Tuesday, October 19, 2010

Confessions of a Mortgage Banker

A Simpler Time and Place

I began my mortgage career in 1972 in Atlanta, GA.  I worked for a Savings and Loan as a Mortgage Loan Officer and Underwriter.  S & Ls dominated mortgage lending during this era.  It was a simple process, the S & L took in savings from the local community and lent the funds to local homeowners.  The S & L was acting as a middle man, pairing savers with borrowers.  We maintained time tested sound underwriting standards for mortgage lending.  This will be very important later. These standards included:

1.  Verifying stable and sufficient income to expect timely repayment of the mortgage, generally one could borrow 2 1/4 to 2 1/2 times their annual income.  For example, with a $25,000 annual income one could borrow from $56,250 to $62,500.
2.  Verifying a satisfactory credit history. 
3.  Verifying funds for the 20% down payment and any funds necessary for closing costs (typically 3% of the loan amount).  Additionally, we required evidence of two months mortgage payment as a reserve.  None of these funds could be borrowed.  With the introduction of private mortgage insurance to protect the lender against loss of principal, some 10% and 5% down payment mortgages were made. Roughly 20% of mortgage transactions were protected by private mortgage insurance.
4.  Obtaining a real estate appraisal that supported value of the property as collateral for the mortgage.  The appraisal was preformed by an employee of the S & L, as opposed to current appraisal practices.   In other words, the appraisal represented the interests of the S & L.

These standards were put in place to protect the bank and our savers from loss in case the home went into foreclosure.  I should also mentioned that the S & L maintained the promissory notes in a fire proof vault.  The original notes would be important in case of foreclosure.  The mortgage is a  contract that pledges the property as collateral for the promissory note.   In the event the borrower did not pay, the remedy was the loss of the home's title to the bank by foreclosure.  The bank took ownership of the home and then resold the home to recover their money.  Because of the high underwriting standards, the frequency of foreclosure and severity of loss was very low.  Our delinquencies were so low that we did not have a full time employee dedicated to handling collections, instead our employees rotated this duty.

There were times when savings from the community were less than the demand for mortgages in our lending market.  When this happened we would sell the notes to another S & L, an insurance company or to the newly formed Federal Home Loan Corporation, today known as Freddie Mac.  This was the beginning of a secondary market for mortgages.  
Whenever the mortgage was satisfied by payoff, the original note was marked "paid in full"  and the mortgage was marked "satisfied" and the lien of record at the county was released.   All original documents were returned to the borrowers.  Many former borrowers held mortgage burning ceremonies when their homes were "free and clear".

An Era of Disintermediation and a shift

Later in the 70s, we entered a time of rising inflation, the S & L model began to fail.  S & Ls were originating  25 and 30 year mortgages with short term deposits.  Eventually, rising deposit rates exceeded the average mortgage rate.  Savings flowed out of the S & Ls seeking higher rates of interest, this was known as disintermediation.  The S & Ls' profits were squeezed (or bled out) until most had failed.
Government Sponsored Enterprises (GSEs), like Fannie Mae and Freddie Mac quickly took command the mortgage market.  The remaining S & Ls, along with banks and mortgage bankers shared the mortgage origination market.  Now instead of holding mortgage loans in banking portfolios, mortgages were sold to GSEs.  These mortgages were acquired and pooled into mortgage securities or held in portfolios by Fannie or Freddie.  At this time the underwriting standards were almost identical to those of the previous S & L era, however, there were the beginnings of a shift of originator's attitudes  to "we will originate to any standard that you will buy".  

The process had changed from a more intimate arrangement between local savers and borrowers to an almost anonymous arrangement between borrowers (through loan originators) and the GSEs (to unseen investors).  At this point, I left the S & L for one of the GSEs.

Late 80s: new players and new standards

Seeing the successes and limitations (loan size, mortgage product variety and underwriting standards) of Fannie Mae and Freddie, new private companies began to enter the mortgage market to fill the voids left by the remaining portfolio lenders and the GSEs.  A new era of mortgage finance was beginning. 
At first the underwriting standards of the new entrants were similar to those of the GSEs.  In fact, the selling feature to those skeptical mortgage originators was "if you know how to sell to Fannie or Freddie, you know how to sell to us".  At this time, I made my last career change to a large mortgage securitizer.

The new entrants began to create new investment instruments backed by their mortgages.  Initially, the private Mortgage Backed Securities (MBS) were pools of individual mortgages.  This new process matched borrowers with savers.   The MBS were attractive to investors since it carried a rating of AAA.  The AAA ratings were achieved by a variety of methods from pool insurance issued by a AA or AAA rated insurance companies.  Later, as pool insurance costs proved to be expensive, AAA ratings were achieved by breaking up the pool into tranches.  The strategy was to have smaller lower rated tranches act as first loss protection for larger higher rated tranches.  Theoretically, in the event of loss, the lower rated tranches would absorb the losses by providing protection for the AAA tranch.  This would be true as long as loss frequency and loss severity remained within expected ranges. Investor demand for the MBS grew exponentially.   

In 1987 these entrants introduced a new mortgage product called "stated income".  No longer was it necessary to verify the borrowers income.  Instead the borrower would claim (without verification) an income high enough to justify the loan amount requested.  Initially, the product's integrity was maintained by a large verified and sourced downpayment of 20% to 25% of the lesser of the sales price or appraised value. Additionally, an established excellent history was required (this was before the era credit scores).  Finally, the purpose of the mortgage was restricted to primary residence purchase money transactions (no refinance rate/term or cash out refinances).

As the demand for rated mortgages securities expanded, even newer investment instruments emerged.  Investors did not care how loose the underwriting standards were as along as the security ratings were AAA. The attitude of investors was "give me all  the AAAs you can create".  Our attitude as securitizers was "your wish is our command".   All the while, these mortgage securities continued to receive AAA ratings from S&P, Moodys, and Fitch (the companies who sold ratings to the securitizers).  The ugly truth is the underlying mortgage characteristics were never worthy of the AAA rating. 

In order to satisfy this investor demand, newer less rigorous underwriting standards emerged.  These programs now included stated income mortgages that required little to no down payment and lower to poor credit histories. Loan purpose expanded into second homes and investment properties.  Eventually,  riskier programs emerged known as No Income,  No Doc and NINJA (no income, no job).  These were combined with a variety of adjustable rate programs, Interest Only and Pay Option Arms. Pay Option Arms programs allowed borrowers to make a payment less than the interest that was accruing and even allowed the principal balance to exceed the original loan amount.  This is known as negative amortization.   Reamortization would only be triggered if the borrower exceeded his original loan amount by 15%, 20% or 25%.  Programs had become so wild that the borrower would need to return frequently for a refinance, thus guaranteeing a steady flow of clients into the mortgage originators' offices.  Additionally, borrower down payments disappeared and were replaced by 100% financing. "Don't have funds for those pesky closing costs?  No problem!  We have 103% and 107% financing available as well."  To speed up  the origination process "automated underwriting" was introduced.  Originators could submit data electronically over and over until they got the desired loan approval.  At the same time,  real estate appraisers had become independent contractors to be hired by originators.  The pressure mounted on appraisers to "support" values demanded by originators so that mortgage transaction could be completed.  At several points, the appraisal profession's trade group complained that their members were under pressure to make values by playing  one appraiser off another.  Appraisers that refused to toe the line were not used by originators.  No one cared to listen and the practice continued.  The mortgage industry continued to layer risk on top of other risk elements.

The origination community called these lax standards "fogging the mirror" and "liar loans".  Any borrower can get any amount he wants and with this new amplified purchasing power, real estate values began to climb.  Values went up, doubling, tripling and more.  "Home prices too high?  No worries! The bank will lend you more money to chase prices even higher."  It did not seem to matter, foreclosure frequency was low and loss severity was nonexistent.  In this new era homeowners could borrower 8, 10 or 12 times or more than their annual incomes.  If a borrower got into trouble, he had the option of selling the house and repaying the debt.  It had become a no risk business or so it seemed.

During the boom years, securitizers viewed any process between the borrower and the end investor as noise or friction.  So the goal was to reduce cost in this space.  One of the outcomes was the creation of MERs (mortgage electronic registration system).  Now it was possible to endorse notes in blank and future registration of ownership along with those annoying recording fees at the county level could be avoided.  Ownership changes were registered electronically.  This made the securitization process quicker and less expensive.  With this innovation the moving, maintenance and storage of the original mortgage notes, instruments, and loan files was no longer necessary.  After all, most mortgages prepay rapidly and there are no foreclosures or losses.  So the idea was "get rid of them, it is too expensive to be in the moving and storage business."  So the files and legal documents were destroyed, not lost.  The thought was "Everybody is doing it, so it must be all right."  Bad practices were driving out good practices.

A Funny Thing Happened in 2006

Sometimes a securitizer would hold the lower rated tranches (the junk bonds) in their portfolio as investments until the market value could be determined (meaning achieving a satisfactory price).   We called this phenomenon "eating your own cooking".   Beginning in 2006 we noticed that loan performance was deteriorating and home price appreciation (HPA) had slowed or went flat.  Of course, as designed our tranches were taking the first hits as the losses mounted.  It's amazing how much loss you can incur in the foreclosure, real estate owned (REO), rehab and resale of the house process.

Beginning in the summer of 2007 home price appreciation went negative and continues until this day.  Mortgage delinquencies exploded and foreclosures soared.   Suddenly, borrowers were trapped by falling values.   If there was any equity it disappeared.  The sale of the property or even refinancing the mortgage to take advantage of falling interest rates was impossible with mortgage debt exceeding the value of the home.  Borrowers were now trapped by their debt.

Here is what you need to know

Borrowers and Investors did not design these ill conceived programs that violated all recognized standards of underwriting.  Borrowers and Investors did not destroy vital instruments that provided proof ownership. 

Bankers created mortgage products that they knew could not be repaid without multiple future refinancing to avoid unfavorable resets.  This is a fraud upon borrowers (fraud in the inducement).  Additionally, a fraud was committed against investors who bought instruments that were rated AAA even though the underlying mortgages were not originated to AAA standards  link.   These instruments are held by pensions funds and other entities.  The losses awaiting these holders of these securities will be catastrophic.  The actual losses have already occurred and now await ownership.   I suspect that investors will soon be asking the bankers to buy back these fraudulent investments at par.  Where will the money come from to accomplish this?

Now we have discovered a new fraud being attempted during the foreclosure process.  Maybe we should call the new process "fraudclosure". There is a cover up of the fact that ownership cannot be provided to borrowers.  The magic phrase that borrowers (as well as title insurance providers) should utter is "show me the note".  During the recent foreclosure frenzy, lenders have changed locks on houses that were not delinquent. They have foreclosed on the wrong homes. Multiple bankers are attempting foreclosure on the same property. There are even cases of foreclosure actions against homes that are "free and clear".   Legal documents have been forged and back dated.  "Oops, sorry just a clerical error.  Nothing to see here, now move along."  This is nonsense. 

As a result, foreclosure activity by Too Big To Fail (TBTF) bankers has been stopped.  Attorneys General in all 50 states are moving against illegal foreclosure activity.  Title insurers have now reacted by creating a list of exceptions in case a previous owner returns to claim a property that was wrongfully foreclosed.  If you buy a foreclosure please read the title policy.

Recently our Congress rushed H.R. 3808 (Interstate Recognition of Notarizations Act of 2010)  through both houses without recording their votes.  This bill would have replaced state specific  foreclosure requirements allowing bankers to select any state that is offering the easiest standards.  Fortunately, this bill received a pocket veto.  Gee, I wonder which interests were behind this bill?  Who is congress trying to protect?  Who are they attempting to throw under the bus?

I am not saying that borrowers deserve free homes.  The bankers are stuck between borrowers demanding proof of ownership and investors demanding repurchase of their securities.  Investors should demand to be repaid at par by the banks.  If the bankers don't have the money, then the regulators should shut them down.  The bankers or the remaining resolution agency should engage their borrowers who find themselves hopelessly underwater and offer realistic terms. These terms should include significant principal write downs to keep borrowers in their homes.  Abandoned, boarded up and ill kept homes destroy the property values of all homeowners.    

If you think TARP took care of the mortgage problem, you are wrong.  The mortgages and the problems are still out there.  The real estate price can not stabilize until the historic ratio for borrower leverage returns (2 1/4 to 2 1/2 times annual income).  Current home prices are too high to be affordable.  Hey Mr. Banker, your losses are still there awaiting recognition.