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Mortgage Lending 2.0

©2008 April Smith

Pardon me for stating the obvious, but it’s time for those of us in mortgage lending to get back to doing what we were meant to do:  process, underwrite, fund, sell and securitize mortgage loan products in a prudent manner that makes sense for everyone -- for the lender, the investor, the servicer and the homeowner.

The current situation isn’t anything new.  If you look at the statistics, you’ll find that the mortgage business has had numerous corrections in the past 30 years.  It’s true that they have been brought on for various reasons, but the industry has survived crisis before and it will do so again.  The fundamentals are there for us to survive – for those of us willing to get back to basics.  Think of it as a gigantic opportunity, albeit one fraught with challenges.

The last time anything like this happened in our business, it took the RTC 6 years and $125 billion in taxpayer funds to complete the sale of mortgages and other assets acquired from savings and loans.  What, you say?  This time is different?  This time is bigger?  Yes, of course it’s bigger.  We’re seeing an international financial meltdown, but fundamentally the problem is the same as it was almost 20 years ago:  reckless lending coupled with too little regulation that came too late.  The fact that this time it’s coupled with tanking real estate prices just causes the storm to swirl even more.  This time the process should be more efficient because more of the loans are already securitized, and because we claim to be more technologically advanced, but everybody pretty much agrees that the numbers will ultimately prove to be many multiples of what we were dealing with in the early ‘90s.   

Sure, we’ll have to claw our way back, but the way to do that is to stick to what we know best, whether it’s originating, purchasing, appraising, due diligence or anything else mortgage-related.  

Everybody has his own theory about how we got into this mess, but one of the most likely causes is that we lost sight of what Freddie Mac and Fannie Mae were chartered to do.  It’s not complicated:  they were chartered to foster homeownership for the little guy, the average citizen purchasing a moderately-priced house.  That’s why they had loan limits that were based on average (the key word is average) home prices.  The government-sponsored enterprises were not created to allow a borrower to purchase a home beyond his means, or to permit borrowers to refinance multiple times, continually taking out equity and in some cases using it to live on.  Did you know that there used to be rules about how many times you could refinance in a year? 

If you want to make a loan where the borrower’s income, his ability to repay the loan, is disregarded, then prudence and common sense dictate that the risk should be balanced with higher credit scores and lower loan-to-value ratios.  Make a 100% loan where there’s a good chance the borrower is lying about his income?  What are you thinking?  If you don’t have the income and you don’t have the credit and you don’t have the security, what do you have?  You have a problem. 

In the early days of subprime lending, loans were graded based on a matrix.  The higher the credit score, the higher you could go on LTV.  The lower the debt-to-income ratio, the lower the rate. And so on.  You get the idea.   This was basic subprime lending.  Somewhere between these beginnings and the start of the current meltdown, something happened.  Our government-sponsored enterprises were buying loans with no proof of the borrower’s ability to repay, and automated underwriting models were approving loans with credit scores below 600.  Basic lending principles were forgotten in favor of volume and profits.  Remember when people paid attention to housing ratios?  Remember when debt-to-income guidelines were 28/36?  The other day I read that, as of January 2, Freddie Mac is increasing its fees on interest-only and “piggyback” loans.  Pardon me, but am I the only one who thinks it’s absolutely unbelievable that they are still purchasing these types of loans at all? Charging a higher fee does not make the loan more prudent; it just makes current income higher.  If we haven’t learned by now that higher rates and fees do not adequately protect against future losses, what have we learned?

The trend during the past few years has been modeling and systems for all facets of mortgage lending, including but not limited to mortgage underwriting, fraud investigation and compliance.  We are fostering a compulsion to use engines for everything we do.  These tools have their place, but none of them can substitute for the human, common-sense touch.  Is there anyone out there who hasn’t seen a case of automated underwriting  that made you shake your head and say, “I can’t believe that loan was approved!”?  And you made the loan, didn’t you?  It reminds me of going to a restaurant and saying, “Well, if they’re serving me that size portion, it must be okay to eat it all.”

Let me share a story with you that I think illustrates my point.  Several years ago we did loan review for a medium-sized community bank in the mid-Atlantic area.  This mortgage lender kept all its loans “in portfolio” and therefore didn’t have the checks and balances of the secondary market to rely on.  In addition to reviewing for creditworthiness, fraud indications, value support and legal, document and data validation, we checked their compliance.  Our tests indicated that the bank’s annual percentage rate calculations were consistently off by a number of basis points.  They were entering the initial interest by hand on their automated system, and the system was calculating it as well, so the interest amount was duplicated,  throwing off the APR.  The bank ended up paying tens of thousands of dollars in fines to the regulators.   The message is that all the systems and models in the world won’t help you if you don’t understand the basics behind them. 

I’m not advocating that we go back to the ‘70s, when life companies required you to fax every document to them, or when we sold participations in order to foster the seller/servicer’s interest in keeping the loan viable.  I’m not suggesting that we gross up interest rates for properties on busy traffic streets.  In order to succeed in the times ahead, our first consideration should be, “Let’s make loans that are practical, common-sense investments.”

We’re like a herd of sheep.  We all run in one direction, and then we all turn and run in the other direction.  If it’s good, we think it will last forever.  And if it’s bad, we think it will stay that way forever, too.  If something is broken, it needs to be fixed.  And the way to do that for mortgage professionals is to hunker down and get back to basics.  As the market “corrections” continue to unfold, the opportunities for mortgage lending are going to explode.  Concentration of investors, correspondents and warehouse lenders, as well as possible curtailment of opportunities at the GSEs, will bring about prospects for the survivors.  The lenders and investors who capitalize on the opportunities will be those who stick to the systems that made them successful to begin with.

Consider these statements:

  • Our loan quality is excellent with very low delinquency and no sub-prime loans.
  • We maintain strong liquidity with plenty of cash for any lending requirement.
  • We have no stockholders.  We are a mutual bank created to serve our community.
  • We are committed to lending in the community to qualified individuals and businesses.

Do you think this happened by accident?  For as long as I can remember, this medium-sized regional bank has had a reputation for conservative lending.  Did they relax their standards to take advantage of high yield “state of the art” mortgages over the last few years?  No.  In their case, slow and steady wins the race.  They stayed committed to doing what they know best – simple, conservative local lending.  For every big bank that is bailed out, there are scores of local and regional banks that are stronger than ever.  How do they do it?  By sticking to the basics.

Go ahead.  Laugh at me.  Roll your eyes.  Call me a simplistic Pollyanna.  This crisis points up the worst in our culture today.  Will we keep trying to make as much money as we can as fast as possible, or do we have the discipline to go back to what works?  You get to decide.