just to be sure.
Are there different types or of pre-approvals? Are some better or more reliable than others? Absolutely. The three types of pre-approval are: full-underwriter approval, computerized approval, and lender approval. Full-underwriter approval is the best, but almost never possible in today’s lending climate. I will occasionally have a specific issue addressed by an underwriter if I have a question – just to be safe – but typically underwriters are too busy to look at pre-approval packages. The computerized approval is usually what most lenders will be able to provide, but even that is not a guarantee; if the loan officer (or mortgage loan originator as we are now called) incorrectly calculated or interpreted any of the information that was used to render the decision, the” findings” will be unreliable. The last type: the lender pre-approval is really just a glorified pre-qualification, but that might be fine for the borrower with an 825 credit score and 50% down payment.
So how can I be sure we are really pre-approved? The real answer is you can never really be sure of anything – especially in lending – especially right now. However you can make sure that the loan professional has sufficient experience, knowledge and ability to do their job. Bottom-line: work with a professional.
So what should I do after I’m pre-approved? Go buy a house! No, really all you need to do is keep in contact with the lender and let them know if you change ANYTHING in your financial profile. In fact, unless you absolutely have to DON’T DO ANYTHING TO CHANGE YOUR FINANCIAL SITUATION! Don’t get a new job, buy a car, buy furniture for the new house, co-sign for a loan, spend you cash, close a bank account, transfer money, get a gift, etc., etc., etc. Remember, anything you do can affect your loan qualification. Keeping the communication going will eliminate a lot of problems down the line. If you have a question, call. Other than that, have fun looking at houses!
Don’t Blame the Loan Program!
One of the biggest misconceptions of the whole sub-prime mess is that the problem was all of these bad loans products. Yes, a lot of the loans that were done at that time were not your boring old 30-year fixed rate loans. But that doesn’t mean that they were bad loan programs. I can’t think of a single loan product that does not have some purpose, or some advantage for some circumstance. I’m not saying that every loan will work for every person. In fact exactly the opposite is true. The problems occur when the wrong borrowers get the wrong loan. Blaming the loan is like blaming the gun when someone gets shot, or blaming the car when someone drives into a tree.
What we did have is a lot of bad lenders. It’s not very hard to understand why – during this time just about everybody you spoke with was either getting into the mortgage business, or knew someone who was. When I first got into the business (WOW that makes me sound like my dad!) it was pretty-much understood that it took about 6 months before you were considered marginally competent, and about two years before you really knew what you were doing. In 2005 there were people managing mortgage companies with less than two years in the business! But that was OK. The mortgage company itself probably wasn’t much older than that, they were selling to a wholesale lender with about the same level of experience, who’s loans were being packaged and sold by someone who probably didn’t even knew what a mortgage backed security was five years earlier. And they were selling these loans to investors who had no idea what they were buying, all blessed by rating companies who just assumed that any investment secured by residential real estate was solid gold. But it was all OK, because business was growing and everybody was getting rich.
The other thing we had was a lot of bad borrowers. Don’t misunderstand; this was not a new phenomenon. We have always had plenty of lousy loan applicants. People with bad credit, undocumentable income, too much debt and not enough cash have never been in short supply. I believe that a big part of my job is to counsel these people on how to get their budgets under control, how to develop a more responsible attitude towards their obligations, and how to save money so that they could make that initial investment. Frankly most people don’t change, but some would and be in a position to buy after working at it. The problem occurred when the investors that establish underwriting guidelines lowered their standards to the point where we basically just gave loans to anyone who wanted to buy. Eventually these borrowers preformed in a predictable fashion: badly.
It’s really not that complicated. Loan performance (how well the borrower pays their obligation) is fairly predictable based on two factors: Borrower quality and market performance. Borrower quality is comprised of a combination of four factors: Credit – how responsible a person is towards their obligations, Capacity – a measure of how much a person can afford to pay in comparison to their income, Cash – how much money a person is investing into the property and how much they will have after completing the purchase, and Collateral – a measure of the property value, condition and marketability. Market performance is simply what is happening to the value of the real property. Is it holding steady or appreciating at about the rate of inflation (normal market,) is it increasing at more than the rate of inflation (hot market,) or is it declining (bad market.) This can be local, regional, state-wide, or even national – depending on what is happening.
- Normal market: Good borrowers will perform well. Marginal borrowers will perform marginally. Bad borrowers will perform badly.
- Hot market: Good borrowers will perform well. Marginal borrowers will perform well. Bad borrowers will perform well.
- Bad market: Good borrowers will perform well. Marginal borrowers will perform badly. Bad borrowers will perform very badly.
The proof is out there. There are a lot of buyers that bought at the peak who still own homes, and are making all of their payments. They’re not very happy about what happened to their home’s value, but they are still making their payments. On the other hand, the borrowers who should have never been allowed to buy in the first place continue to default on their loans at very high rates – even after they have been modified into loan products with terms that are substantially better than even the most qualified buyers can get.
I know it’s not popular to think of borrowers as part of the problem because the media continues to paint the picture that all of the people loosing their homes are victims, and refuses to even consider their culpability in the whole mess. There are people who paid $100,000 for a home and pulled out a bunch of cash – refinancing the home up to $250,000. Since they are now underwater they just walk away. The same thing goes for people who bought way more home than they ever could hope to afford – and put $0 down. If the home’s value had gone up, they could have sold and pocked the cash; but now that the value is lower, they live rent free until the bank gets around to foreclosing – and then just walk away…
Please don’t misunderstand; I’m not saying that everyone who lost or who is in the process of loosing their home should never have bought or refinanced. Even the most well-qualified borrowers can run into problems; life happens! The problem is today you not only have a lot of people that have run into problems, you also have the people who were never really qualified in the first place, plus the people who can afford their payments, but just walk away anyway!
So now the government stepped in and is fixing he problem – not! The fact is the problem fixed itself. There are no investors out there buying stated-income 100% financed loans – and there will probably never be again! Loosing a few trillion in wealth tends to make a permanent impression. When was the last time you heard of someone rushing out to buy “junk bonds”, or invest in tulips? (see: http://www.investopedia.com/features/crashes/crashes2.asp) What the government IS doing (and has already done) is taking away the ability to do creative financing – even when it makes sense. Most of the riff-raft is out of the lending profession, and mortgage licensing will probably drive even more out. The pendulum was WAY OVER to one side, so logic would dictate that it’s going to go way over the other way – and it has. The problem is the government seems intent on freezing it at the extreme position and that is making it harder for the market to recover.
In my next piece I will show how some seemingly “bad loans” and bad loan terms” do have (or in most cases now had) a function and a purpose.
What does getting “Prequalified” mean?
What is it? A prequalification is an opinion based on the information provided. If the lender is competent and the information is accurate, a prequalification can be a useful tool.
What value does it have? Since a prequalification is NOT an approval, its main function is to determine what the next steps should be. Those steps could include: getting full a pre-approval, meeting with a Realtor to see what you can buy with the financing limitations/information that was provided, taking a homebuyer education class, or working on the issues that are limiting or preventing you from buying what you want.
What are the biggest problems with prequalification? Because the lender is usually working with less than a complete loan package, they need to make a lot of assumptions that may turn out to be incorrect. I’m not of the opinion that people actually lie, but rather people not in this business don’t know what we are looking for. The result is that the child support payment that comes out of the paycheck is forgotten, or the unreimbursed business expenses that are written-off or the Amway business loss are not mentioned. Then when the tax returns or paystubs are reviewed, things change drastically.
What information is needed? Income, bills, cash, credit, and family size.
What documents are needed? It’s entirely possible to do a prequalification with no documents whatsoever. About 10 minutes on the phone and a competent lender can give a fairly good idea of what a borrower’s options are. However, it’s really not a very good idea… The more documentation the lender receives, the better. Personally I like to see paystubs, bank statements, a list of bills with balances and minimum payments, and an idea of what the borrower thinks their credit looks like – or a copy of a credit report if they have one. Then I ask a few questions to get some basic details and to see if there is something else I should ask about.
Who should NOT get prequalified? Anyone who might want to buy in the near future should get pre-approved, not prequalified. The question I use to determine this is: “If you found the perfect house, priced right, and in the exact location you want to buy, would you want to write an offer? If the answer is no, we aren’t ready yet, then a prequalification is probably all you need to do. However if the answer is yes, if it’s exactly what we want then I probably would want to submit an offer DO NOT JUST GET PREQUALIFIED! Go to the next step and get the information to your lender, and get pre-approved. There is nothing worse than loosing out on a home because you could not provide a strong pre-approval letter. Listing agents are starting to demand not only strong pre-approval letters that specifically mention what steps the lender has taken, but proof of funds and even Fannie Mae approval printouts!
The Role of the Mortgage Broker
There was never anything wrong with the independent mortgage broker. In fact, in many ways working with a mortgage broker was far superior to going to a bank. Mortgage brokers typically had more experience, and by being able to shop between several lenders brokers could usually get their buyers a better deal. Plus banks usually had higher overhead, and those costs are eventually paid by the borrower; mortgage brokers almost by definition had much lower overhead, and were willing to go into areas and markets where banks would not go. As far as loan quality goes, the simple fact is mortgage brokers have never created a loan program, or had any authority to approve any loan; that was always done by the bank or investor that closed the loan. All the broker did is compile the loan package and submit it to the lender who would then underwrite, approve and close the loan.
So consumers had three different options when it came time to get a real estate loan. They could work with a bank, but the banks were really usually interested in only doing their fairly limited loan products. They could go to a mortgage company, but while mortgage bankers had more programs, they were still restricted to the loan products they carried. Or they could go to a mortgage broker who had no money to lend, but put lenders and borrowers together, working with the “wholesale” side of many different banks and mortgage companies. That was until the State of California changed the laws so that companies with consumer finance lender licenses (CFL) could not only do real estate loans, they could also broker mortgage loans. The CFL is the license that payday lenders, check cashing companies and consumer finance companies get. The thought was that banks and mortgage companies were not serving the low income borrower because their standards were too tough. Mortgage brokers were not much help because they had to follow the same standards as the banks and mortgage bankers.
So starting in 1995, CFL lenders were in the mortgage business. Sure they were restricted to only being able to broker to other CFL lenders, but just about every lender – especially the sub-prime lenders – had CFL licenses. CFL lenders do not have to have a physical presence in the state of California, and require no licensing or background checks on their employees. Basically a lender out of Guam could open a virtual office here in California made-up entirely of people who were on house-arrest for fraud wearing ankle bracelets. By contrast The Department of Real Estate (DRE) requires that each company have a designated broker who holds the brokers license, and also requires all loan officers to be individually licensed as well. DRE requires all licensees to complete college level education classes, pass a state exam, and pass a Department of Justice background check. They then must take continuing education to remain licensed. Additionally consumers can file complaints with the DRE and even receive compensation for damages caused by wrongful acts through a special fund, even if the broker is insolvent.
The path of least resistance, of course, was the CLF license. If you wanted to start a mortgage company or get into the business it really didn’t make sense to go through the hassle of a DRE license. It took a while for the change to take effect, but by the turn of the century the mortgage broker industry was becoming dominated by the CFL lender – especially in lower income areas. CFL lenders were different. They didn’t look at their role as counselors, but rather as sales people – and sell they did. After all, they weren’t burdened with the inconvenience of fiduciary responsibility like DRE licensed lenders. Rather than explain how a loan program worked this new breed of lender sold their borrowers – sometimes into very bad situations.
Of course at that time nobody really cared if the loan program was bad – the house was worth 20% more the next year and the borrower could just refinance. Since the investors didn’t require verification of income, why not just overstate the income. That way everybody could realize a huge profit when the home went up in value. That 1% rate (that was only in effect for one month) allowed borrowers to buy twice as much house! Super-loan sales people were making $50,000, $100,000, or more a month but couldn’t explain how the loans they were selling worked. Those of us who took the time to explain why buying a $400,000 house on a $30,000 a year income was not such a good idea were laughed at as being stupid, or behind the times. “You see, even though your payment is only $1,300 a month, the interest alone is actually $2,000 after the 2nd month and going up every month as your balance grows. You really should be paying $2,400 if you want to pay off your loan in 30 years.” Hey, everybody’s getting rich! What’s the problem? I WANT THE BIGGER HOUSE!”
Yea, it all blew-up. One year the home values only went up about 5% and some people couldn’t make their payments. When they tried to sell, there weren’t enough buyers so the next thing you knew, home values started to actually go down. I think the rest of the story is pretty well known. Mortgage brokers became the fall-guys – and rightly so in many cases. A lot of experienced lenders ignored their guts and drank the Kool-Aid right along with the idiots who really didn’t know any better. But brokers don’t create loan programs, they don’t set underwriting guidelines, they don’t approve loans, and they don’t fund loans. At the end of the day all the brokers did was match-up the borrower with the loan product they wanted. During that time borrowers didn’t care about the loans they got, investors didn’t care if the loan file was a complete work of fiction, and rating companies just cashed the checks. Everybody got what they wanted, but nobody understood what they got.
Five years later only about 10% of the mortgage brokers that were around at the height of the insanity are left. Many had no business being in the business in the first place, but many more just closed their doors because they were legislated or regulated out of business. Their employees retired, got out of the business, or went to work for banks or mortgage bankers. The ironic thing is that the very companies that created the toxic loan products have successfully reduced the brokers to insignificant players in the market. All of the “Financial Reform” we hear about mysteriously exempts depository lenders (read banks), creating a very unlevel playing field. It will be interesting to see just what happens next.
The role of the Investment Banker
To understand what role the investment banker had in this mess, an explanation of how an investment banker differs from a traditional banker is required. With a traditional bank, depositors put their money into the bank, and the bank then turns around and lends out about 95% of that money to someone else to buy a car, run a balance on a credit card, buy inventory for their store, etc. They charge a higher rate to the borrower than they pay to the depositor and take the difference to cover the costs of carrying the money they are required to keep on hand, to cover any loan losses, and for their profit. An investment banker does much the same thing except they do it through the creation of a security, or bond that is bought and sold in the investment markets. We see their creations as corporate bonds, government bonds, and of course, mortgage backed securities.
The Holy Grail of investment banking, however, is the creation of a new investment instrument. Investor bankers are always looking for some way to get investors and borrowers together. One of the best examples of this was what Michael Milken did in the 1980s with the securitization of “Junk Bonds.” Prior to then, if someone had a struggling business, or great idea for a business, they had few choices: they could find someone with money and partner with them, they could start small and hope to build, they could sell everything they owned and max their credit cards, or they could just keep dreaming. What they could almost never do was get money from a bank; banks don’t like risk – they like well secured loans to established businesses.
But some of these ideas were really great – especially since the invention of a thing called a computer that nobody really understood how to use yet. Milken convinced a few investors to put-up some money for some of these start-up companies that had already maxed their credit cards and were in desperate need of cash. In exchange for a really high rate of return these investors risked their money by buying the first “Junk Bonds.” Some of the investments didn’t pan out, but many of them did. The huge returns on the bonds that didn’t go bad more than made-up for the few that did. That did it. Soon everybody and their uncle wanted to invest in these magic “junk bonds” and Milken was flooded with cash to invest. This caused a problem; there were really only so many really good junk bond investment opportunities, and even these still sometimes failed. But he did the best he could, putting together investors with more and more marginal businesses in need of cash. At the height, standards dropped to absurd levels, but the money kept coming in. (This is when he started dumping his own investments because he saw the writing on the wall. The SEC didn’t think this was kosher and so he had to give them a lot of money and spend a little time at Club Fed.) Eventually the whole thing crumbled because too many borrowers just couldn’t make it and the bonds failed in high numbers. However, the junk bond industry is still around; it learned how to better evaluate the risk involved in this kind of investment and the investors are correctly leery.
Well guess what. In the 1990s the investment bankers found the sub-prime mortgage industry. These Mom and Pop companies coupled with a few comparatively small-potatoes players were making huge returns. And it was just in time! Stocks weren’t doing that well, and bonds weren’t much better. People who had become accustomed to double digit rates of return were eager for the next big opportunity. So they started securitizing these loans, billing them as slightly higher risk investments all backed by the homes of hard-working Americans who were not having their needs met by those overly-picky traditional lenders. And it worked; they created the sub-prime mortgage backed security – the funding source for sub-prime loans.
It was just a few at first – after all there are only so many borrowers out there who have lots of equity or cash who will accept these ugly (but profitable) loans. But then something strange happened: the loans performed way better than anyone dreamed they would. Defaults were low, and even those that did default didn’t cause losses to the investors because the loans were well secured. But how could they increase business? They had lots of potential investors! So they lowered the standards – just a bit to see what would happen. Well two things happened: one – they did a lot more business and two – the loans still preformed well – really well! But how could this be? These are supposed to be challenged borrowers. But hey, don’t look too deep, we’re on a roll!
Then the cash really started rolling in, so the standards had to drop even more to meet the investor’s demands. Since these were a completely new type of security, there was really no history to evaluate their true performance. That, and the rating agencies were so cozy with the investment bankers that they just rubber stamped whatever they wanted to do in exchange for the business. Basically everyone just gave the green light to these lower standards. Lower standards would again increase business; and again the loans would perform well. This cycle of lowering standards with little effect on the performance of the loans that made-up the sub-prime mortgage backed security continued for a few years. Of course, after a while these early pioneers of the new lending order were pretty sure they had re-invented the mortgage business. And it was hard to argue with them. They were making hundreds of millions of dollars; the loans were performing and everybody was getting rich. The old-guard of lending was all but replaced by these new lenders and investors, and they absolutely knew that the good times would never end. What they didn’t understand was that the loans were performing well because the value increases were bailing-out all of the bad loans.
What happened next can only be compared to what happens after that 5th tequila shot; things get a little blurry and it’s hard to put a finger on just where and when it all went wrong. At some point, the subprime industry created its own firestorm; lowering the standards created more “qualified” buyers, more “qualified” buyers created more demand, and that drove up the prices even more. Even these terrible loans continued to perform well, but only because the appreciation rates were higher than the interest rates on the loans. Unfortunately these new lenders and investment bankers that were buying the loans and creating these new mortgage backed securities didn’t want to hear this, and the rating agencies just turned a blind eye in exchange for their fees and continued business. To their minds, this was a new reality and those of us who disagreed with them were just a bunch of jealous has-beens.
Eventually, standards were lowered to the point where just about anyone who could write their name could walk into a mortgage company and buy whatever home they desired. This is when it collapsed. They couldn’t lower the standards any more because there were no standards. Without this ability to create more demand with more and more unqualified buyers, home prices stopped going up and then – very quickly they began to go down. This put a lot of heavily-leveraged borrowers underwater. With nobody to bail-out the unqualified and over-leveraged borrowers, the house of cards just collapsed.
As Paul Harvey used to say… “And now you know the rest of the story.”
Just what was a sub-prime loan?
To understand what happened, one of the things you need to understand is just what a sub-prime mortgage is (or more accurately was.) The sub-prime mortgage was an integral part of the mortgage landscape since well before I got into the business (in 1983.) It came out of the “Hard Money” portion of the industry, and was typically worked by individuals and companies that excelled in that type of lending. It was never for the faint of heart. People and companies that worked in this arena were a different breed than those of us in the “Prime” mortgage business. It was rare for someone to truly work in both the Prime and Sub-Prime markets. There were several reasons for this.
The Customers: Sub-prime loans are not good loans. They never were, and were not intended to be. They were very expensive, had high rates, and bad terms. They were for people who could not get better loans. They also required a lot of cash or equity (except when the Wall Street idiots were running – I say ruining – our business.) So the basic customer profile for a sub-prime loan was someone with lots of equity or cash for a down payment who was willing to take an ugly loan because that’s all they could get. Because of this profile traditionally these loans comprised about 5% to 15% of the overall mortgage market.
The Investors: There were two prime investor types for these types of loans: Individuals, and Banks who understood this type of lending. The individual usually had a good sum of cash to invest, wanted a very good return, were willing to wait for their money should the loan go bad, understood real estate, and had some understanding of how lending worked. Working with a “Hard Money Broker” they would literally do loans one at a time by weighting the risk and the yield. The Banks were typically small local banks run by people who had a lot of experience in this type of lending and often started by “Hard Money Brokers” who had enough capital or who simply expanded to the point of being able to own a bank. One of the biggest here on the West Coast was Long Beach Bank; the Money Store was a very successful sub-prime lender from the East Coast that eventually expanded nation-wide.
The Guidelines: Individual investors of course had no “guidelines” and pretty-much would do any loan they felt was secure enough if the yield was good enough. The institutional investors (Long Beach Bank, The Money Store, etc.) would set guidelines based on a combination of equity and traditional standards with acceptable variances. Things like stated income, poor credit, mortgage lates, foreclosures and even bankruptcy were considered with higher rates, higher fees, and larger down-payments. The industry rating jargon was usually something like A- to C-. The investor would usually look at a file and tell you that they thought it was a B, maybe a B+ loan and would then tell you what they wanted for documentation. Each instruction was different, and each set its own guidelines, documentation requirements and rating criteria. (Then they wouldn’t follow them if they didn’t like the deal, or if they wanted to make more money on it.)
The Servicing: As I said before, these are not good loans made to poor quality borrowers. Prime loan servicing (loan servicing is basically collecting the payments) typically works on a high volume of loans and is pretty-much paid a servicing fee (+- .5% a year depending on the loan type) to open 12 envelops a year and pass the money along to the appropriate parties. If a loan falls behind there are rules and systems to help the borrowers get caught-up. If it becomes more of a problem, it would be elevated to a senior counselor. Only if all other options were exhausted would it be handed over to a small group of people who were saddled with the unpleasant task of actually foreclosing on the borrowers.
By contract, Hard Money and Sup-Prime loans were usually serviced by individuals, private loan servicing companies or the institutions that created them. They usually had a very simple system: If the loan was 30 days past due, they started foreclosure. If the person caught up that was fine; if they didn’t, the foreclosure would proceed. After the foreclosure they either retained the property – effectively buying it at 50% to 70% of market, or resold the property – almost always at a profit.
The Business Environment: The Sub-Prime industry and the Prime industry had very different personalities. In the Prime business, it was usually a relationship business that relied on customer service and working to serve the customer’s wants and needs. The people that excelled in the sub-prime arena had a different approach – and they needed to. The investors that they work with wanted the best return for their money, and would take their money where they get it. The institutional investors work the same way – getting bait-and-switched was almost part of the game. The customers were just as difficult. For the most part, these are not responsible people. They would lie to you, give you fraudulent documents and take advantage of every opportunity. The people that excelled in this arena learned to be just as hard as those they worked with – or they went broke really fast.
The Profit: This is what attracted Wall Street. Sub-Prime lenders were almost always very profitable. They made a lot of money when they closed loans, they had high rates, and they also made a lot of money when they foreclosed on the borrowers. Many investors would see returns of 20% per year between the profit made when they resold the property, the pre-payment penalties, and the huge loan fees charged up-front.
In summery Sub-Prime lending was a difficult, marginally ethical, hard business that served a small cliental at a very high price. It was fairly specialized and not standardized. However it served a purpose. There was – and still is – a need for hard money and sub-prime lending. The person in foreclosure or bankruptcy sometimes still wants or needs a lending option. These small, unsophisticated, non-standardized lenders served that need. And then it all got screwed-up…
What the hell happened? – Introduction
No. I don’t think I’m some kind of genius, and I’m not trying to say that I was the only person who saw what was happening before everything hit the fan. But I did know it was going to hit the fan. And I also knew that it was going to be devastating. Before you ask, yes I did say so. And no, basically nobody listened – except the other seasoned lenders with twenty-odd years in the business who were saying and thinking the same thing. You would be surprised just how un-satisfying it is to know something bad is going to happen and then see what you predicated come true.
Yes, I’ve been in the mortgage business since 1983, and that experience has a lot to do with why I thought what I did. But in addition to that, I was on the board of directors (for 6 years,) and was the chair (for two years) of the Home Loan Counseling Center. While living in Stockton I was a part-time instructor at San Joaquin Delta College in Stockton, and along with several other mortgage professionals I helped start the mortgage certification program at California State University, Stanislaus. I was also an active member of the San Joaquin Mortgage Association, and was their president in 1993.
Currently I’m an adjunct instructor in the Real Estate department at American River College, I teach the finance section at the Real Estate Training Institute for the Sacramento Association of Realtors twice a year, and I’m an active member of the California Association of Mortgage Professionals here in Sacramento. I was one of the first certified trainers for “Don’t Borrow Trouble” launched in 2003 by Freddie Mac; its objective was to “create a nation of educated homeowners who seek advice, understand their financial options, and know how to avoid the mortgage pitfalls that could ultimately lead to foreclosure.” (OK, so they dropped the ball a bit those first few years – but they had the right idea.)
What irks me to no end is what I see and hear today about how those bad mortgages caused this problem, or how those awful mortgage brokers caused that problem. I have never heard anyone come close to what the root causes of the problem were. And to add insult to injury, the same people that swore up and down that there was no problem are the same ones tasked with fixing it! For the most part, all they are doing is making it very difficult to get a real estate loan, and punishing those of us who were trying to do business the right way in the middle of all the insanity. The crooks and incompetent idiots that invaded my industry are, for the most part, gone now. They’re back to selling aluminum siding and used cars, or working some telemarketing scheme. The really sad thing is that the people who really suffered the most were the buyers who did it right. That’s why I was compelled to write this series of articles.
What follows are five chapters that each explain a little bit about what happened, or how the pieces fit together. The first one explains what a sub-prime mortgage was, how it fit into the spectrum of mortgage products, and how it got screwed-up. The next one explains how the investment banking industry provided the gasoline for the fire. I defend the role of the mortgage broker – somewhat – in the next section. The last two I attempt to explain how and why different mortgage products benefit different situations and what role the mortgage professionals plays in making sure the borrower understands their options and makes a well-informed decision.
Next: What is a sub-prime lender