Overview of the Mortgage Market

With all that’s been written over the last several 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.

 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 Mortgage 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 Investor – an entity that invest money to 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.

The Applicant

Caveat Emptor, Latin for “let the buyer beware” is a phrase we all have seen but too many of us don’t live by. At the end of the day, we are responsible for the decisions we make. The world is full of con men and thieves constantly looking for ways to separate you from your assets. The government can only do so much to inhibit their ability to steal from you. Your last line of defense is your personal ability in analyzing the information available to you and making the decision.

What does this have to do with mortgages? Companies made mistakes, employees of the companies made mistakes and con men and thieves have entered the industry. The trouble in today’s mortgage market derived from poor business decisions, incompetence, greed and fraud. It’s impossible to identify the magnitude of the contribution that each one of these components made to the problem. What we do know for sure is that in each instance the borrower let his guard down and either made a poor decision or allowed himself to be a victim.

We are all human and we all make mistakes. We do whatever we can to avoid injury, both physical as well as fiscal with varying degrees of success. The big problem we face when dealing with our own personal financial position is being objective. Emotion clouds our judgment, another human trait. Emotion will make us hold onto a property longer than we should, it will lead us to believe that “everything will work out fine” without any basis in fact or push us to ignore a problem blindly hoping it will “go away”. In its worse case, emotional attachment to property will set us up to be scammed. If allows us to ignore the concept that something can “be too good to be true” and see it as a solution to the problem. It’s this mindset that a con man looks for.

During the period of easy lending that we’ve just been through I would tell my clients “getting the mortgage is the easy part, living with the payments is the hard part.” By addressing how the new housing expense was going to fit into the client’s budget we could see how their lifestyles will change. In many cases this was an eye opener.

Some clients saw how overextended they were going to be and modified their house hunting to suit. Other clients that were looking to improve their cash flow through a debt consolidation quickly realized how deeply in debt they really were. Some discovered that they weren’t going to lower their payments enough and a refinance wouldn’t be the right course of action. There were even some that didn’t like to hear what I was saying and went to another mortgage broker that would tell them what they wanted to hear.

There are areas of the country where there was a high level of investor speculation that is now seeing depressed prices such as the Florida market. Investors here are suffering due to one of a number of reasons. They could have been experienced investors that made a bad business decision in buying. They may have been novice investors that got caught up in the buying frenzy and ended up in over their heads. There will also be a group that was conned into buying. They are all suffering the same in a down market but for different reasons. How many of these individuals may have avoided the problem if they would have just taken the time to do a more detailed evaluation before making the decision to buy?

We have other markets, such as Ohio, that have been hard hit with the contraction of the auto industry. As high paying jobs began to be hard to find, many homeowners over the last few years decided to cash out the equity they had in their homes. The theory being that they would to ride out the soft employment market. They believed that things would get better and they would soon be earning the income they were accustomed to. The employment picture never improved, the values of their homes have declined and the mortgages started to go into default.

The news media keeps telling us that these mortgages should never have been written. If it weren’t for the cash out refinances these homeowners would still have equity in their homes right now. There is one big problem with this statement. If these homeowners didn’t refinance their homes they would have been forced to sell at that time or would have defaulted on their mortgages then instead of now. These individuals either had the false hope that the local job market was going to improve or they were sold on the idea by the mortgage originator. Two causes of action that lead to the same conclusion.

Did the industry become too easy in approving mortgage applications? Yes. Did the volume of originations and the profits that were being generated from them blind all the people and companies involved in the mortgage market? Yes. Did the mortgage industry become a destination for con men and thieves to practice their profession? Yes.

Should the industry take all the blame for the trouble we’re in? No, there is a level of accountability that the borrowers are responsible to.

Should the government enact laws that make it difficult for the con men and thieves from entering the business? Yes. Should the government through its regulatory bodies do whatever is possible to make sure all companies are operating in an ethical manner? Yes.

Should the government enact laws that protect consumers from themselves? No, It would make the availability of financing for individuals too restrictive and make it more difficult for families to improve their financial well being.

One of the basis tenants of the American culture is we all have the freedom to take a chance. Whether you want to start your own business or invest in your own home, you are free to try. If you’re successful you are entitled to all the benefits associated with the decision. If you’re not you deal with the consequences, and try again. It’s this attitude that has made this country great and a destination for people from all over the world to establish a new home.

If we encourage the government to enact laws that protect us so completely that we lose the ability to overextend ourselves we will never discover our true potential. We will tend become a country devoid of all innovation and creativity. Is this something we really want?

The Originator

The Originator can be working for a banker, broker, credit union, commercial bank, etc. Any entity taking applications for a mortgage will need a person to work directly with the applicant. This individual’s job title is “Originator”.

The Originator’s compensation depends on the entity he is working for. He could be on straight salary. This means it doesn’t matter how many mortgages he writes, the size of the mortgages he writes or the profit margin on the mortgages that close he is paid the same. An entity that doesn’t depend on mortgages as a major part of their business would probably have a member of their staff take on the role of an originator as one part of their job description. Under this condition the Originator is most likely on salary.

Most Originators are paid based on some form of commission structure. The entity an Originator works for sees the position as a sales position and as is typically done in sales, compensation is done based on productivity. This is done to motivate the Originator but it can have the negative side affect that in his drive to write more applications the Originator may not be giving his client the level of service that they deserve.

Making matters worse, there are some entities that give their Originators a certain level of pricing flexibility. This allows the Originator to increase his compensation on certain mortgages by simply charging more when he feels he can get away with it. This “up pricing” as it’s called is not fair to the consumer and is done in a way that the consumer doesn’t know it is even happening. There are even nationally renowned lenders that utilize this form of compensation to their Originators making this a wide spread problem. Fortunately this is becoming less and less prevalent as it has gained the attention of both Federal and State regulators.

As long as the Originator presents himself to the public as a source for a person to obtain a mortgage and nothing else there is no problem. When a customer goes to buy a car, he anticipates that the salesman is looking to maximize his profit on the sale. As long as the customer sees this Originator as a salesman for the entity he is working for, the customer will deal with him with the same expectations as when buying a car. The problem arises when the Originator presents himself as an advisor to the applicant but in reality is looking to maximize his profit. Now the customer thinks he is dealing with an individual who is looking out for his best interests when in fact he is dealing with nothing more than a salesman.

Not all Originators work as salesman. Many do conduct themselves as advisors to their clients. Those that do strive to give a high level of professional service so their clients are better equipped in making decisions about mortgage financing. These Originators see themselves as professionals and are in the business as a career. Their largest source of business is from satisfied clients recommending new clients.

The Originator’s contribution to the current trouble in the mortgage market was due to putting their own personal interests above those of their clients. Making matters worse, they were typically misleading their clients into thinking that they were the client’s advocates.

The mortgage market grew at an unprecedented pace and the industry’s need for manpower grew accordingly. With such a large number of new employees entering the industry training suffered. This problem was most evident at the Originator level. As companies pushed for higher and higher levels of originations they increased their staff of Originators without any thought given to training. Originators were giving out incorrect information and making promises they couldn’t keep to their customers. The contact person that the consumer was using to access the mortgage industry in many instances knew less about the business than the consumer.

One positive effect of this market correction is that these untrained Originators are leaving the business as fast as they entered. Mortgage companies are now more concerned about the quality of originations and less about the quantity. An approach that is totally different than the one that was used over the last several years.

The Mortgage Broker

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 the personal contact with their applicants. Add this to the increasing complexities associated with financing a property and a need developed for a service that would help the applicant. This service gives the applicant the tools 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 they didn’t hire additional personnel through 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 forcing them now to lay off staff. This doesn’t make for a healthy work environment.

The support staff that a lender needs to service a mortgage broker is much less than when dealing directly with the public for several reasons. To begin with, lenders can make demands on the broker than they can’t do to the general public. Packages being submitted by a broker must be complete. If they’re 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 also will close.  

Typically only 40% of the applications submitted directly to a lender by consumers actually close where a lender will expect at least 80% of the applications submitted by a broker will. 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 due to employees feeling secure in their positions.

The discounted pricing that a lender gives to a broker costs them less than it would cost a 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 business. 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. Due to 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. It’s for this 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 the 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 in underwriting mortgages, they may have underestimated the greed of many brokers, etc. This resulted in a lowering of the quality of mortgages that were being closed. Lower quality mortgages will 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 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. Because of this, I feel the broker has the largest amount of responsibility to the applicant of all the industry players. 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 interests over the interests of their clients. There were 3 general reasons for this, greed, incompetence and lack of respect for their clients. I don’t want you to conclude that all mortgage brokers failed to do their jobs properly. Being 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 though additional government regulations and improved due diligence from the wholesalers’ and lenders’ prospective that finding the right mortgage broker is getting 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 is 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 incompetence issue. Someone looking to become a mortgage broker typically needed little or no education or work experience. For example in New York State there was never an educational requirement in being a mortgage broker. This changes 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 there are 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 standards to be an originator are lower than the standards in becoming 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 to originators and a criminal background check but 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 to 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 are misused.

The Lender

The Lender is an 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 their own pricing. A lender that uses investor funds will also 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 are using 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. Combining a desire to increase their volume of originations and being blind to the risk exposure of their underwriting standards put them down the path to a nonperforming portfolio.

It’s a little different with the smaller lender. Here its wholesalers and investors are dictating the underwriting standards. A mortgage banker is interpreting the 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 based on their liberal interpretation of the underwriting standards they were closing on mortgages that they shouldn’t have. Common sense was ignored in order to keep the volume of closed mortgages as high as possible. They didn’t feel responsible since they were following the guidelines of their investors. The investors 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. Through common sense interpretation of underwriting standards and 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. Adding to this was the expanding mortgage market was keeping the country’s economy strong. In an environment like this it’s extremely difficult for any person or company to stray away from the pack.

The Wholesaler

Before we can discuss the responsibility of the wholesaler in this mortgage market, we first need to define what he does. Once a mortgage is originated and closed it will eventually make it into the secondary market. It will end up in one 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. He bundles mortgages and sells them to either a GSE or Wall Street firm who then will 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 them selling them directly so 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 it is 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 qualified the wholesaler’s ability to function suffers.

While the mortgage market was rapidly expanding and Wall Street was hungry for mortgages for which 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.

It the wholesalers were doing their job properly, the troubles we’re seeing today would be much less severe. We keep hearing that originators put people into mortgages they couldn’t afford and Wall Street was buying mortgages at such a rapid rate they didn’t care what they were buying. Originators wanted their commissions through any means and Wall Street needed product to securitize. I have no argument with these statements but 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 we generous, again, no argument. The wholesalers were in the position to maintain a narrow interpretation of those standards and should have A perfect example is the stated income mortgage, that has now been called the “liar’s loan”. When this product was originally designed it was meant for business owners, individuals whose financials aren’t consistent from year to year. Thus 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 in the transaction it was also a way to confirm that the borrower has proven fiscal responsibility is 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 of 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 no 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 chance in making 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, it is then submitted to the wholesaler. If the wholesaler were doing his job responsibly the application would be declined.

Wholesalers were not doing their jobs. They were concerned solely in production figures. Going back to my example, a wholesaler would be afraid to decline this loan for 2 reasons. First, the fear that wholesaler down the block would close on it anyway and second, the fear that the originator would no longer use them. This logic is the reason so many wholesalers are now out of business.

Wall Street

Wall Street is where Mortgages are pooled, securities are created and the 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 through 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 obligations 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 due to the predictions being 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 analysis the risk of each security offered. 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 what was 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 between 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 interdependencies.

This brings us to the most important questions. 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 being made 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 health will we be in when investors begin to put them money elsewhere?

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

The Investors

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” has 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 historically have been available. It’s basis 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 high 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 save investment yet 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 was for a lender to close loans a 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 the 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 businessman 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 failure.

The Rating Agency

The rating agencies play an important role in the financial marketplace. Their job is to evaluate public traded securities and estimate the risk an investor exposed himself to when purchasing the securities. The agencies review past performance of the type of security they are reviewing, 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. Through 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) of subprime mortgages 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 in the combination of two issues. To begin with there is not a long history of subprime mortgages and whatever history that was 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 off of the reliability of future projections becomes in question.

Should this short history have impacted the rating; after all they certainly must have seen this? I believe they did recognize the limitation of the date they were working with and concluded that it wasn’t a big enough issue to negatively affect their ratings. 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 highly 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 2007 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 writedown 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. Investors from Singapore and the Middle East purchased a 10% ownership of UBS. JP Morgan Chase purchasing Bear Stearns for a fraction of what the company was worth only weeks earlier. We are going to see more and more of this.

The market is slowly reestablishing. 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 relearn 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 loses.

 The 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 that the 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. There 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 lose, a medical emergency, a natural disaster, a divorce, etc. Things happen in lives and 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. In the prediction is too low, meaning that more mortgages go into default than planned, the profit seen by the investor are 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 mortgage that were considered Alt-A or subprime previously.

What happened is that the portfolio of mortgages held by the GSEs were no longer performing as well as they have been. Not only were the newer mortgages not performing as well as they were expected but the default rate 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. Once the financials of Fannie and Freddie are looked at over a several year period a different conclusion becomes evident. Yes, these have been bads year for both GSEs. There is no argument there. The issue is one of magnitude and using a longer historical prospective will yield a more accurate evaluation of the situation.

The fact of the matter is that the more liberal underwriting standards that the GSEs started using has made a substantial contribution to the problems in the housing market today. The intentions of both the GSEs and the government were good, more people becoming homeowners and at a lower cost. Unfortunately, it did encourage 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 shared responsibility for the mortgage crisis is yet another way. We’ve just shown that a consequence of lowering their underwriting standards was an increase in their default rate. An increase that was larger than they expected. In lowering their standards they began funding the better-qualified Alt-A and subprime borrowers. The lenders who specialize 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 leaving.

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 with the result of 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. This will only make matter worse.

The Government

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, is through influencing the inventory of housing and job creation. Through zoning laws local municipalities can increase or decrease the rate at which additional housing units come on the market. Through creating tax incentives they can attract or hold onto businesses with the result of increasing the desire of individuals to move into 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. Governments on all levels need funds in order to supply services to their communities. Generally speaking our elected officials prefer to raise 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. Raising 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 scenario is 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 of 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 moving 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 every looking to purchase a home they 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 that 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 during that period.

The government decided is 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 more a proper decision.

The bigger problem that this created for the mortgage market is that this freedom of pricing combinations and types of mortgage products can be used by criminals. The criminal can use the same tools that an applicant uses, except now these tools are used to confuse and take advantage of the applicant. 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 as well as 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 more 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 is 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 help 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 don’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 lower 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 on his income on housing expenses. It’s felt 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.

 © Shelter Rock Mortgage Corporation, 2001 - 2008

One Hollow Lane (Suite 104) Lake Success, New York 11042

info@shelter-rock.com

Phone: (516) 627 - 0800

Fax: (516) 627 - 1056