In our four years of working together, I never suspected Richard of anything questionable. In one instance, he called me on a loan in process and said he needed to cancel the file. He had just caught the borrower trying to pass off phony pay stubs and did not want me to get stuck with a fraudulent deal. At the time, I didn’t have the pay stubs in my possession so it was easy to conclude that he had covered my backside.
Not having spoken with Richard in more than a year, I tried to locate him in early 2008. Since all of his phone numbers had been disconnected, I turned again to Google to see what I could find out.
When I learned that he had pleaded guilty a few weeks earlier to one count of bank fraud and one count of engaging in monetary transactions in property derived from specific unlawful activity, I was stunned. When his 32-page federal indictment was unsealed and I was able to read it, I couldn’t believe the fraud he was accused of perpetrating.
Seeing this news prompted me to dig deeper. After reading numerous postings from residents on a local Houston-area blog, I discovered a whole other side to Richard. I now understand why some people are called con artists. Like any professional who practices his craft in seek of perfection, Richard’s path of destruction left a wide and devastating trail. The stories that surfaced, from accusations of horrendous spousal abuse to a myriad of investors and neighbors that had been duped, made his life sound like something out of a Grisham novel.
Why would anyone with his level of intelligence falsify most of the information on his loan application? The indictment covered everything from his pay stubs and tax returns to cashiers checks that had been scanned and subsequently forged. He originally worked in a banking environment, in “Compliance” no less. He knew that banks have extensive audit requirements and would eventually connect the dots.
Richard was originally charged with more than six counts of bank fraud but struck a deal to reduce everything down to two charges. When sentencing comes in June 2008, he could face up to 35 years in jail.
I was lucky to have avoided the carnage of Richard Bell. As with other brokers before him, I could easily have been thrown under the proverbial fraud-mobile, but was somehow spared. I have witnessed more than most when it comes to the greed this industry has to offer, and after a while nothing seems to surprise me. But after reading about Richard, it is hard not to lose some faith in humanity.
CHAPTER 4
Making Chicken Salad Out of Chicken Shit: The Art of Creative Financing
The subprime lending industry has received volumes of press coverage. From the brokers who wrote the loans to the investors who securitized them, every level of the food chain has been scrutinized. However, there’s one critical component that’s been largely overlooked—how borrowers who initially didn’t qualify for mortgages became eligible for financing. While stories of consumers who took stated income loans are well documented, the strategies used to qualify borrowers were much more complex. This chapter explores these methods and shows how difficult loans were massaged to make them saleable on the secondary market.
By 2000, the industry had become matrix driven, which meant lenders took a borrower’s credit profile (credit score, bankruptcies, foreclosures, and so on) and put it on a grid to determine his credit grade. The higher the grade, the smaller the down payment (or equity) required and the better the interest rate. What happened when borrowers didn’t have enough money for a down payment because they were graded too low? Assuming there was no rich uncle to help out, the choices were clear: deny the loan, commit fraud, or get creative.
If there is an art to the business of subprime lending, it’s making something out of nothing. While I worked for RFC on the investor side of the business, we focused on buying closed loan files that met our guidelines. By the time the underwriters saw the deals, they’d already been massaged, squeezed, pushed, pulled, and manicured into a presentable state. Until I worked directly with brokers, I had no idea what creative financing entailed. My sales manager Rob Legg referred to the process as “making chicken salad out of chicken shit.” It lacks poetry but epitomizes the true nature of the business.
This first section of this chapter explains the basic principles of risk management and how they apply to subprime mortgages. The next section reviews multiple case studies and shows the different techniques used to make difficult loans work. The final section examines residential appraisals and the methods used to manipulate a property’s value.
These strategies were implemented by mortgage brokers, lender’s account executives, underwriters, loans processors, and appraisers. The process of massaging loans to qualify borrowers became standard practice in the subprime industry. It was an integral part of making tough deals work.
Understanding Risk
Everything in mortgage lending revolves around the four Cs—collateral, capacity, character, and credit. Collateral is the property used as security against the loan. Capacity is a borrower’s ability to pay the mortgage, determined by his income. Character is whether the lender believes a borrower is likely to repay the loan based on past performance. Credit is a borrower’s payment history reflected by credit scores and overall credit profile. These fundamental principles are collectively used to determine a lender’s underwriting decision.
While all four Cs are important, collateral tops the list. Since subprime borrowers typically face multiple challenges, accurately determining a property’s value is vital to the process. In many cases, property value is one of the few redeeming qualities in a subprime loan.
Every subprime loan starts with analyzing credit. It’s comprised of the following components: credit score; mortgage (or rental) history; previous bankruptcies and foreclosures; plus collections, charge-offs, and judgments. While every investor has his own specific guidelines for assessing risk, each of these components factors into their thinking. Some put greater emphasis on certain areas, but they all share the same basic philosophy. As a borrower goes from performing well (good score, no bankruptcies) to having problems in one or more areas, the risk goes up, which causes them to get a lower credit grade.
Figure 4.1 is a credit matrix my company used for RFC’s subprime product line in 2005, but it’s been simplified for easier reading. To qualify for a credit grade, a borrower needed to meet the minimum requirements in each category. For example, to be an A+ borrower you had to have a minimum 600 credit score, no late mortgage or rental payments in the last 12 months, no bankruptcies or foreclosures in the last three years, and all adverse credit (collections or charge-offs) over $500 in the last 24 months should be paid off prior to closing the loan. If a borrower had twice been 30 days late on a mortgage during the last year but met all other requirements, he received an A- grade.
The last row is labeled maximum loan-to-value (LTV). Expressed as a percentage, LTV is calculated by dividing the loan amount by the property’s purchase price or appraised value, whichever is lower. The actual matrix is much more complex as LTVs are broken down further based on loan amount, property type, and income documentation.
Figure 4.1 Credit Matrix
As borrowers moved down the grading scale (A+ to C-), the mortgage became a riskier proposition. To compensate, lenders required a larger down payment (or more equity if it was a refinance) and a higher interest rate. On the flip side, borrowers wanted to move up the grading scale to get better terms. Massaging a loan file means artificially improving the areas that contribute to the lower credit grade (low score, excessive collections). That’s how you make chicken salad.
There’s one final factor to consider and that’s depth of credit. Investors required borrowers to have a minimum number of acceptable trade lines. A trade line is an installment loan (such as a car payment) or a revolving account (such as a credit card). The number of required trade lines varied between investors, but usually ranged from three to five.
The policy made sense on several levels. First, a history of paying multiple creditors helps validate the credit score. When a borrower with only
one or two trade lines receives a high score, it’s not an accurate reflection of their limited credit history. Second, when a high-risk borrower can prove that he’s paid multiple creditors in the past, it validates the lender’s decision to finance the mortgage.
Yet some investors made us scratch our heads and question their thinking. For example, RFC required five trade lines, but their definition of what made a trade line acceptable was different from that of other investors. They allowed collections and charge-offs to be counted as trade lines as long as one trade line was either a revolving or installment account. If a borrower had a Target charge card with a $100 maximum credit limit and four collection accounts, he met the minimum requirement. Here’s the craziest part. If the same borrower had a 580 credit score, he qualified for 100 percent financing.
So how does paying on a Target charge card qualify a borrower to purchase a home with no money down? The answer lies in the belief that credit score could accurately predict a loan’s performance. While working at RFC, I attended a meeting in which a member of the risk department provided an analysis on the company’s entire book of business. His report showed a near-perfect relationship between delinquencies and credit score. As credit score went down, delinquencies went up.
This fundamental belief changed the way the industry operated. By 2000, subprime investors used credit score as the primary determinant for assessing risk. Even so, most of them believed the other credit elements—housing history, bankruptcies, foreclosures, and collections—should meet the guidelines in order for credit score to be a reliable indicator. Holding these other factors constant was a critical part of the equation. One of the greatest mistakes made in the mortgage industry occurred around 2005 when many of these guidelines started to loosen, allowing more unqualified borrowers to get approved.
How Creative Financing Works
The following case studies show how loans that didn’t initially qualify were massaged to improve the borrower’s credit grade. Although each case study focuses on one or two elements to make it easier to digest, the majority of subprime loans required the use of multiple techniques to qualify borrowers.
Case Study One—Massaging Credit
Steve and Cassie Hodge are purchasing a home. He manages a restaurant and she works as a hairdresser. Since Cassie had a baby a year ago, she has been working only part-time, and because she is paid in cash she can’t prove her income. They have little money in savings but Steve’s parents have agreed to give them 5 percent toward a down payment.
Steve went through a bad divorce a few years ago and his ex-wife ran up charges on their credit cards, which left him with bills he couldn’t pay. The resulting collection and charge-off accounts have negatively impacted his credit—his score is 520. Cassie’s score is 600, but she has limited credit with only three trade lines reporting—two collection accounts and a Visa card.
Here is how credit scores are used in subprime lending. If two borrowers are proving income (a full doc loan), the lender uses the primary breadwinner’s score to determine the credit grade. In this case, Steve makes the most money so the lender would use his score. For a stated income loan, the lender uses whichever score is lower. To maximize the credit grade, most stated loans only list the borrower with the highest score, and the other person is left off the application. A stated income loan for this couple would be written only for Cassie since her score is higher.
Steve qualifies for the loan based on just his income, but the challenge is the down payment. With a 520 credit score, the lender requires 15 percent, which leaves them 10 percent short. Cassie’s 600 credit score qualifies her for a stated income loan with 5 percent down, but she has limited credit. For her credit score to be valid she needs five trade lines, which leaves her short by two accounts.
In either case, they don’t qualify. To make this deal work, they need more money, better credit, or both.
Option A—Credit Repair
Steve and Cassie are in luck. They’ve chosen a savvy loan originator who works closely with a local credit repair company. As the name implies, these firms help consumers repair or improve their credit.
After six weeks of work, the company increases Steve’s credit score by 40 points. At 560, he’s eligible to purchase with 5 percent down, but there’s another problem—the lender wants proof that timely rental payments have been made. In this case, they’ll only accept copies of cancelled checks or a verification of rent (VOR) form completed by a management company as proof. Since parents, relatives, or friends who double as landlords will lie to help out, private VORs are not as reliable. While many subprime lenders accepted them, others wanted more dependable proof for borrowers classified as a higher risk.
The problem is for the last year they’ve been living rent-free with Cassie’s father. Looking for any possible solution, the broker discovers her father owns a one-person consulting firm, STM Inc. This gives him an idea. He supplies the lender with a rental verification using STM as the property management company. The broker thinks a generic name like STM might just fool the lender. Even if the lender calls to verify the document, they’ll end up talking with Cassie’s dad, who’ll verify its authenticity.
Why Is This an Issue?
From a lender’s perspective, credit repair companies present a dichotomy. For borrowers who’ve had their identities stolen or need to challenge legitimate credit issues, they provide a much-needed service. In most cases, however, the service is the mortgage equivalent of cosmetic surgery. Using the tricks of the trade, they give Steve’s credit report a face-lift, making it look better than it is. Artificially raising his score doesn’t make him a better risk, it means he gets a loan with better terms.
Because Steve’s housing history is altered, the lender can’t accurately assess his credit profile. Since rental history is the one debt that best resembles a mortgage payment, it’s a critical piece of information required to validate a lending decision for high-risk borrowers. When the VOR is manipulated, the final assessment is based on a flawed assumption.
Since their credit is poor, Steve and Cassie are more likely to default on a mortgage than someone with better credit. Requiring them to have more skin in the game by putting 15 percent down instead of only 5 percent is how the industry manages risk. If high-risk borrowers don’t have as much to lose, their likelihood of walking away when times get tough goes up. This partially explains why this country is faced with record levels of foreclosures, as a large percentage of borrowers were financed with little or no money down.
Option B—Credit Enhancement
Instead of taking several months to repair Steve’s credit, the broker opts for another strategy—credit enhancement. This is one of the newer tricks developed by the credit repair industry. A person with good credit is paid a fee for each account they let someone else use. The person with the challenged credit doesn’t get access to the account, just the benefit of the performance history that comes with it.
You’ll recall that Cassie couldn’t qualify for a stated income loan because she didn’t meet the five-trade-line requirement. Thanks to the credit enhancement process, three new trade lines are added to her credit report, which increases the score to 665. Because she had limited credit from the outset, doubling her total number of accounts significantly increases the score.
Her improved credit score creates two benefits. First, she qualifies for 100 percent financing under the stated income program. Second, because the score is now above 640, the rental verification becomes less of a concern. In this case a private VOR is considered acceptable by the lender. Not only can they qualify with no money down and no income verification, her father doesn’t have to lie for them.
Why Is This an Issue?
From a risk perspective, credit enhancement is smoke and mirrors, a total facade. Nothing about the loan makes sense. The lender uses Cassie’s credit to make a risk-based decision, but she has no ability to make the payments. Steve can make the payments, but his credit score is 100 poi
nts lower than hers and he’s not on the application. This deal is based entirely on false assumptions.
Let’s change the scenario and assume credit enhancement wasn’t necessary. Cassie had the necessary depth of credit and was able to qualify with 5 percent down using a stated income program. What’s been described so far has been a process driven by the broker. However, the lender’s account executive often played a key role in structuring difficult deals.
The broker is looking to the lender’s account executive for guidance. When it comes to configuring deals, the account executive will tell the broker how to package them so they get approved. A loan must be structured properly before it gets to the underwriting department or it will be denied. If a broker submits a stated income loan and includes a borrower’s W-2 by mistake, most lenders won’t allow the deal to go through because they’ve seen the income. If the loan is sent this way to a lender’s account executive, he’ll pull out the income documents, send it to underwriting, and the problem is solved. It’s the account executive’s responsibility to make certain the broker gets it right the first time.
Like brokers, account executives work mostly on commission, which means they don’t get paid unless the deal closes. With the exception of Accredited Home Lenders, I don’t know of any other mortgage company that tied loan-level risk factors, such as a stated income loan versus one with full documentation, to an account executive’s commission structure. It was a brilliant model. By effectively giving the reps a financial interest in the quality of the loans they obtained, it motivated them to act in the best interest of the company. The majority of other lenders, however, paid their reps more money for higher margin products like subprime, which did nothing to prevent irresponsible behavior. Not surprisingly, the highest producing reps were usually the most creative.
Confessions of a Subprime Lender Page 8
