July 21, 2008

What matters most

Last week there was this in the WaPo regarding the criticism of a bailout by the Fed's of Fannie Mae and Freddie Mac. At the end of the day, the question is not whether IT is right or wrong; The question is whether or not it will do the trick.

As for Fannie and Freddie, nobody would be particularly happy if it became necessary for the Treasury to inject some fresh capital into the mortgage giants, in exchange, say, for newly issued preferred stock that could be sold back at a profit when the mortgage market recovers. But even the editorialists at the Wall Street Journal acknowledged yesterday that this wee bit of socialism might be the most effective and least costly way to keep the mortgage market functioning and prevent a meltdown in global credit markets.

A financial crisis is not a morality play. What matters most isn't the precedents that are set, the amount of taxpayer money that's implicated or whether people are made to suffer fully for their financial misjudgments. In the end, what matters most is that we get through it as quickly as possible with an economy and a financial system intact.

Friday I had the opportunity to sit through the Subprime Lending panel at Netroots Nation. Honestly, I expected much more mostly because I have a tremendous amount of respect for the people on the panel. Even Rep. Miller who seems, though well intentioned, very unwilling to understand the impact of what he wants to do.

For one thing, Rep. Miller has a real problem with mortgage brokers. ALL MORTGAGE BROKERS. Working in the industry I can tell you from first hand experience that there are far more great brokers than mediocre or even bad ones. Rep. Miller makes no distinction between the two groups. In fact, he really doesn't understand the difference, apparently, between brokers and bankers. Nor does he seem to realize that the end effect of his legislative agenda will not be to kill an industry or to stop abusive lending practices. It will be to convert brokers to bankers.

Both Miller and Mark Griffith really seemed to come alive at the notion of new regulations and laws restricting what they considered to be unfair lending products. They are operating from the mistaken assumption that some of these products were engineered to create default or, worse, continual refinancing. I say mistaken because neither of them are apparently aware of the fact that loans that pay off early end up costing investors money and banks hate foreclosures, mostly because they end up costing more than a loan that just pays off. But I digress... the point was new laws and regulations. Which aren't really needed because the ones that are ON the books now would have gone a long way to preventing the current crisis. However, they weren't enforced. Griffith and Miller live in that fantasy world where people always follow the law and there's no need to fund the people who look over their shoulders. I guess neither of them have ever driven on a freeway.

Hale Stewart made some excellent points and, having worked in the securitization side of the industry, had a great command of the subject matter. He made a comment that 20% of Countrywide's non-prime portfolio (made up of deep subprime and Alt A credits) was delinquent. That's true, but the actual default rates are the key and they aren't near 20%. Countrywide hasn't disclosed them, but industry estimates put the number at close to 5%. While Cwide didn't price these credits for the underlying risk (they booking these loans at far too low a coupon), the default estimates are inline with what you would expect for loans of this type.

There was one minor point that made regarding Hale about securitization and elimination of risk. Some investors, the same ones who are panicked right now, never understood that home loans can go bad. Even the ones with really high credit score borrowers and big down payments. Securitization was a way of balancing risk and creating fungible product that could be traded like a bond. Hale was spot on in that investors panicked when they discovered that securitization didn't mean complete and total safety.

The panel, on the whole, presented about half and half in terms of correct information vs. incorrect information. It was the stuff that was bad that got me since it wasn't just wrong, it was REALLY wrong. For instance, Griffith claimed there aren't subprime borrowers, only subprime loans. While this may fit an progressive ideological frame, it does not fit reality. The reality is that some people have credit that is significantly worse than others, people who have shown a history of paying slow or not at all on even the most minor debts. Should these people receive the same terms and interest rates that people with fantastic credit get? If so, how exactly do you plan to compensate lenders for the substantially higher risk of default you're asking them to assume? That thought apparently had not occurred to Griffith.

Griffith also discussed the right wing talking point that CRA REQUIRED subprime lending. He's right and wrong in saying that's not true. While CRA did not require 2/28 ARMs and Pick A Pay, it did lead to the creation of subclasses on the prime side represented by products like Freddie Mac's Home Possible and Fannie Mae's My Community. Both of these products required minimal or no down payment (a high risk factor), had income limitations (usually no more than 100% of area median income unless the property to be used as collateral was in a designated census tract for renewal), were aggressively priced and the mortgage insurance on them was far lower than the coverage on comparable prime products. To add to the risk on the loan, these products were extended down to credit classes that would ordinarily have been unacceptable on the prime side. The end result is that the loans having the most problems on the prime side are these, vintage 2006 and 2007 when the guidelines were loosened so dramatically that damn near anyone could get a loan as long as they could prove income.

The panelists were unclear as to what to do to fix the problem of abusive originators. So, I'd like to offer a few suggestions that will actually work... these are geared toward cleaning up and standardizing origination. The larger problem in the industry right now, liquidity in the market and solvency of the firms, is being addressed and should be considered a separate issue. You'll note that I'm using originator exclusively in this... these rules should apply to EVERYONE in the market, whether banker or broker.

1) National licensing for all originators. The state by state foolishness has to stop and there needs to be a national program in place to regulate.

2) Eliminate prepayment penalties. My peers will hate me for this, but the reality is that these penalties end up not producing stability in a portfolio which is why they were put in place. Period. Therefore, it makes sense to scrap them altogether and price loans appropriately for a payoff in 4 years or less.

3) End bait and switch... this happens infrequently but often enough that it's a problem. The best way to do it is to eliminate all advertising which bears an interest rate. These are teasers and only available to those with superb credit and 20% or more to put down. Needless to say, that doesn't remotely represent the majority of the borrowers in the market. Further, eliminate all disclosure of rate at initial application. Most of the time, when a borrower first applies for a loan, they don't even have a house selected yet. No underwriter has seen the file to determine if the borrower meets credit guidelines. In that condition, there is no way for an originator to disclose rate and they shouldn't be doing it. Rate should not be disclosed until the loan has been through initial underwriting and a house has been selected. At that time an originator should fully disclose a locked rate and the money they are making on the end sale of that loan.

What no one on the outside realizes is that an interest rate must be locked prior to closing a loan. Every one that 'falls out' (doesn't close) ends up costing money. No one comes after the borrower for this. However, we expect originators to commit to an interest rate BEFORE knowing the risk on the loan which is absolutely insane.

4) There need to be definitive metrics for originator performance. Offering 'the best rate' is not enough since not everyone is entitled to the same rate or terms. What these metrics might be are fairly simple. For example, if a borrower wants to refinance their home without cashout, does the new loan meet a net tangible benefit to the borrower in saving them money? If so, then the originator has fulfilled their obligation to the borrower. Does the borrower have the wherewithal to make payments on the house in the event of a job loss or other financially damaging event? If no, the originator should have the responsibility to terminate the transaction.

There also need to be some easy to understand disclosures to the borrower that if they change properties they'll lose their rate lock. If they decide to materially change the terms, the rate may change. Borrowers have to understand that their decisions and delays in providing necessary documentation can put their loan in jeopardy.

5) Absolute ban on all payments by originators to Realtors under any circumstances and a complete ban on any Realtor having an ownership interest of any kind in an originator. While we're at it, lets just go ahead and ban cross ownership by people or businesses in the industry. Realtors shouldn't own appraisers or title companies. Originators shouldn't own credit companies, etc. Every piece must be independent from the others to maintain the integrity of the system. And throw in the builders as well. They don't need to subsidize their primary business with mortgage lending because it has a real impact on the true value of the collateral.

6) Restrict, either through legislation or Fed regulatory guidance, the use of limited or no doc products. These are FANTASTIC products... for a self employed borrower with 10% or more to put down, fantastic credit and who can prove low payment shock (i.e., not jumping from $800 per month in rent to $3500 per month in mortgage). These are not loans for W2 wage earners who are trying to buy more home than they can realistically afford. The panel on Friday addressed this and they were SPOT on. However, there seemed to be agreement among them that these products were de facto bad and it's simply not the case. The problem is that they were handed out like candy to people who frankly didn't require them. Not to mention the fact that, again, they weren't priced appropriately for the underlying risk of default which was substantially higher than a full doc Fannie/Freddie loan.

7) Eliminate all option ARM and Pick A Pay loans. Really, do I need to go into this? A home loan with credit card-like repayment terms is just a bad idea and a prescription for default.

8) SEVERELY restrict home equity lending. It frankly should not be so easy to pull equity out of your home. Further, you should not be able to pull out more than it's worth. This is not only to protect homeowners but banks as well. Texas has some very restrictive home equity laws that could serve as a good starting point.

9) Mandate disclosure of YSP/SRP at time of rate lock. This disclosure should explain to the borrower that the low out of pocket costs for their mortgage are being covered by this fee paid by the lender to the originator and that the money represents the profit to be made off servicing that loan until it pays off. Brokers are already required to do this. Banks will throw a fit. However, if you want to level the playing field and make things transparent, then this is the way to go.

As for YSP, it's time to note something. I have originators here in Austin that I work with who write mortgages at basically par rates. They provide no real customer service and they only accept applications with extremely good credit and at least 20% down. Obviously, this is a very narrow segment. I have others who charge more and price their loans at higher coupons. However, they deliver superior service to their borrowers. They also work with borrowers who the other originators wouldn't touch. Both groups are still, on average, cheaper than retail banks.

Banking is, at it's core, a service. No service is free and people should be compensated for the work they do. This has got to be understood. When I originated I had an extremely loyal client base. I still talk to most of them. Some of them could have found better rates somewhere else and they knew it. However, they came to me because I answered their questions, worked with them on their plans and gave them the options they had available. To them that was worth an additional 12.5 basis points (1/8th of a point on the interest rate).

For a more readily understandable example, I have been going to the same lady for haircuts for 7 years. I don't go to her because she's the cheapest. I go to her because she does a great job and she's a blast.

10) FUND REGULATORY AND INVESTIGATIVE BODIES. Rules and regulations are worthless without enforcement and I, among many, have been begging for it for years.

Most of these ideas would be supported by the industry wholeheartedly. Well, except for maybe banning prepayment penalties but that's just a cross they'll have to bear. As for the budding consumer advocates, you're never going to kill payments of YSP. PERIOD. All you're going to do is force brokers (who have to disclose YSP) to bankers who don't have to disclose. The solution is to make everyone disclose and make the disclosure easier to read so people can really compare apples to apples. As a side note, there is an element of stupidity in the let's ban YSP movement. In ANY market there are going to be some providers of a good or service who charge more than others. Be a savvy shopper and really think about the level of service you want and are willing to pay for. I don't shop at Neiman Marcus because it's the only place that has clothes, I shop there because I want my ass kissed when I go to spend money. That and my experiences buying clothes online have been something of a dismal failure.

In the final analysis, ideological blinders, whether Democratic or Republican, are absolutely worthless. Demonizing whole industries, especially when it's clear you don't understand them, is counterproductive and stands a good chance of digging us deeper into the hole. Make an effort, policymakers, to understand the industries you are trying to regulate and work with the people in them on rational solutions. Those of us in the industry would do well to make necessary changes now.

Posted by mcblogger at July 21, 2008 01:56 PM

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