Figure 2.1 Mortgage Industry Food Chain
Lender-Broker Relationship
The business of brokering mortgage loans is subject to controversy. As independent agents, brokers don’t work for the lender, nor do they represent the borrower. They provide the borrower with a service, but the two have no legal agreement. Depending on the circumstances, the broker might get paid by the consumer, lender, or both. So, to whom do they have a fiduciary duty? The answer is unclear, which creates the potential for abuse. Since neither the industry nor the government has adequately addressed the issue, the broker is left to determine what constitutes appropriate behavior.
Unfortunately, most broker-lender agreements provide little clarity on the subject. Instead they focus on the main concern for all subprime lenders—fraud. With hundreds of millions of dollars in transactions occurring daily, one rogue broker can inflict tremendous damage on a lender. Because of the risk, lenders require brokers to repurchase a mortgage if it’s found to be fraudulent. The challenge, however, comes with enforcement. There are two issues to consider.1. A lender may suspect a broker of committing fraud, but proving it is often difficult. As you’ll see in Chapter 3, fraud can often be subtle, making it hard to spot. Even when a suspicious act is detected, the lender will ask who is responsible, the consumer or the broker. If the broker is guilty, the lender will inactivate his account. When the answer is unclear, the lender has to make a judgment call. Unless the lender sustains a financial loss as a direct result of a broker’s actions, the broker has little to lose by acting recklessly. Even for the worst violators, lenders must still use the courts to obtain any financial relief.
2. Brokers seldom have the ability to repurchase a loan. Most of them are small companies with little cash. A broker with a net worth of $50,000 (which is high for the average broker) can’t buy back a $250,000 loan. It’s difficult to recover any money from brokers, which makes litigation a costly and unappealing alternative. Unfortunately, when lenders don’t pursue legal action, brokers are left to inflict damage on other mortgage bankers.
Lender-Investor Relationship
Historically, the investors who purchase subprime mortgages from companies like Kellner have been large lenders, banks, or financial institutions such as Countrywide or HSBC. This group would eventually include the Wall Street investment firms such as Merrill Lynch or Bear Stearns.
These investors set the tone for the market. Their tolerance for risk and what they can securitize will determine the products they offer. In turn, the products are made available to lenders, who offer them to brokers and ultimately the consumer. As a small lender, my company partnered with four investors: GMAC Residential Funding (RFC), Countrywide, HSBC, and Citi. Most subprime lenders partnered with several investors to provide multiple outlets for selling mortgages.
Any institution that either funds or purchases a mortgage has a financial interest in its performance. For lenders and investors, there are three areas of mutual concern: prepayment speeds/premium recapture, early payment default, and loan repurchase due to fraud.
1. Prepayment Speed/Premium Recapture. When a mortgage pays off (prepays) through a home sale or a refinance, this asset no longer exists. If loans are prepaying faster than expected, the performance of the mortgage-backed security is negatively impacted, which means investors make less money.
Since subprime borrowers are charged higher interest rates, investors are concerned with how fast loans will prepay. If a borrower closed on a mortgage and then improved his credit, he could refinance at a better rate. If his loan prepays within the first year, the lender is required to pay back a portion of the premium paid by the investor, which is called premium recapture. To mitigate this risk, lenders attach prepayment penalties to mortgages whenever possible.
Lending money to people with bad credit is a risky proposition. The subprime business model only made sense if borrowers kept the mortgage and made payments for at least a few years. The use of prepayment penalties helped the industry create a deterrent against accelerated loan payoffs.
Until states and consumer activist groups began to address the issue, investors paid a greater premium for loans that carried longer prepayment penalties. I attended a client event sponsored by HSBC in 2003 and listened to the head of trading discuss their pricing model. He confirmed in great detail what we had been seeing for some time. Most investors built their pricing models around the sweet spot, the two-year adjustable mortgage with a three-year prepayment penalty, because it maximized revenue for everyone in the food chain.
Unfortunately this model also handcuffed the consumer. When the interest rate was set to adjust after two years, a borrower trying to refinance faced some unpleasant choices: pay a stiff penalty (as much as 5 percent of the loan amount), or make higher payments for the next year. If the borrower had little equity in the property, it meant he was stuck with the loan until the penalty expired.
2. Early Payment Default (EPD). In most cases, lenders are contractually obligated to repurchase a loan they’ve sold to an investor in the event of an early payment default (when a borrower doesn’t make the first payment to the investor). Although this was the industry standard, it varied between investors. At one end of the continuum was GMAC Residential Funding (RFC), who had no EPD requirement. On the other end was Countrywide, who required a loan to be repurchased if the borrower either missed the first payment or became 90 days delinquent within the first year.
3. Loan Repurchase (Fraud). If a loan isn’t considered an early payment default but still becomes delinquent at some point in the future, investors perform a quality control review to search for any sign of impropriety. When a loan experiences problems, the investor is looking for any reason to have a lender repurchase it. Unlike brokers, most lenders have the financial capacity to repurchase loans. When a broker commits fraud, the lender must prove it in order to make the broker buy it back. The investor, however, only needs proof that fraud occurred—who committed the act is largely irrelevant. Because of this threat, lenders have little motive to act in a fraudulent manner. However, as Chapter 4 illustrates, it doesn’t mean they can’t get creative.
A Conflicted System
When you consider the motives for all three players—brokers, lenders, and investors—the mortgage food chain presents a system in conflict. Lenders are sandwiched between two groups with completely different agendas. On one hand, they answer to investors who care about loan performance and prepayment speeds. If a lender’s book of business performs poorly, the investor can terminate the relationship. Therefore, lenders want the performance of their loans to meet the investor’s expectations. On the other hand, lenders cater to brokers, a group whose only motivation is closing the loan. Since brokers have no financial interest in a loan’s performance and face no liability, lenders must always question their actions and motives.
A Culture All Its Own
Until a few years ago, most lenders fit into one of two categories—those who handled subprime mortgages and those who didn’t. Since subprime involved taking on more risk, it also required a different mind-set and willingness to operate under a different system.
The first difference was the need for more capital. Unless a lender is a bank, it seldom uses its own money to fund mortgages. Instead, most lenders use warehouse lines of credit as their source of capital. A warehouse lender holds or stores the note until an investor purchases the loan. It’s like a giant secured credit card, with the note to the property serving as collateral.
The advance rate, the percentage of the loan amount the warehouse lender will provide to fund a loan, has traditionally been higher for prime than for subprime loans. In the 1990s, a prime lender might get a 99 percent advance rate, meaning the warehouse lender advances 99 percent of the loan amount with the lender contributing the other 1 percent. A subprime lender might get a 98 percent advance rate, which requires twice as much capital to invest as a prime lender. Funding $10 million in monthly volume requires $200,000 ($10 m
illion × 2%) in capital just to fund the loans. That’s a large capital requirement, and it doesn’t include the money needed to run the rest of the operation.
The second difference came from not knowing if investors would buy the loans. Conforming lenders benefited from the use of automated underwriting programs developed by Fannie Mae and Freddie Mac. An approval through one of these systems all but guaranteed an investor would purchase the loan.
By 2000, automated underwriting was just being developed for subprime mortgages. This meant underwriting a loan file was a risky proposition, one that could prove costly. If a lender made a mistake or if the investor’s underwriter declined the loan after it had been closed, they had to find another outlet. That usually meant selling the loan at a loss on the “scratch and dent” market, where lenders go to sell loans their investors won’t purchase.
If your vision of mortgage lending is one of high finance with suits and ties, then you’re thinking of the prime side. Subprime lending was more of a jeans and t-shirts crowd. Many of the earliest subprime employees got their start in the consumer finance industry at companies like Beneficial, Conseco, and The Associates. Since these companies lent money to people with poor credit, subprime mortgages were a natural transition.
If anyone fit the stereotypical profile of a subprime lender, it was Tony DeLuca. Standing over 6’6", Tony, with his goatee, large physical presence, and a deep voice that would have made James Earl Jones envious, looked intimidating. If he hadn’t been a subprime lender, he would have made a great collection agent.
For me, dealing with Tony was a challenge. Coming from the prime side of the industry, I was used to customers with low-key personalities. With Tony, most transactions were a struggle—either our price was too low or our underwriters were too conservative. Even when deals went smoothly, there was a palpable tension that made doing business a painful process.
Even though Tony could be difficult, his loans performed well. After 10 years of running a subprime mortgage company, he understood how to manage risk. I pushed hard to get his business and Tony quickly became my second-best customer. Even though he represented 20 percent of my total business, his hardened approach eventually wore me down.
After an especially difficult transaction, I finally had enough. When he picked up the phone, I went after him. “Tony, it’s Richard. We need to have a conversation. Actually, let me rephrase that. For the next 30 seconds, I’m going to talk and you’re going to listen. This relationship is becoming a complete and total ass-whip. No matter what we do, you end up treating us like shit. So here’s what’s going to happen. Starting right now, you’re either going to begin acting civil to everyone on my team or we’re done.”
It was a risky move considering that Tony could have told me to go to hell. Even though the recent correction had significantly reduced the number of subprime investors, GMAC Residential Funding (RFC) wasn’t the only game in town. He could have gone somewhere else.
Tony fired back at me, “Well then, I guess I’m going to have to get a new RFC rep.”
“No Tony, you don’t seem to understand something,” I interrupted. “I’m your only option. There are no other reps available for you. You either play nice, work with me, or this relationship is finished.”
The most important part of running a convincing bluff is knowing what cards your opponent is holding. I had no intention of cutting him off, but something had to change if this relationship was going to work. Tony could use other investors, but I knew he was very selective about whom he sold to. He disliked having to bring new companies into the mix and I was counting on that to work in my favor.
Looking back, the whole conversation must have taken him by surprise. Because of his booming voice and physical presence, most people had no desire to go toe-to-toe with him. I believe it might have been the first time a vendor tried to back him into a corner. Fortunately, his tone changed. Instead of fighting back, he admitted that he occasionally acted abruptly and let his emotions get the best of him. He went on to explain that even his wife told him he could be gruff at times. I was thinking of a different word but left it at that.
Ultimately, the conversation paid several dividends. Standing up to Tony not only helped us to become friends, it taught me something about myself. I already knew that being a subprime lender required a high tolerance for risk, a willingness to get your hands dirty, and thick skin. I now knew just how thick my own skin was.
The most interesting part about the subprime business was the people, some of whom were very colorful. As a business owner, the challenge was figuring out who you could trust and who was a scoundrel in disguise. Although my five years in the business were filled with numerous stories, some of the most interesting discoveries continue to unfold to this day, more than two years after I left the company.
Shortly after opening Kellner, we used a warehouse line of credit through nBank, a Georgia-based lender. Our contact, Ron Walton, came across as a true southern gentlemen—very professional in his approach. We used his company for only eight months, but our dealings led us to believe he ran a good, clean operation. I only recently discovered just how wrong we were.
In August 2007, Walton was sentenced to 97 months in federal prison and ordered to pay restitution for using his position at the bank to facilitate a fraud scheme with several mortgage brokers. Even though he had several co-conspirators, he is credited with putting this 103-year-old Georgia bank out of business.
Whether it was the lure of higher profit margins or the risky nature of the business, something about the subprime industry attracted a different crowd. While some individuals were more reckless than others, almost fearless, I viewed many of them as gun-slingers. It would ultimately take someone with a gunslinger mentality to help launch our company.
How to Start a Subprime Company with No Money Down
For us, starting a mortgage company seemed like a long shot. In 2000, most subprime investors required lenders to have a net worth that ranged from $250,000 to $500,000. It was a small number by industry standards, but for the collective partners at Kellner Mortgage, it was far more than we could afford. We didn’t lack desire or ambition, just capital.
But having worked in subprime lending for 18 months, I understood a few things about the business. If you make a sales pitch to enough people and sound convincing in the process, you’ll find someone willing to take a risk, even if it makes little sense. The birth of our company would depend on it.
We came up with an idea to start off as a branch office under an existing subprime lender. In our proposal we asked for total access to the lender’s warehouse lines and investors, along with complete underwriting authority. Not surprisingly, no one we pitched this proposal to was willing to back it. Their reluctance was understandable, since we wanted total control. Despite all the risks in this business, we asked for a lot. It would take little effort to inflict major damage on another lender’s operation. Whoever took this deal would need to be more than a gunslinger—they’d need to have an exceptionally high tolerance for risk.
Luckily, one of my customers saw something he liked and went after it. Randy Gomez, owner of American Fidelity Mortgage, put us in business. Of course, the price of admission wasn’t cheap—it cost us 25 percent of gross revenue and 12 percent interest for an unsecured line of credit, just so we could operate.
Fortunately our timing was perfect. By early 2001, we had a small staff of 12 employees. The Fed was cutting rates, volume was beginning to increase, and things were looking up. At the same time, Gomez’s offices were also growing, which created a problem. Earlier in this chapter we discussed how lenders use warehouse lines of credit to fund mortgages. Like a credit card, when the line is maxed out, loans must be sold to investors to make room for new ones. With Gomez scrambling to acquire new warehouse lines, we didn’t have enough space on the existing lines to fund the loans.
For weeks, borrowers closed on their loans and were forced to wait for days for the funds to ar
rive. Customers were furious and the situation was getting desperate. We could only operate this way for so long until brokers would pull their loans and go somewhere else. The following morning, my partners and I decided to take control of our future.
In a desperate move, I convinced my parents to mortgage their house to capitalize the company. With the profit made during our first six months, we had enough cash to run the business, but needed to show money on the audited financial statements to get our investor approvals. Having secured the necessary funding, we formed our own company and made a break.
We started the company with a total net worth of $414,000, still short of the $500,000 many investors required. Fortunately, we were able to leverage the relationships we built selling loans under the American Fidelity umbrella to get our approvals. We also benefited from incredible timing—had we tried this idea two years later it would have failed. By 2003, most investors had raised the minimum net worth requirement for lenders to $1 million, an amount we couldn’t obtain.
The biggest challenge came with getting our Countrywide approval. At the time, Countrywide required all wholesale lenders to have a minimum net worth of $3 million. With only $414,000 on our audited balance sheet, asking for the exception seemed laughable. As a start-up with 12 employees closing less than $5 million per month, there was no justifiable reason for them to approve us.
Confessions of a Subprime Lender Page 4
