Confessions of a Subprime Lender

by Richard Bitner

  CHAPTER 7

  How to Fix a Broken Industry

  If the first six chapters have accomplished nothing else, they’ve shown that the subprime problems are multidimensional. From the brokers to the rating agencies, every player shares responsibility for this crisis. Since the issues we’re currently facing are the result of a collective effort, the solution must be comprehensive as well. Unless the fundamental flaws that exist at every level of the mortgage food chain are properly addressed, any effort to change the way the industry operates will fall short. I’ve exposed the inner workings of the subprime industry in the hope that this information can serve as a guide to changing policy.

  The key to effective legislation is striking a balance by protecting the consumer from predatory behavior while not restricting the availability of credit to borrowers who present a good risk. The question is whether Congress can solve the problem without going too far. While borrowers in the near term will face reduced mortgage options regardless of how the legislature responds, my concern is for the longterm.

  We’ll eventually work our way through this crisis. There will be a lot of pain and finger-pointing along the way, but a time will come when subprime mortgage financing, in some form, makes its way back into the marketplace. Why do I believe this? Because at the very heart of subprime lending, beneath the greed and the ineptitude that overtook the industry, is a business model that can provide value to the homebuyer.

  After closing thousands of loans for subprime borrowers who made timely payments, I understand subprime’s capabilities, good and bad. While the upside is likely to be overlooked in light of the current housing crisis, I know the positives can far outweigh the negatives, provided the business stays grounded in the basic principles of risk management. My objective is to show that a middle ground is possible—one that protects the consumer and still allows the market to determine what constitutes an acceptable credit risk.

  Since the topic is a high priority among politicians, it’s possible that a national predatory lending law will be in place by the time you read this book. The House of Representatives passed a predatory lending bill and the Senate is expected to do the same in 2008. As I explain my plan to address each of the industry players and develop lending standards to protect consumers, I’ll use the House bill for comparison.

  A Plan for Change

  If there’s one word that best describes my proposed solutions, it’s accountability. Industry players who acted in a fraudulent or deceptive manner did so because there were few consequences for their actions. Although it’s not feasible for every player in the food chain to be held responsible, there are ways to discourage or reduce predatory behavior.

  Let’s begin with the investment banks and rating agencies that handle the securities and the brokers who originate the loans. If you’re wondering why I don’t include lenders, it’s because there’s no need to discuss them separately as long as we address the issues at both ends of the mortgage process and develop lending standards that all mortgage companies must adhere to.

  Investment Banks—Creating Liability

  The idea of holding investment banks that securitize mortgages accountable for their actions has promise. It goes against the Holder in Due Course doctrine, but a limited form of assignee liability that targets securitizers is conceivable, provided it doesn’t extend to the investors who purchase the bonds. Any effort to extend liability to bondholders would mean the end of mortgage securitization as we know it. But if borrowers have recourse against securitizers, it creates accountability. It’s difficult to hide behind a veil of deception when there’s an underlying threat of litigation.

  The predatory lending bill passed in the House of Representatives creates limited assignee liability by defining the parameters of a “qualified” mortgage. If a loan doesn’t meet a long list of guidelines and it’s placed into a mortgage-backed security, the securitizer could be held liable. However, there are two concerns. First, the proposal faces an uphill battle in the Senate. Given the current climate in Washington, this provision will probably need to be removed in order for the legislation to pass, so the issue of assignee liability may become a moot point. Second, by creating boundaries for what is and is not a qualified mortgage, the bill restricts the availability of credit to the consumer.

  The credit restrictions would apply primarily in two areas. First, they would severely restrict the use of most stated income loans. Although many people support the elimination of this product in light of how it was abused, I still believe that kind of loan makes sense under the right conditions. This product will be addressed later in this chapter. Second, the bill would create an annual percentage rate (APR) cap of 1.75 percent above the market rate for a 30-year conforming mortgage. Unlike the interest rate, APR represents the total cost of credit to the consumer, which takes into account one-time fees like loan origination and processing. Although interest rate and APR are not the same, they are often close in range when the fees being charged are not excessive. Therefore, you can view the 1.75 percent above market figure as an interest rate cap to keep things simple.

  While the idea of mandating a rate cap might appear to be good for the consumer, it has the opposite effect. This provision would prevent borrowers who are a B credit grade or lower from obtaining a mortgage, and this group represents 15 to 20 percent of all subprime borrowers. If you believe these borrowers pose too great of a risk, consider the bigger picture. Anyone classified as a B grade or lower must provide a minimum down payment of 15 percent. They are a higher risk, but these borrowers aren’t the reason we’re in our current predicament. The problem was largely a function of lending money to borrowers at higher credit grades with no money down and no proof of income. Borrowers in the B grade category never had that option. Although I don’t support a plan that restricts credit, an alternative solution is to move the APR cap another 100 basis points, to a total of 2.75 percent. That should allow the majority of borrowers to obtain financing.

  If the Senate doesn’t allow assignee liability to be included, there’s another alternative that would require some effort on the part of the mortgage industry. Chapter 2 showed a credit matrix from RFC, explaining how borrowers are assigned grades based on their credit profile. Each lender developed an independent matrix, which meant the industry had no uniform standard. Expanding on the idea of credit grades to develop an industry-wide classification system for all mortgages could make the securitization process more transparent. John Mauldin initially suggested the idea in his weekly commentary “Outside the Box.”

  Here is how the idea works. The industry would develop multiple standards. One standard (class AAA for example) might include loans with a maximum loan-to-value (LTV) of 75 percent, debt-to-income (DTI) ratios of 25 percent, FICO scores of 740+, and so on. Another standard (class AA) would have maximum LTVs of 80 percent, DTI ratios of 30 percent, and scores of 720+. These standards would apply to all companies that create mortgages.

  When an investment bank packages a mortgage-backed security made up of thousands of loans, it could develop a class AAA standard security. With very clear payment and default risks, the agencies could give ratings based on these standards. By assigning every mortgage a classification, loans would be identified by their risk characteristics. With every loan class representing a different level of risk, investors could determine how much exposure they’re willing to take. If there is a market for subprime loans, it would redevelop over time.

  Implementation would require the cooperation of mortgage industry leaders, investment banks, and rating agencies. Even though all three parties have a vested interest in restoring order to the industry, the process would still be challenging since reaching a consensus would not be easy. However, developing a standard for all mortgage products could have a significant impact. At the very least, it would take some of the mystery out of the securitization process.

  The Rating Agencies—A Major Overhaul

  In late 2006, Congress passed
the Credit Agency Reform Act requiring agencies to register with the Securities and Exchange Commission (SEC). Granting the SEC oversight has also given them enforcement capability. Time will tell whether the SEC does anything of substance with this authority, but there are some positive signs. They’ve already signaled that the agencies must disclose their procedures and methodologies for assigning ratings, which is a step in the right direction.

  New authority aside, there are several ways to remedy the inherent flaws within this system. First, a separation of the advisory and rating functions should be mandated. The conflict of interest that arises from helping to structure securities and then rate them has already been discussed.

  Second, the agencies should be required to regularly review and rerate debt securities. Even though this function is currently performed, there are no standards. Developing a systematic process for monitoring performance and adjusting the ratings would make the agencies more accountable. Had this been in place in 2005, it’s conceivable that the downgrades would have sounded the alarm bells much earlier. There’s also a third option. It would be difficult to implement and more radical in approach, but it would fix the problem.

  For three years I paid a man to hang Christmas lights on my house. His price was so reasonable that most of my neighbors used him as well. As soon as Thanksgiving was over, he’d hang the lights, get paid, and take them down after the holidays. Since he proved trustworthy, none of us had an issue with paying him the entire fee once he hung the lights. On the third year he disconnected his phone shortly after Christmas, ending his reign as our favorite Christmas light guy. Since he already had our money, there was no motivation to finish the work.

  Most of us are paid with the understanding that we’ll produce a certain quality of work. Poor performance usually means losing a job. The agencies, however, operate under a different set of rules. They’re paid the same regardless of performance and there’s no motivation to replace them unless they are too conservative in their efforts. If ratings are judgments on whether a bond will pay interest on schedule until it matures, why aren’t the agencies compensated against this measurement? The only way to change the agencies’ behavior is to change their motivation.

  The solution is to defer a portion of the agencies’ income and tie it to the accuracy of their work. This isn’t designed to pay the agencies less money, just to link income to performance. Under this scenario a portion of the fees paid to the agencies by investment banks, say 30 percent, is put into an escrow account for 12 or 18 months. Let’s assume a security is expected to produce a specific return based on the rating. If the security performs as projected, the agencies receive the full amount of the deferred income. If the security performs worse than expected, the agency receives less.

  An agency could provide an overly conservative rating to maximize the deferred income, but the natural forces of the market would likely prevent this from taking place since investment banks want the agencies to be aggressive.

  What happens to the deferred income that doesn’t get paid to the agencies? The same way mortgage insurance protects a lender in cases of default, the excess funds could compensate investors in cases of substantial loss. At the very least, it could restore confidence in the MBS market. Another option would be to use the funds to support a housing-related charity like Habitat for Humanity.

  Under this system the agencies are motivated to monitor a security’s performance and to be accurate with the initial rating. Of course, the SEC would have to work with the agencies to define expected default rates for each type of security, but that shouldn’t be a difficult task given the available data. Once in place, the standards would serve as a scorecard to measure agency performance.

  Admittedly, ratings are not indicative of how market forces might affect the price of a security, but maybe it’s time for that to change. Expecting a risky mortgage to perform the same when home prices are dropping as it would in an appreciating market is completely unrealistic. Tying a portion of income to performance would change the agencies’ motivation, forcing them to reevaluate their models and develop an unbiased rating process.

  The hard part is implementation. It’s questionable whether the SEC even has the statutory authority to modify how the agencies are compensated. If they don’t have the power then Congress would need to grant it to them by amending the Credit Agency Reform Act or some other legislative reform, not an easy task. Given the current climate in Washington and the powerful influence of the rating agencies, my belief is that Congress will do very little to hold them accountable.

  Mortgage Broker—Fixing the System

  I was explaining to a friend the challenges we encountered working with mortgage brokers when he raised an interesting question. He asked whether the borrower was better served with or without brokers, given the problems they create. To this day, I still struggle with that question. In light of everything that has taken place, it’s hard to specify the value they provide unless better forms of consumer protection are put into place.

  While a good broker can be the best option for a homebuyer who needs a creative mortgage solution, this same type of borrower, the one with less than perfect credit, is also more vulnerable to manipulation. A middle ground, however, is within reach. In order for the system to provide sufficient consumer protections, reduce the ability to manipulate borrowers, and allow the broker to remain competitive, only a few modifications are required.

  Fiduciary Duty—Start with the Money

  The predatory lending bill in the House of Representatives requires the broker to act in the borrower’s best interest. Since the measure has wide support in the Senate, it seems likely the final version will include such a provision. There are, however, a few concerns. First, how do you define best interest? Since the bill’s language is somewhat nebulous in this area, it leaves room for interpretation and, inevitably, frivolous lawsuits. Second, creating a fiduciary duty doesn’t completely address the problem’s root cause. Admittedly, the broker should have a responsibility to the borrower, but unless the solution addresses the broker’s motivation, it’s only partially effective.

  A recent movement that has gained popularity is the use of up-front brokers. A broker who operates in this manner agrees to take a specific fee that may be paid by the borrower, lender, or a combination of the two. The borrower and broker sign an agreement at loan application that details how much the broker will make on the transaction. Some states, like South Carolina, already require such an agreement to be signed for every mortgage application.

  Developing this standard would put mortgage brokers on par with other real estate and financial service providers. When a homeowner sells a property, the listing agreement identifies how much the realtor will earn. When an investor buys stock through a broker, the commission is paid according to a designated schedule. Consumers who use CPAs or financial planners pay according to predetermined formulas. The mortgage broker’s total compensation, however, can be a mystery until the final moments of the transaction. There are two reasons for this.

  First, like any mortgage provider, brokers must disclose their fees on the good faith estimate (GFE). Since the GFE is just an estimate, there’s no legal obligation to honor the quote. If a broker (or any mortgage professional) wants to increase fees at the last minute, the only thing that’s required is a newly signed disclosure from the borrower. It’s a deceptive practice that doesn’t occur frequently but is allowable under the current system.

  Second and more importantly, confusion occurs about how brokers disclose the yield-spread premium (YSP) on the GFE. Unlike the origination fee, which is identified by a dollar amount and percentage, the YSP is shown as a range, usually 0 to 3 percent. Since the borrower won’t know the total YSP until shortly before closing, when the final settlement statement is developed, the broker’s compensation remains a mystery until the last minute.

  The use of an up-front agreement for brokered loans would create a significant protection for borro
wers. Here’s how it would work. Let’s assume the two parties agree the broker will earn 150 basis points (1.5 percent of the loan amount) in total commissions. The money can come from the borrower, lender, or a combination of the two. Once a broker is bound by a set figure, consider what happens to his motivation. If the total fee can’t change, there’s no reason to treat a borrower unfairly. It would be nearly impossible to pull a bait and switch on a customer.

  To be clear, I don’t advocate limiting the amount or percentage a broker can earn. If a broker believes his service is worth more than the market average, he should be allowed to charge more. Of course, he’ll need to set a higher standard for service to earn it, but that’s how the free market is supposed to work.

  Before opponents cry foul, let me address the obvious concern that it creates an unfair advantage for lenders. When borrowers shop for a mortgage it means comparing two items—interest rate and closing costs. Requiring an up-front agreement doesn’t make the broker less competitive, just more transparent. It will require the broker to educate the borrower on the differences between brokers and lenders and how each of them makes money. Now there’s a novel idea—an educated borrower. It appears the idea has started to gain traction. Washington Mutual announced in late 2007 that brokers would be required to inform borrowers how much money they’ll be making for each loan. Unfortunately, a short time later, Washington Mutual announced it was shutting its wholesale division.

  Since subprime has all but disappeared, the issue is not as relevant in today’s market. The majority of loans are being written for borrowers who present a good credit risk. These are the same consumers who have options and will typically go with the provider that offers the lowest interest rate and fees. But that shouldn’t be used as an excuse for not addressing the inherent flaws within the system. The day will come when credit standards begin to loosen, and when they do, the opportunity for abusive behavior will become more prevalent.