CHAPTER 1
What Happened, and How Did We Get Here?
TO THE CONSUMER, it may seem like a mortgage is a mortgage is a mortgage. Find a house, put some money down, and move in. But the mortgage industry has gone through some major changes that affect absolutely everyone who wants to obtain financing to buy a home. Everyone.
Understanding and interpreting these changes is critical to properly planning for the right financing. Make a mistake, and you’ll get the wrong loan. A mistake on a 30-year mortgage means a potential reminder of that mistake for the next 360 months. It can even mean the difference between getting approved or not getting approved.
What used to be a complex mess of literally hundreds of different loan types has now been broken down into two basic categories: conventional and government. But those loans have also taken on their own twists and turns like never before.
For a 30-year fixed-rate loan, there are now literally 54 permutations to calculate not only the rate and terms but the literal approval itself. Loan programs have vanished. Credit guidelines have been restored to their original roots and in some cases made more onerous. Still others provide financing options not available before.
It used to be that simply applying for a mortgage loan meant an approval of some type, somewhere. No longer. It also used to mean that almost anyone could be in the mortgage business and become a “loan officer.” No longer.
This is the first book that lays out the new rules, why they’re there and how to get approved in the new mortgage market. Or perhaps “new” isn’t the best descriptor. Perhaps it’s simply a reversion to original lending guidelines. In reality, both statements are correct.
But to understand where we are now, we have to understand how we got here.
A LITTLE HISTORY
Early in the twentieth century, mortgages were made the old-fashioned way. When someone wanted to buy a home, the bank would have a meeting and decide whether to make a loan. If it decided its customer was deemed worthy of a home loan, it would go to the vault, or most likely write a check, on behalf of the borrower paid to the seller of the real estate. Needless to say, many people were kept out of home ownership in the metropolitan areas.
Even if you could get a mortgage, the terms made it such that only the rich people could get a home loan, as the down payment could be as high as 50 percent or more. One would think that if the down payment were 50 percent, then why even bother with getting a loan—why not keep saving for the down payment until there was enough money to write a check for the entire amount?
The loan would go to a loan committee and the participants would review things such as the customer’s income and profession. They would review the customer’s history with the bank to make sure the applicant had paid all previous loans on time.
If the bank felt good about the loan, voila, new homeowner.
As the country began to sink into the throes of the Great Depression in the late 1920s, pretty much everything financial came to an abrupt halt. The stock market crashed, home values declined, and people were laid off from their jobs.
Among other things, it took the government to help an economy mired in economic distress and fear. (Does anything sounding remotely familiar here?)
In 1934, the Federal Housing Administration was created under the auspices of the Department of Housing and Urban Development, and FHA loans were created. Actually, FHA loans aren’t loans but are just called that. FHA instead insures mortgage loans. If a bank made a loan that conformed to FHA guidelines and the loan went into default, the lender would get its money back.
This loosened the purse strings of the bankers, and soon mortgage loans became a bit more commoditized with the introduction of FHA-insured mortgage loans. The plan worked, and more loans were being made to more people with less money down.
However, banks need to have money to loan money. If they ran out of money, they would have to advertise and raise more money through offering interest on people’s deposits. If, for instance, they offered a savings account paying 2 percent, they could take enough money and charge someone getting a home loan 5 percent and make 3 percent off of the money. This is a bit simplistic, but at its core is exactly how it worked. Banks would lend the money they received from their depositors. It’s also why banks worked more with wealthier people, because it was those people who had the assets that needed to be protected. At least that was the theory.
In practice, banks sometimes ran out of money to lend. Thus, the Federal National Mortgage Association (FNMA), or Fannie Mae, was created in 1938 to foster home ownership. It also operated under the auspices of HUD.
Fannie’s job was to buy mortgage loans from banks that made FHA-insured mortgage loans when banks ran out of money to lend. This was the infancy of what is called the “secondary” market for mortgage loans, which we’ll discuss in detail later in the chapter.
The federal government provided Fannie Mae with money, and Fannie Mae began to establish guidelines for the types of loans it would buy. If a loan conformed to these newly issued guidelines, Fannie would buy the loan from the issuing bank if the bank wanted to sell the loan and free up its capital to make more loans.
In 1944 as part of the GI Bill, zero-down mortgage loans were available for returning war veterans, and the pace of home buying began to pick up; the effects of the Great Depression were long since gone.
During this very brief period from 1934 to 1944, the mortgage industry began to show its force in the economy. When people bought their own homes, they also bought all the other stuff that went with home ownership, like furniture, appliances, and general maintenance on the home.
As more and more veterans returned from the war, lenders were making more loans than ever—both VA loans as well as FHAinsured ones. Banks began to lend like never before, and a housing boom went right along with the Baby Boom.
Things worked this way throughout the 1950s and 1960s. In 1968, Fannie broke away from HUD, and a couple of years later, the Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac, was formed. In 1968, Fannie’s charter changed to become a government-sponsored entity, or GSE.
Fannie was a private company that issued its own stock but was sponsored by the federal government. Although it wasn’t exactly a business owned by the government, it was close to it. Freddie’s chartering in 1970 was set up the same as Fannie Mae. Both entities were supposed to foster home ownership by freeing up cash for lenders in the mortgage markets.
But at the same time, both had stockholders they had to please. Fannie and Freddie both had an obligation from the federal government to provide liquidity in the mortgage marketplace, while at the very same time had to satisfy their shareholders to make a profit. The GSE was an interesting experiment, crossing government and private enterprise with two separate goals.
Things went smoothly for much of the next 20 years. Then things began to change, slowly, for the worse.
SECONDARY MARKET GROWTH
Although the two GSEs went along buying mortgage loans from lenders, they did so by issuing their own underwriting guidelines, much the way FHA did. The GSEs didn’t guarantee the loan in case it went bad but guaranteed that if the loan was underwritten to Fannie or Freddie standards, there would be someone to buy that loan.
One of those guidelines was the maximum loan limits set by Fannie and Freddie. As part of their lending guidelines, each would set their own loan limit each year. The problem was that there were other markets where houses were selling for much more than the conforming loan limits and buyers were saddled with going to a savings and loan and getting adjustable rate mortgages without the benefit of lower fixed rates offered with FHA and conforming loans.
A new secondary market was established for these loans that were above the conforming limits; they were nicknamed “jumbo” loans. Residential Funding Corporation, or RFC, was privately established to buy and sell jumbo mortgage loans with underwriting guidelines similar to conforming loans.
Other secondary markets were soon established to buy and sell mortgage loans that went beyond the standard conforming and government fare. Soon, capital markets were established that would facilitate buying and selling of other loans, such as loans that didn’t document income or assets or loans made to those with bad credit.
If there wasn’t a secondary market, mortgage bankers could invent a new type of mortgage loan and pitch it to some investors on Wall Street who could agree to buy these new mortgages if the bank made them.
The pitch might go like this: “We’ve got a new loan program here designed for those who can’t quite prove their income, but we know its there. The advantage is that the returns on these investments provide an insured return of at least 11.15 percent,” or some such. The secondary market provided the housing market with even more flex in its muscles. The mortgage market became a major player in finance around the world.
SUBPRIME LOANS
For 70 years, the mortgage market was, give or take, on autopilot. Loan guidelines rarely changed, as government and conventional loans all had to meet their respective rules. In the late 1990s, a couple of loan types began to emerge, and they weren’t government or conventional. They were subprime and alternative. Subprime loans were so labeled because the credit grades of the borrowers were “less than prime.” Alternative loans were sometimes called “Alternative A,” or simply “Alt A” because even though the credit grade of the applicants was good, the loans didn’t fit the conventional or government box. It was an alternative to conventional or government loans.
Subprime lenders have been around for 20 or so years and required that the borrowers have more money down for their purchase, usually a minimum of 20 percent or more.
Subprime loans, then, were designed for those who had enough money for a down payment but, for whatever reason, ran through some hard times. They were laid off from work or otherwise lost their main source of income. Perhaps there was a death in the family— such an event can wreak havoc on anyone’s financial profile. When losing a loved one, it can be hard to concentrate on making the car payment on the first of the month.
Subprime loans were designed as a temporary solution to fix a mortgage problem. Their rates were much higher than what could be found for those with good credit, but were a temporary fix—a financial Band-Aid. The trick with subprime loans was to get someone into a house with a mortgage and begin to repair their credit with timely mortgage payments and meeting all other credit obligations each month, every month.
After a couple of years’ worth of good credit behavior, the subprime borrower could then apply for a refinance mortgage into a traditional conventional or government loan. This typically worked because the borrowers had to pony up some major cash at the closing table, and the subprime loan provided a path to credit repair. Subprime loans weren’t intended to be issued to those who had no intention of paying anyone back on time.
Alternative loans, or alt A loans, also had their intended market— those who couldn’t or didn’t care to divulge their income or asset information. Often times, this meant someone who was obviously very well-to-do, had good credit, and could perhaps have a very complicated financial portfolio.
I recall a client here in Austin who was wealthy, owned several corporations and investments, and hence some complicated tax returns. Alt A loans will accept “stated” applications, meaning the income or asset information isn’t documented by tax returns or bank statements but instead relies on sufficient down payment and excellent credit. People with excellent credit didn’t get excellent credit by accident: they earned it over a period of time.
My client’s tax returns for all his businesses, and this wasn’t even counting his assets, were literally eight inches thick. Alt A loans don’t require all the typical documentation. In lieu of that documentation, the loans accept a sizable down payment and also a slightly higher interest rate. If a conventional jumbo loan could be found for 7.00 percent, then an alt A loan might be available for 7.25 percent. This is such a small increase in rate in exchange for fewer headaches.
In each case of subprime or alt A loans, lenders made sure there was a pool of buyers for those loans. They guaranteed significant rates of return, while at the same time churning out loans day after day and opening up credit markets that weren’t previously available. But that presented a slight problem. If a lender came up with a mortgage loan that addressed a segment of the consumer market, what if the market soon became saturated and there was no longer any consumer to offer that loan to?
Subprime and alt A lenders would regroup, identify another market segment they could offer a new loan program to, and then pitch it to investors, who would buy those loans. After all, so far, the buyers of those loans were making tons of money.
In the early 2000s, subprime and alt A loans began to take charge of the mortgage lending environment in the United States. In fact, in many estimates, these loans managed to capture nearly 40 percent of all loans made in the country. Think about that for a second. Since the early 1900s, FHA, VA, Fannie, and Freddie, were the mortgage rule of law. Suddenly, and for a very short period, subprime and alt A loans collectively owned more of the mortgage market than Fannie, Freddie, VA, or FHA did individually.
This also came about when the federal government was making a major push for home ownership. Since owning a home was such a major force in the economy, not to mention the pride of home ownership, the government began to require banks to make loans to people who didn’t necessarily qualify under traditional circumstances. Moreover, mortgage bankers—who simply find loans to make and then sell those loans—ultimately saw that they were running out of people and businesses to make loans to. If they didn’t create new markets, they would be out of business.
So mortgage companies would go to a group of investors and say something to the effect of: “Okay, you guys made a ton of money with our new 10 percent down purchase with a 600 credit score, but we’ve got a new one for you that’s just as profitable. How about 5 percent down and a 600 credit score?’’
The investors would say, “Heck, yeah!” and provide a vehicle for those mortgage bankers to sell more loans. So they saturated the market for those with a 600 credit score and 5 percent down. What about 580 score and zero down? What about a 500 score and zero down?
More and more money kept flowing to the secondary markets, which kept buying more mortgages from subprime and alternative lenders. That’s a lot of money, so where did the secondary markets get their money in the first place? They could package them up with millions of dollars’ worth or more mortgages in securities, or bonds.
Instead of selling a $300,000 loan here and a $150,000 loan there, multiple loans were bundled together and sold as one large package to investors around the world. Wall Street got heavily involved in this so far profitable venture and began rolling not just mortgage loans together but all sorts of bonds. Wall Street also had bond-rating agencies give these mega-investments solid ratings so the buyers of these packages were assured of a top-tier performance with no delinquencies.
There was even something new called a “credit default swap” that provided those investors with an insurance policy that would pay them back their losses in case the bonds ever went bad or they lost their top rating due to loan defaults. The company who wrote those insurance policies was AIG. More money fueled more money, and investors were eager to buy more of these bond mortgage bonds. Mortgage companies were constantly challenged to find new markets.
As markets dwindled, the quality of loans had to deteriorate to accommodate the new loan programs being offered. Still, because loans had been performing and investors had been making so much money from these loans, they were willing to continue to provide funds.
Subprime and alternative lenders got their product in front of the consumer by concentrating heavily on mortgage brokers. Mortgage brokers could find these new clients and promote the new mortgages to their local communities.
Each time a new mortgage was invented, the mortgage companies sent out their notices to their mortgage brokers promoting the new product and who it was designed for.
Does your borrower have hard-to-prove income?
Does your borrower have no money down?
Does your borrower have a credit score of 520?
Then this is the mortgage for you!
Not only did the new loans find new customers, but it was an easy pitch for the loan officer: “David, I know the rates are higher, but this will give you time to repair your credit while still being able to write off the mortgage interest on your tax returns. In three years, your credit will be repaired, your property will have appreciated, and you can refinance into a conventional mortgage and avoid the higher rates!” was the standard presentation.
In addition to the easy sell of the mortgage itself, mortgage companies paid big bucks to the mortgage broker to sell the product, even if it meant the customer could have gotten a better deal by going FHA or conventional.
Mortgage brokers were getting as much as 4 percent additional on each mortgage loan they placed. On a $300,000 loan, that’s another $12,000 lenders paid brokers to promote subprime and alternative loans. It’s no stretch to understand why mortgage brokers began to promote these loans at the peril of the consumer: They were getting rich.
I recall a sad story about a couple just outside of Washington, D.C. I received an e-mail from an older gentleman about a loan he had taken out a year earlier. He had just received a notice from his lender that his loan payment was going to more than double, and he wouldn’t be able to make the payments. What could he do?
I called him up on the phone and got a little more information about his loan and his situation. He was 75 years old, disabled, and had been so almost all of his life with a cognitive disorder. It takes him a long time to decipher things, and he even related to me that it took him about half an hour to compose his short five-sentence e-mail to me.
His wife was working at Wal-Mart to help supplement their income, and she was 65. They had bought the house they were living in about 12 years earlier and were about halfway through their mortgage. One day, pretty much out of the blue, they received a postcard, then a phone call, from a mortgage broker explaining how he could drop their monthly payments down to almost $1,100 from the nearly $1,700 they were paying each month.
Living on fixed incomes and working part time at Wal-Mart, the lower monthly payments looked attractive and seemed like a good way to save some money each month.
What the loan officer didn’t explain was that, yes, while the monthly payments were lower by $600, it was what is called a “negative amortization” loan, explained in Chapter 6. This meant that each month they didn’t pay another $900 every month, it would be added back onto their loan.
The mortgage actually grew in size instead of being paid down. Soon, the added amounts triggered a clause in their mortgage that made their payments nearly double after about only a year.
He wanted to know if there was anything he could do, and unfortunately, there wasn’t. All of the proper disclosures that are designed to make people aware of such negative loan terms were signed by the borrowers—they simply didn’t understand them. All they saw was their monthly payment was going to drop. They didn’t know they would be in danger of losing the home they planned to live in for the rest of their lives.
The only thing they could do was sell the home or be foreclosed on. I sent them the name of a good real estate agent out of D.C., and they got together to check their options. Unfortunately, home values had declined so much that they owed more on the house than what it was currently worth. They would have had to come to the closing table with about $30,000. The real estate agent contacted the lender and began to negotiate a short sale (explained in Chapter 8), and the lender finally accepted after three months of effort.
The homeowners lost their home and their credit and moved into an apartment. All because some fast-talking mortgage broker talked them into a loan they had absolutely no business taking.
This true story was duplicated all across the country. Loan officers profited as alternative lending grew and grew.
FHA suffered. In fact, according to the GAO, FHA’s market share dropped from 32 to 7 percent of the market share from 1996 to 2005. And it wasn’t just FHA loans that were dwindling. So were conventional loans from Fannie and Freddie. Although FHA simply insures mortgages made by lenders, Fannie and Freddie had stockholders to satisfy. They decided to join the alternative and subprime party.
Both GSEs introduced loan programs designed for the subprime borrower to compete head-on with the subprime mortgage companies. They also invented various types of loans that didn’t require pay stubs or tax returns, to compete with alternative lenders. Moreover, they bought into the notion that home prices will always appreciate, and if the borrowers ever got in trouble, they could always sell and get out from under the mortgage.
Home prices, on the whole, have always appreciated over time. Especially so during the mortgage loan heydays of the first half of the 2000s. Rates were low, and at the same time, home prices were still appreciating. This was all during the Iraq War, and one would think that through a pressing political climate an economy would be held in check. But not in the United States.
If homeowners ever got in trouble and fell behind in their mortgage payments the thinking was that they could always sell the property and come out ahead. In fact, many became real estate “investors” and bought real estate under relaxed credit guidelines, with the thinking that, “Hey, if worse comes to worse, I can always sell or refinance.” Or maybe they can’t, if home values don’t appreciate. We’ll discuss that ramification in detail in Chapter 8.
Around early 2007, something interesting (and problematic) began happening. Those people who took out subprime mortgage loans began to default on their mortgage. By itself, it seems nothing more than a late payment on a loan. But because these loans were ultimately packaged with other instruments in the form of megabonds, those defaults affected the performance of the bond itself.
At the same time, alternative loans began to become delinquent. And those same investments began to sour as well. Revenue streams that were expected from all these various transactions came to a halt. People began to default on their mortgages at breakneck speed.
The economy was in a slow down, home values began to deteriorate, and people couldn’t refinance out of those mortgages. Home sales also slowed, and people couldn’t sell their property and get out from under the mortgage. Hybrids and adjustable-rate mortgages began to reset at interest rates triple what they were before.
Now the investment lost its top-tier rating. Now the holders of those bonds were asking for money from those who sold the bonds to make up for their losses. AIG paid billions out to investors who purchased their credit default swap policies that protected them against loan defaults.
Almost everyone involved in the alternative and subprime business started to go broke. When a mortgage loan goes bad, the investor can send the loan back to the mortgage company and force a buyback of the loan. But mortgage bankers aren’t equipped to buy back mortgages. They make their income on selling and servicing loans, not buying them back.
Mortgage brokers certainly can’t buy back bad mortgages. They only get paid by finding a mortgage loan for a mortgage lender. Many of them also went out of business. The mortgage landscape had changed within a matter of months.
FALLOUT OF THE SUBPRIME COLLAPSE
Perhaps the most dramatic episode during all this mayhem was the near collapse of Fannie Mae and Freddie Mac. They had made too many bad loan decisions and made mortgages to people who couldn’t afford them. The federal government took them over. You and I now own our own little slivers of Fannie and Freddie.
To stave off any future failures, the lenders that were still in business stopped making alternative and subprime loans almost immediately. Even if they wanted to make an alternative or subprime loan, they couldn’t sell them because there weren’t any buyers.
Many national banks and mortgage companies stopped doing business with mortgage brokers as well. We’ll discuss mortgage bankers and mortgage brokers in detail in Chapter 5.
Mortgage brokers claimed they had a 50 to 60 percent market share in the United States. Some estimates were even higher, at nearly two-thirds of all loans originated by mortgage brokers. That number has fallen to as little as 10 percent of all mortgage loans in the country being originated by mortgage brokers.
Credit guidelines have tightened up as well, and for the first time, lenders now use a combination of credit scores and equity to help calculate an interest rate for a borrower. There are now required minimum credit scores for mortgage loans.
But it’s not true that only those with perfect credit and 20 percent down can get a mortgage loan. Interestingly enough, those government stalwarts of VA, FHA, and now USDA remained unscathed during all that period. They stuck to their underwriting guidelines that have been used for decades. The same can now be said for both Fannie and Freddie. Yes, they tightened their credit guidelines, but in reality, what they did was go back to their original credit standards and they got out of the alternative and subprime business altogether.
There have been calls that the mortgage industry is unregulated and loose and there should be tighter restrictions on them. The notion that they’re unregulated is not true. Having worked in the mortgage business as long as I have, I can tell you that plenty of laws are in place to regulate and monitor mortgage companies.
The problems occur when people don’t follow the guidelines, cheat, or lie their way around them. Any mortgage loan that doesn’t require documenting income or assets leaves itself open for fraud. And with the potential income an individual can make on a mortgage loan, it can be tempting for some with few morals to fudge this number or inflate that number.
Stated income loans were designed as a borrower convenience, not as a way to qualify people for mortgage loans that they would not be qualified for otherwise. But these loans were placed in the wrong hands, those that had the ability to defraud the system.
The mortgage companies who relied on alternative and subprime loans are out of business. The loans that regulators have decried simply don’t exist any longer. So what does exist?
The core mortgage market now rests with conventional and government lending. We’ll discuss both in detail in Chapters 2 and 3, but that’s where the money is. I think it’s ironic that we’ve ended up with what we started out with more than 70 years ago—but with important twists.
Although the staple loans are now Fannie, Freddie, VA, and FHA, they all now have their own set of guidelines and rules never seen before. Without knowing how these new rules piece together, one can get placed in the wrong mortgage program and pay for that mistake every month, or placed in an even worse situation: being declined for a mortgage loan in the new mortgage lending environment.