The bill approved in the House of Representatives proposes the use of a simple disclosure to identify the basic parameters of the mortgage—loan amount, loan-to-value, prepayment penalty, and other details. While out-of-pocket costs are included in the mix, the bill does not address the issue of an up-front agreement for brokers. Adding a paragraph that incorporates the language used in the South Carolina disclosure is the key to protecting consumers from unscrupulous brokers.
It’s worth noting that Congress has been considering a ban on yield-spread premiums (YSP). While the bill in the House of Representatives prohibits brokers from earning YSP for loans above the APR threshold, as discussed earlier in this chapter, restricting its use in any form is unnecessary if an up-front agreement exists between the broker and the borrower. Any limitations on YSP would significantly hamper the broker’s ability to compete in the marketplace.
If a borrower chooses not to pay a loan origination fee, whether he’s working with a lender or a broker, he’ll still pay for it in the form of a higher interest rate. While brokers must disclose this income as YSP, lenders have no disclosure requirement. They still earn the revenue from the higher interest rate when the loan is sold on the secondary market, only the borrower never knows about it.
Additionally, when a mortgage company advertises a no-cost refinance , it means the interest rate has to be raised so the premium earned from the higher rate can cover all the closing costs—proof that nothing is free in mortgage finance. Without the ability to earn a premium from the lender, brokers would be severely restricted in how they could structure loans for borrowers.
The next challenge is raising performance standards. This means focusing on two areas—knowledge, which is managed through licensing, and fraud prevention, which requires a creative, out-of-the-box solution.
Licensing and Accreditation
While many states have implemented licensing requirements for mortgage brokers, a national standard is long overdue. The question is whether licensing should apply to just brokers or to all loan originators. Some states exempt loan officers from licensing provided they work for a mortgage banker. The assumption is that lenders have a financial interest in the loan’s performance and therefore have greater controls in place. Even though brokers were the primary instigators, it’s clear that problems existed at every layer of the mortgage process. The solution is to hold all loan originators to the same standard, regardless of whom they work for.
Unfortunately, passing a licensing exam doesn’t equate with competency. Most state tests are relatively easy, requiring candidates to answer multiple-choice questions on federal compliance, state licensing laws, and ethics. These are important subjects but they in no way assure the licensee is a proficient originator. Since the current proposal in the House of Representatives calls for a national licensing process similar to what many states already require, the bill doesn’t go far enough to ensure that licensed loan originators will be competent.
The industry should consider raising its own standards and developing a system of accreditation. The Mortgage Bankers Association (MBA) has an accrediting process for mortgage lenders that leads to designations similar to those for accountants and financial planners, but there’s nothing in place to certify the expertise of a loan officer.
In November 2007, the National Association of Mortgage Brokers (NAMB) introduced the Lending Integrity Seal of Approval (LISA) to identify mortgage brokers and loan officers who meet the industry’s highest standards for knowledge, professionalism, ethics, and integrity. It’s a positive step, but given the timing of the announcement, which coincided with the House of Representatives nearly passing a no-YSP provision in their lending bill, it looks more like a public relations strategy than a real effort at accreditation. Since the approval process takes only six weeks and the requirements are relatively simple to meet—hold a state license, complete a background check, attend educational courses—it scores points for style, but comes up short in the substance department.
The recent debacle has given brokers a reputation similar to used car salesmen. Although the bankers and brokers associations don’t have a history of working together on issues, a collaborative effort to accredit loan originators would be a key step to rebuilding credibility for the industry. One day a CLO (Certified Loan Originator) designation could hold the same distinction as being a CPA or CFP. Allowing loan originators to earn a designation that recognizes their expertise not only improves their professionalism but also separates and identifies the strong performers from the average or weak ones.
Tackling Fraud—Thinking Outside the Box
With the recent upheaval in the real-estate market, the courts have shown a willingness to punish violators. In August 2006, a former American Home Mortgage Investment Corp. branch manager in Alaska was sentenced to two years in prison, fined $50,000, and ordered to pay $140,000 in restitution for wire fraud. He pleaded guilty to falsifying documents to secure stated income loans for customers while working for American Home Mortgage Investment Corp. and Countrywide Financial. This is the first known case in which an originator received jail time for increasing a borrower’s income on the application, a common industry practice.
While advancements in technology have improved the industry’s effort at detecting fraud, there’s still a long way to go. By most estimates, lenders lose tens of millions of dollars each year as a result of fraudulent activities. For our purpose, the subject of fraud is addressed at the broker level. Even though borrowers, title companies, and other industry professionals contributed to the problem, they require a separate analysis and go beyond the scope of this book.
Though my company encountered fraud on a daily basis, there was little we could do to help other lenders. Without a mechanism for sharing the information with other mortgage companies, fraudulent brokers could easily move from one lender to another. The solution is to develop a national scoring system that tracks fraudulent activities for all loan originators.
Just as borrowers are scored based on their total credit profile, loan originators would earn fraud scores based on how they performed relative to certain measurements. If lenders took the raw data from each loan (without the borrower name and Social Security number) and submitted it to a central repository, a group of skilled statisticians could use the information to develop a scoring model.
In order for it to work, the system would require a gatekeeper. Whether the score was developed by a private company or through an industry-wide effort (coordinated by the Mortgage Bankers Association, for example), the system would be dependent on lenders providing the gatekeeper with data to develop a scoring model. Any lender that wanted access to the scores would pay a subscription for the service. Ideally, lenders that contributed data to the service would pay less for the subscription than lenders that didn’t.
The key to making it work is to insure that the methodology is understandable to lenders and brokers. The reason goes back to motivation and behavior. If a loan officer realizes that his fraud score worsens if a large percentage of his deals are closed as stated income loans, he will be motivated not to take the easy way out. Conversely, if loan originators know certain behaviors will improve their score, they will be more inclined to act in that manner.
Once enough information has been compiled to create a reliable database, lenders will develop their own policies on how to use the scores. A loan officer who consistently received a poor fraud score would quickly find himself looking for a new career. A scoring system that potentially threatens an originator’s livelihood becomes an enormous deterrent to fraudulent activity. If the use of fraud scores gained widespread acceptance among lenders, the agencies could eventually use them in rating securities.
Appraisers
Chapter 4 conducted a thorough examination of the appraisal process, detailing how a property’s value can be manipulated. While today’s problems resulted from a multitude of issues, overvalued appraisals caused significant economic damage. The so
lution to fixing the appraisal process comes with reducing the ability of brokers and realtors to influence an appraiser.
The best idea would be to completely overhaul the system and assign appraisers on a random or rotational basis, similar to the system used by the VA and thus eliminating the pressure to inflate property values. But the enormity of this task makes it difficult to envision, and a more realistic solution should be considered.
In the early days of the industry, lenders provided brokers with a list of approved appraisers. If a broker submitted a loan and the appraiser wasn’t on the list, the deal was rejected outright. As brokers gained a larger share of the market, lenders loosened the requirement, believing it created an obstacle to attracting the broker’s business. In time lenders went from having an approved list to identifying only appraisers they wouldn’t accept, usually the worst violators. Letting brokers choose the appraiser may have reduced the barrier, but it also gave birth to a flawed process.
Of all the solutions discussed in this chapter, this one may be the easiest to implement: Reverting to the previous system would decrease the broker’s ability to influence the property’s value. The difference between having a list of approved and a list of unacceptable appraisers may seem minor, but it’s actually significant. Since lenders develop the list, an appraiser has to apply to them in order to make the cut. Having to earn and keep a lender’s confidence means thinking twice before giving in to the wishes of a manipulative broker. The threat of being removed from the list serves as a natural deterrent to massaging property values.
What are the negatives? If a broker moves a loan from one lender to another and the appraiser isn’t approved by the second lender, a second appraisal must be ordered, which costs money and creates delays. This issue, although minor, will eventually fix itself. Once lenders develop their own lists, brokers will start choosing appraisers that are sanctioned by multiple lenders or encourage their preferred appraisers to get signed up with multiple companies.
Since lenders set their own appraisal policies, it’s inconceivable that an industry-wide requirement could be mandated. Each lender would need to implement its own standards policy and develop a list of approved appraisers. Given that the total number of wholesale lenders has dropped by more than 60 percent over the last year, now is the best time to make this change. With brokers no longer carrying the influence they once did, if a few of the largest wholesale lenders announced the change, others would follow.
Of course, the underlying assumption is that lenders will act responsibly. Conventional wisdom dictates the risk of manipulating an appraised value far outweighs the reward for any lender. The financial upside from closing more loans is comparatively small compared to the repercussions of foreclosing on an overvalued property. In light of recent events, however, it seems that conventional wisdom may have taken a back seat to greed.
Andrew Cuomo, New York State’s Attorney General, filed a lawsuit in November 2007 claiming eAppraisalIT, a subsidiary of First American Corporation and Washington Mutual, colluded to inflate appraised home values. Since eAppraisalIT provided over 250,000 appraisals to Washington Mutual during the course of their relationship, a guilty verdict would create an avalanche of consumer lawsuits.
Although we can’t prevent a lender from acting irresponsibly if greed overtakes their thinking, Congress could prohibit mortgage bankers from having an ownership interest or participating in a joint venture with an appraisal company. This would require a provision in the national predatory lending law that lenders have no monetary or partnership interest in the appraisal company that conducts their work.
Lenders like Countrywide will argue that owning an appraisal services company allows them to accurately access a property’s value, but the conflict of interest is too great. Objectivity only exists if there’s distance between a lender and the appraiser. The SEC wouldn’t allow an investment bank to own an agency that rates their securities. Why should mortgage lenders be permitted to own an appraisal company that determines property values for their mortgages? It’s a conflict of interest that needs to be addressed.2
Lending Guidelines—Meaningful Changes
Chapter 5 explained how the industry creatively structured loans to make them saleable. For all the faults associated with the business, changing the entire way it operates is not realistic. If a loan has problems, someone will devise a creative solution. The key is to address the areas that will protect the borrower from predatory practices while not restricting the availability of credit to consumers.
The next section identifies guidelines that need to be changed and proposes viable alternatives, which will be compared to the bill approved by the House of Representatives.
Prepayment Penalties
As a consumer, it’s difficult to see the value in a prepayment penalty. When given a choice between a loan with a prepayment penalty and a loan without one, the natural inclination would be to choose the loan with no penalty. Unfortunately, the subprime industry failed on two fronts. It used prepayment penalties excessively and neglected to consistently give consumers other options.
When used correctly, prepayment penalties should allow for a trade-off. Any quote that includes a prepayment penalty should also include a corresponding alternative with no penalty. If a borrower chooses a mortgage with a prepayment penalty, he benefits from a lower interest rate, while opting out of a prepayment penalty means paying a higher interest rate.
The lending industry has argued that a total elimination of prepayment penalties will result in the reduction of credit availability to the consumer. I believe this is false. Each of our investor’s rate sheets had pricing options that ran the gamut from loans with no prepayment penalties to those with penalties for five years. Kellner could offer the same loan programs in every state; the only difference between them was the interest rate.
Over the last eight years, several states have addressed the issue with proposals ranging from total elimination of prepayment penalties to various restrictions on their use. When used fairly, prepayment penalties can serve their intended purpose without creating an unnecessary hardship for the borrower. To accomplish both objectives requires a national prepayment policy that includes the following components:
95 Percent Maximum Loan-to-Value (LTV). Prepayment penalties shouldn’t be allowed for mortgages exceeding 95 percent LTV. If a borrower purchased with no money down or refinanced the full value of a property, the likelihood that the home will sell or the loan will refinance in the near term is small. Prepayment penalties for loans above 95 percent create a hardship for borrowers who have to move unexpectedly. An alternative solution is to allow a “soft” prepayment penalty for loans above 95 percent LTV. This penalty would only apply if the borrower refinanced the mortgage and it would not apply if the home was sold. At present, the bill in the House of Representatives does not address prepayment penalties relative to LTV.
3 Percent Maximum Prepayment Penalty. A 5 percent prepayment penalty does wonders for a lender’s profitability, but it creates an unnecessary burden for consumers. By standardizing penalties using a step-down method, 3 percent for the first year, 2 percent for the second year, and 1 percent for the third year, the secondary market will get its deterrent and consumers won’t be excessively penalized. The 3/2/1 formula is the fairest approach for both groups. It allows the industry to retain the maximum benefit during the first year, when it needs it most, and less for the following years. This is identical to the current proposal in the House of Representatives.
Adjustable Rate Mortgages (ARMs). Prepayment penalties on adjustable rate mortgages should be limited in duration until the first rate adjustment occurs. If a borrower has a two-year adjustable rate mortgage, the prepayment penalty should be limited to 24 months. Whether a loan is fixed or adjustable, all penalties should be capped at three years. The proposal in the House is more favorable to the industry, allowing penalties to go three months beyond the initial adjustment.
ARMs—Chang
ing the Methodology
The steady rise we’ve seen in mortgage delinquencies is due, in part, to the widespread use of ARMs. To understand how this type of loan impacted the borrower’s ability to pay, consider the numbers in Table 7.1. It summarizes the debt-to-income (DTI) ratios for all full-documentation ARM loans my company closed from 2000 to 2005. DTI is calculated by adding together the monthly mortgage payment (including property tax and homeowners insurance), plus installment and revolving debt, and dividing that figure by gross monthly income. Most subprime lenders allowed maximum DTI ratios of 50 to 55 percent.
The first column is a range of DTI ratios in 5 percent increments, and the second column represents the percentage of loans that fit into each category. The second column shows that almost 90 percent of borrowers had DTI ratios of 50 percent or less. The third column estimates what the DTI ratios would be for the same loans once the interest rate adjusts (either two or three years into the future). Calculating this estimate requires making two assumptions: First, borrower’s income and debt levels remain constant, and second, the interest rate increases by 3 percent, the maximum allowed at the first adjustment period. This scenario is very likely for borrowers who obtained an ARM after 2003 when the Fed started raising interest rates.
Table 7.1 Debt-to-Income (DTI) Ratios (ARM Loans Only)
The impact of the rate increase is profound. Most borrowers started with DTI ratios that were already high. Once the interest rate adjusts, the ratios increase an average of 7 percent. While most borrowers had DTI ratios less than 50 percent at the initial closing, column three shows that six out of ten borrowers would have DTI ratios greater than 50 percent after the interest rate adjusted. This means the majority of these borrowers would no longer qualify for financing.
Confessions of a Subprime Lender Page 16
