by Tanta on 5/19/2008 10:28:00 AM

Ken Harney reports in the LAT:

The FHA, which for decades has used a one-size-fits-all approach to pricing its insurance on home loans, plans to shift to a "risk-based" system keyed to FICO scores and down payments, beginning as early as mid-July. Private-sector lenders and insurers have priced interest rates and premiums using sliding scales of FICO scores and down-payment amounts since the mid-1990s.

The agency's move, which will cover new applications including "jumbo" loans up to $729,750 in high-cost markets through December, will bring the FHA in line with the private sector's main approach. . . .

Under the old approach, [Montgomery] noted, buyers with stellar FICO scores paid the same premiums as borrowers with poor scores. That amounted to a pricing inequity for applicants who presented a low risk of default on loans and an inappropriate subsidy of applicants who were likely to default.

A study of an entire year's applications turned up the additional fact that the FHA's lower-income borrowers typically had higher FICO scores than those with larger incomes.

"Is it counterintuitive? Yes," Montgomery said.

According to the study, applicants with FICO scores of 680 to 850 had a median income of $48,756 last year, while those with low scores of 500 to 559 had a median income of $53,388. Fair Isaac Corp.'s FICO scores range from about 300 to 850 -- the higher, the better -- and are predictive of future defaults and foreclosures. Even at rock-bottom down payments of 3%, applicants with lower incomes had higher credit scores than applicants with bigger incomes making similar-size down payments.

I would like to get my hands on that study, which I haven't yet found online. (If any of you have a link, please drop it in the comments.) I did locate this HUD document that outlines the actual premium schedule currently proposed; it provides only one chart with aggregated information on income/FICO breakouts for 2007 FHA applicants in the Appendix. You might be interested to know that the original proposal for risk-based premium pricing distinguished between source of downpayment funds, with borrowers using such things as the notorious DAP (seller-funded "assistance") paying higher premiums than borrowers making downpayments from their own funds or a gift from relatives. That provision has been eliminated.

As far as I know, there is better data on relative performance of FHA loans with or without DAP than there is on relative performance of FHA loans with FICOs just over or just under 600. But HUD is forging ahead with FICO-based pricing while pulling back on downpayment-source-based pricing. I'm having some problems with that.

I think it's important to concede that FICOs do indeed have an established track record of establishing relative default probabilities. The trouble we have had recently with FICOs is mostly, in my view, that they were relied on to offset extremely high risk characteristics in loans with a lot of "risk layering." The problem is not that a 90% LTV loan with a 720 FICO won't outperform, statistically, a 90% loan with a 620 FICO. It will, although it isn't always clear that the difference in performance is all that substantial. The problem is that a 100% loan with a 720 FICO will not necessarily outperform a 90% loan with a 620 FICO. The idea that a high(er) FICO offsets lack of downpayment or high DTI is currently dying a painful death.

The difficulty, however, with deciding that a (theoretical) 90% loan with a 720 should pay a lower risk premium than a 90% loan with a 620 (all other things being equal) is the problem of calibration. How significant is the difference in default probability? Of course, with the FHA premiums the question is how significant the difference in default probability is in some pretty small FICO buckets that are already well within the "subprime" or high-default-probability range. For instance, in the highest-LTV group of loans, the new upfront premium is 200 bps for FICOs from 560 to 599 and 225 bps for FICOs from 500 to 559. But is there really a significant difference in default probabilities in these two FICO buckets? Enough to warrant 25 bps in premium? I would really like to see more information on how HUD calculated all this.

Part of what is bothering me is this set of charts provided in a recent Moody's investor presentation. These numbers are based on a representative sampling of loans closed between the first quarter of 2006 and the second quarter of 2007.

This is of course only one data point, but it certainly raises a question in my mind about making FICO-based premium distinctions within the general category of subprime FICOs, particularly since in the new premium scheme a loan with a downpayment made by the builder gets treated the same as a loan with a downpayment coming from the borrower's own funds. I would really like to see the work on this one.

It gets Nerdier from here . . .

by Tanta on 4/10/2008 08:34:00 AM

It does upset them so much.

This is a rather startling NPR piece about NACA, a non-profit housing assistance outfit, recruiting former subprime brokers (on the "it takes a thief" model, apparently). I was struck by the phrasing here (I see this a lot):

Barbosa says she was pretty fair to her clients and got them the best deal she could in the marketplace. But she says there was plenty of incentive not to put the customer first: Lenders would offer her 1 percent or 2 percent of the price of the loan as a kickback if she persuaded her client to take a higher interest rate. That was legal and commonplace.

Then there were the negative-amortization or "pick-a-payment" loans. Those offered low payment options to begin with but often exploded on the homeowner. As interest rates reset, often at much higher levels, homeowners faced larger payments. That's because the minimum payment required at the introductory rate didn't even cover the interest on the loan, let alone the principal.

"The bottom line is that the lender offered an incentive of 3 percent to the broker if they put [a client] into that particular loan," Barbosa says.

I truly wonder how people who have never been a wholesale lender or a mortgage broker think this works. Read it with naive eyes: it rather sounds the lender is doing a real sales job on the broker, doesn't it? As if the lender called up and said something like, "I see you have here a 7.00% loan. You know, I could pay you a couple of points if you can change this to 8.00%. Or, you know, three points if you can go with the "Pick A Payment." What do you think? Want to be rich today?"

However. Unless things changed markedly in this business in the few years since I worked in it, it doesn't really play out that way. Brokers get rate sheets faxed to them by wholesale lenders. Those "premium" rates with the 102-103 pricing are simply printed on the rate sheet along with the "par" rates. Certainly you can conclude that if wholesalers didn't want brokers to use those premium rates, they wouldn't have published them on the rate sheet. On the other hand, I'm a touch doubtful about the implication that these rate sheets did such a high-pressure sales job on these brokers. After all, you can conclude that if the wholesalers didn't want brokers to use the par or discounted rates, they wouldn't have published them on the rate sheet either.

It is a bit tendentious of NPR to use the term "kickback" here for what is, currently, a perfectly legal practice. I suggest that this is a measure of how disgusted the public has become with mortgage brokers: the public, unlike the regulators and the industry, fails to see any meaningful difference between an illegal unearned "referral fee" (the classic definition of the "kickback") and "Yield Spread Premiums" or "normal" broker compensation. I suspect, however, that a lot of brokers will want to shoot the messenger.

(Thanks, Ziggurat!)

by Tanta on 4/09/2008 11:07:00 AM

The Center for Responsible Lending released a fascinating paper yesterday, "Steered Wrong: Brokers, Borrowers, and Subprime Loans." Using a nationwide database of prime and subprime loans, both retail and brokered, originated in the 2004-2006 period, the authors "paired" retail and brokered loan transactions with similar risk characteristics (such as FICO, LTV, DTI, and loan amount, among others), to compare interest costs over a one-year, four-year, and life of loan (30-year) horizon. The results are no doubt stunning as well as surprising to a certain reliably-stunned-and-surprised contingent of the regulatory and securitization enclaves:

We find significant differences between broker and lender pricing on home loans, primarily on mortgages originated for borrowers with weaker credit histories. During the first year of the loan, borrowers with credit profiles in the subprime range pay statistically more for brokered loans than they would have if they had obtained their loan directly from a lender. Over a four-year period, a typical subprime borrower pays over $5,000 more, and over the 30-year life of the loan, the cost gap grows to almost $36,000. . . .

Significant disparities exist between broker and lender pricing. After matching loans on objective factors that affect interest rates, the analysis reveals that interest payments were significantly higher on broker-originated mortgages in the majority of risk categories we examined. Disparities are greatest for subprime borrowers. For people with weaker credit, brokers consistently charged higher interest rates than retail lenders. A typical subprime borrower was slated to pay $5,222 more during the first four years of a $166,000 mortgage compared to a similar borrower who received a loan directly from a lender. Over thirty years, this borrower would pay $35,874 more in interest payments, equivalent to an interest rate approximately 1.3 percentage points higher than a similar borrower with a retail loan.

Cost disparities grow greater after initial years. For subprime borrowers, significant disparities are apparent even during the first year of the loan. However, because so many subprime mortgages come with short-term introductory rates that rise substantially when they adjust, the cost disparities become more pronounced after the first four years of a loan. Prime borrowers generally do not pay more for brokered loans. In general, people with higher credit scores—those who received prime loans—did not pay higher interest on broker-originated loans. In fact, some borrowers with very high credit scores who received loans from brokers achieved modest savings, although long-term savings were largely limited to fixed-rate loans.

The study zeroes in on two basic "market mechanisms" in play: the fact that borrowers with weaker credit are less informed about competitive rates and less able to analyze the often complex products they are offered than prime borrowers, and that brokers are more inclined to raise "profit margins" on low-volume business (subprime) and maintain thinner margins on high-volume business (prime). What I find most refreshing about the approach is that it mostly dismisses the issue of "better disclosures" as a regulatory side-track. That's a long-time hobbyhorse of mine, too.

Given the prevalence of brokers in today’s market and their impact on the ability of borrowers to build and maintain home equity, we propose specific policy recommendations below.

First, yield spread premiums and prepayment penalties should be banned on subprime mortgages.

Second, lenders should be more accountable for the actions of mortgage brokers originating loans in their names and investors should share responsibility. Third, mortgage brokers should have a
fiduciary responsibility to the borrowers they serve. . . . Notably, our proposals do not focus on increased disclosures. While improved disclosures and increased financial literacy are laudable goals, the magnitude of the problems identified in this paper indicate the need for a direct and immediate response. Moreover, experience and findings from behavioral economics as well as findings related to limited financial literacy among consumers suggest that improved disclosures are likely to have limited effect, at best.

I strongly recommend the entire paper to those of you with an interest in the matter. I want to suggest something that the authors of this paper do not suggest, but which I think cries out for further study.

The CRL paper does comment on the possible causes for retail lenders' pricing practices in regard to subprime loans:

People with weaker credit scores naturally pay more for mortgages than people with strong scores. However, it is very difficult for borrowers with weaker credit or less experience in financial matters to know precisely how much more is appropriate, especially since, unlike prime rates, subprime rates are not generally publicly available. In addition, subprime loans tend to be much more complex than the fixed-rate mortgages that have long dominated the prime market, making their costs more difficult for borrowers to compare. Accordingly, we hypothesize that brokers have been able to take advantage of this situation by
emphasizing maximum revenues per loan for subprime borrowers. While retail lenders are probably not immune from these dynamics, we believe the effects on the costs of retail loans are less pronounced due to more regulation, better internal controls, and concerns about reputational risk.

Depository retail loan pricing has been subject to "fair lending" as well as safety and soundness examination--not just regulation--for quite some time. What I doubt most consumers and observers realize is that since at least the early 90s, retail lenders used loan origination systems that "integrated" the lender's rate sheet and the loan application; the "rate sheet" is simply a printed version of rates and prices calculated by the system based on imported market price data, established tables of profit margins by branch, and "rules" or calculations that adjust rates for lock periods, "buy up" or "buy down" rates by calculating premium or discount prices for higher or lower rates, and apply various loan-level adjustments to rates or prices for individual loan characteristics. Importantly for our present purposes, these systems "know" when a loan is priced above or below the required rate sheet price--this is known as an "overage" or "underage," meaning that the price or points of the loan are more less than the required price. Not only do they "know" this, they also store this information, which can then be pulled into reports and analyzed for frequency, patterns, and possible discriminatory practices. There just aren't many "rogue loan officers" in a retail environment in which all loans must be "priced" with the computer, and in which a pattern of "overages" will result in a report on someone's desk sooner rather than later.

A practice that developed, formally or informally, in the 90s was often called the "point bank" or "price bank." Individual originators or branches were basically allowed to charge overage or underage on individual loans, as long as the monthly or quarterly pipeline "balanced" to zero or thereabouts. An overage or two (or three . . .) could be "banked" and used in essence to subsidize a concession or two on other loans.

Point banks, in my view, were complete disasters. A whole lot of lenders found--sometimes with the assistance of their examiners--that the concessions were being offered to, precisely, those "best customers" who could shop around or negotiate or quite possibly were just part of the loan officer's social or business network. (They were frequently RE agents, builders, or other mortgage market participants the loan officers wanted to "reward"). Meanwhile, the overages that paid for those concessions were being charged to the least informed borrowers with the weakest "bargaining position": weak credit borrowers, first time homebuyers, and small-balance loans (the latter of which don't pay handsome commissions in dollars, but are just as much work for a loan officer as a larger loan).

In other words, weaker and less informed (and possibly more financially prudent) borrowers were "subsidizing" the rates offered to the strongest, best informed, and quite possibly most debt-heavy borrowers. Insofar as the largest loans were most likely to get a concession, and the smallest loans most likely to be charged overage, it generally required several small loans with overage to each single large loan with a concession to make the "point bank" balance. It does not take long for this pattern to appear on the reports. There was a time, at least, when it didn't take long for regulators to issue some threats regarding this behavior. Retail originators basically lost interest in the "point bank" idea as corporate policy.

I bring all this up because brokers often argue--at least in the comment section of this blog, they do--that they offer highly competitive rates on prime business, indeed, often better rates than a retail lender would offer the same customer. The CRL study backs this up to a limited extent:

[B]orrowers with higher credit scores pay virtually no additional interest and occasionally pay modestly less interest when they receive their loan from a broker versus a retail lender, and borrowers with lower credit scores pay more interest. What’s more, the figures illustrate that the additional interest paid in brokered loans increases dramatically as credit scores decline. The figures also help clarify that the results vary considerably between loans that would be considered prime and those that are subprime.

In essence, retail lenders charge slightly more for prime loans than brokers, and much less for subprime loans. (Note that this analysis is precisely attempting to control for individual risk factors by pairing comparable loans; the difference cannot therefore be due solely to brokers originating the lowest-quality end of the subprime spectrum more frequently than retail lenders.)

My suggestion is that we ask whether brokered mortgage lending is, in practice, running on the old "point bank" model that retail lenders largely abandoned, in which "strong" borrowers are basically subsidized by "weak borrowers." The defenders of "risk based pricing" have always argued that loan-level pricing adjustments are fundamentally fair, because "average" pricing would mean that the highest-quality borrowers were paying more to "subsidize" lowest-quality borrowers. Yet here we have a study that weeds out the "risk-based pricing effect," and that shows that in fact in brokered business the weakest borrowers seem to be paying more than their fair share of risk, with the savings passed through to those borrowers who can demand competitive rates, whether that is because of their credit profile or simply their social profile.

The CRL study touches on the question of the "brokered loan premium," which also needs further analysis and study, in my view:

Finally, we note that part of the explanation for higher rates could arguably arise as a consequence of expectations for worse loan performance among brokered loans. In other words, under this explanation, lenders who expect worse loan performance on brokered loans charge higher baseline rates to “price in” the added risk associated with a loan originated by a broker. Alexander et al offer an analysis of subprime loans consistent with this theory, but end up with a net effect of just half a percentage point.37 Moreover, they do not distinguish whether this increase is associated primarily with increased default risk (which they do detect) or yield spread premiums. Even if the entire amount were attributable to increased default risk, the reported half percentage point difference would be less than half of the 1.3 effective percentage point difference we report here. Moreover, since we control for the vast majority of risk factors, we believe our analysis already directly controls for much of this concern. In addition, to the extent that broker-origination itself is the risk factor that may cause higher delinquencies we question whether the risk factor could be related to the very additional expenses we identify here. In addition, Jackson and Burlingame do explicitly isolate yield spread premiums to identify differences.38 Consequently, the differences they report between brokered and retail pricing have their origin with the broker and cannot be the result of higher prices built in by a lender to account for anticipated worse loan performance.

This is a profoundly important question begging for sophisticated empirical work and analysis, since it gets to the very heart of the matter from a consumer standpoint. If there is such a thing as "brokered transaction risk" that is logically and analytically separate from "borrower default risk," that is to say that there is something about the brokered loan transaction or broker business model that results in higher defaults or (more likely) increased prepayments from churning that eat into lender profitability on loans, all other things being equal in terms of the underlying loan characteristics. The idea of a "brokered loan premium," then, would signal that wholesalers are pricing this in by charging higher rates/prices to brokered loans than to retail loans across all credit categories/loan types.

This immediately raises some troubling questions: If there is a "brokered loan premium," are consumers aware that they are paying higher credit costs by using a broker? If there isn't a "brokered loan premium," then the pricing differentials identified must be due solely to brokers' practices, not the wholesaler's policies. Do consumers understand, then, that by using brokers they are quite possibly subject to pricing practices that differ substantially, at least on the aggregate, from retail pricing practices?

We need to bear in mind that even twenty years ago, there were relatively few nationwide lenders, there was no internet, and there were substantial pockets of the country in which there simply wasn't an easily-accessed depository retail lender who offered a wide array of mortgage product, and specifically subprime credit. Brokers filled the market need in those areas by being able to access out-of-state or niche lenders on the borrowers' behalf. In such an environment, paying a "brokered loan premium" hardly seemed unfair to consumers.

Yet we are long since past such an environment, in my view. Insofar as a "brokered loan premium" exists in areas already saturated by Megabank branches on every corner offering mortgage credit all the way down the spectrum from prime to subprime, and insofar as the internet offers consumers access to direct lenders anywhere at any time, it is distressing to think that borrowers are still paying a premium for the services of an intermediary. This is particularly troubling given that consolidation in the wholesaler business means, in many markets, that brokers are all relying on the same dozen or so mega-lender rate sheets; I see little evidence that brokers are still able to find "inefficiencies" in the delivery of mortgage credit to underserved areas, or seek out small niche lenders to make them available to borrowers who could not otherwise find them--not when the big wholesalers are all offering "niche" products.

No doubt a lot of people will be troubled by the implication I am making that more than a few "good" borrowers got better rates than they probably should have, courtesy of those "bad" borrowers who paid not only their own "risk premium" but part of someone else's, as well. But I am more and more convinced that this has occurred at least in those markets that saw the explosive growth of subprime originations in the period in question. We are clearly seeing higher rates and prices paid by prime borrowers now, in the throes of the credit crunch, than we have in the past. A certain segment of the market (and nearly all the media) wishes to see this as an "overreaction" to "subprime problems," meaning that those most excellent borrowers are "paying too much" and that prices should return to "normal" once everyone realizes that the world hasn't ended. I have my doubts about that.

If, in fact, "normal" prime or "super prime" pricing for the last several years was subsidized by an unprecedented growth in subprime originations--for which there is certainly evidence of some "steering" of decent-quality loans into those high-rate subprime products--then "normal" pricing won't be back if we lose some 20% of the applicants who can be made to keep pricing "competitive" for those who know how to and can "compete." It seems to me, at least, that further research and analysis of this question is time much better spent than, say, tinkering with new disclosure forms.

by Tanta on 3/19/2008 04:48:00 PM

HUD has just released yet another proposal for changing the disclosures required under the Real Estate Settlement Procedures Act (RESPA), a federal law that is implemented by regulations promulgated by HUD. I’m not terribly impressed by the proposal, but it’s hard to say why without a lot of background rambling. So I’m going to ramble. Those who aren’t up for it should skip this. In a future post, I’ll get into the specifics of what I don’t like about the proposed new GFE.

A quick recap: RESPA requires a lot of things, two of the most important of which being the Good Faith Estimate of settlement costs, known as the GFE, and the HUD-1 or HUD-1A Settlement Statement, the exact accounting of closing costs and settlement charges given to borrowers when the loan closes. The GFE is given at application. The idea when RESPA was first enacted was to prohibit lenders from giving low-ball estimates of costs up front, only to shock the borrower with a lot more costs at closing, when it was often “too late” for a purchase-money borrower (or a refi borrower with a rate lock expiring) to back out. The estimates of costs on the GFE have to match what’s on the HUD-1 within a certain tolerance, or else you have a regulatory problem. The GFE/HUD-1 rules have been around for decades. In the last few years HUD (the agency, not the document) has made a few attempts to revise them, all of which have failed for one reason or another. The current proposal is just the most recent in a long line of unsuccessful attempts to get control of the disclosure of financing costs to borrowers, most specifically in the case of brokered loans (although the new rules would apply to retail lenders as well).

In some ways, what HUD is doing is formalizing the brokered application model into the RESPA disclosure scheme, a decade or two after certain problems and concerns first arose. One of the troubles that wholesale lenders have had for a long time is making sure they’re meeting RESPA rules for when the GFE has to be given to the applicant; the rule has for a very long time been that the disclosures must be provided within three business days of “application.” But what is the date of “application”? The date the broker takes an application from a borrower, or the date the wholesaler receives an application from the broker? From the borrower’s perspective, of course, this is easy: it’s the day you gave the broker sufficient information to complete the application. This implies that it is the broker’s job to provide you with the GFE. (And for what brokers charge borrowers, you might well think providing a written estimate of closing costs isn’t so much to ask.)

But the wholesaler has always had a problem here, because the wholesaler is going to close that loan and the wholesaler is going to have the “RESPA risk,” or the risk that the disclosure was inaccurate or not provided in a timely fashion. As with other things, it has never especially mattered that it might be the broker’s “fault”; brokers haven’t got the money to make you whole on fines, penalties, recissions and re-closings of loans, or sales of loans as “scratch and dent” because the higher-paying investors won’t buy a loan with iffy RESPA docs in the file. So wholesalers developed this habit of simply “redisclosing” or providing a GFE for the borrower within three days of getting the application from the broker, even if the broker had already supplied one. This was supposed to assure that whatever the broker did, the wholesaler complied with RESPA and made sure that the fees disclosed on the GFE were fees the wholesaler was comfortable with charging on the final settlement statement.

That meant several things, one of which is that borrowers were usually waiting the three full business days to get a GFE, and were paying application fees before getting one. At minimum, borrowers were paying for credit reports, since in these days of risk-based pricing, you don’t get a GFE until we know what your rate/points are, and we don’t know that (even approximately) until we know what your FICO is. RESPA, which predated such practices, was based on the assumptions of an older way of doing business, in which an application could be submitted and an estimate of costs given well before any “processing” on a loan, like ordering a credit report, commenced. Of course, once a borrower has paid a fee to get a GFE, it’s much less likely that borrower will “shop around” and pay several other lenders the same fee to get alternative GFEs.

It also pretty much erased—and then some—the wondrous efficiencies we had achieved at least since the mid 90s with cool technology. I am hardly the only person to have spent centuries of her life she’ll never get back in meetings and task forces and committees and piles of documentation and user testing working on rolling out “point of sale” (POS) technology that would allow loan officers armed with laptops and a portable printer to take a complete application right there, on the granite countertops, at the open house, and print out a pretty, complete GFE, right there on the granite countertops. With a dial-up connection, the LO could run the loan through an AUS and even hand out a commitment letter (subject to getting the appraisal and so on). Ah, the glorious days of progress, when we congratulated ourselves on providing a GFE to applicants in three business minutes.

It’s not exactly an accident that the acronym “POS” means both point-of-sale and piece of . . . stuff. There were any number of problems with the POS technology, not the least of which was those portable printers, which were “portable” as long as you didn’t expect them to be “printers” and vice versa. Many lenders got gung-ho about giving their loan officers the authority to issue commitment letters at POS, and found themselves committed to making loans that the underwriting department wouldn’t have approved on PCP. There was also, it transpired, a little problem with those pesky consumers. It turned out that what they really wanted out of life wasn’t always to stand around at an open house giving personal information to an LO and getting not just “estimates” but a commitment letter they were feeling pressured to sign without any cooling-off period or shopping around. As is often the case, the industry told itself customers were really interested in speed, when in fact the industry was really interested in speed and the customers had to be made to see reason about it. I can remember at one point a local competitor of mine proudly announcing it didn’t offer that “high-pressure tactic” of POS technology, and that competitor took a lot of our business.

The issue for retail originators was having an LO out there like a loose cannon with a laptop, making quickie commitments often based on quickie evaluation of the borrower’s seriousness or capacity. Those commitments were always supposed to be “subject to” finally getting all the real documentation and verifications and so on, but some loan officers figured out that such a heavily-conditioned commitment is hardly much of a commitment—it just encouraged people to “shop around”—and so “competitive pressures” led to leaving out a lot of those conditions. In fact, at least one of us believes that the “stated income/stated asset” phenomenon really began here. The Official Story in the industry is that it grew out of perfectly reasonable ways to underwrite self-employed borrowers with complicated financial lives, and somehow spread to W-2 borrowers with a single checking account when we weren’t looking. I don’t personally remember it happening that way.

The issue for wholesale lenders was even worse, since the brokers often weren’t quite sure which wholesaler they’d be closing this loan with—it would depend on who paid the richest premium, often, and that couldn’t be established until they got back to the office and checked rate sheets. So the brokers would hand out GFEs based on wild-arsed guesses of the fees required by the wholesalers, leading to endless situations in which the fees charged on the final settlement statement were pretty far off the original estimate, leading to endless situations in which regulators and consumer attorneys had to remind everyone what the “good faith” part of GFE meant. That was when the broker actually bothered to hand out a GFE, or do it within the holy three days. The wholesalers concluded it would be better for them to “re-disclose” on receipt of the application package (later, the electronic submission) from the broker. Aside from the monumental customer confusion that creates—which GFE is the “real one”?—it began to dawn on at least a few wholesalers that duplicating too much of the work the broker was supposed to be doing was approaching the same operating cost structure of a retail lender. It wasn’t just the disclosure issue, after all. You had to re-verify the broker’s verbal verification of employment and order (and review) a field review appraisal to reality-check the appraisal you let the broker order and so on until there wasn’t much the broker did that you didn’t also do.

The obvious answer to that was to make the borrower pay for it all. You began to find GFEs showing “underwriting fees” and “document preparation fees” all over the place, for instance. Now, underwriting your loans and drawing up your closing documents used to be considered basic overhead, you know, and lenders covered that in an origination fee charged to borrowers (or in the margin on the interest rate). The only time you ever charged a “doc prep fee” to a borrower was a situation in which you actually had to draw up unusual, complex documents—like a convoluted trust agreement or one of the gnarlier “hold harmless” agreements—that you needed to actually pay outside counsel for. You never charged anyone a separate fee for standard mortgage docs; that was like charging them for the air conditioning in the closing room. But in the wholesale model, you had to find some way for the broker to draw up GFEs and the wholesaler to then do it again and the whole thing to remain profitable for everyone. All kinds of other things, like flood hazard determinations and tax service contracts, that we always had to obtain for loans but that we always just covered out of the origination fee, started to appear as separate items on the GFE and HUD-1.

It was and still is argued all over the place that these practices are really pro-consumer, since it’s a clearer “itemization” of the real cost of credit than some all-in “origination fee” or “broker fee.” Had the origination fees shrunk proportionally to the newly added itemized fees, that might have been plausible. But in way too many cases, you were paying the same origination point you had always paid, plus $40 for a flood cert and $75 for a tax service contract and $100 for doc prep and on and on and on. In fact, you were paying so much in fees at closing that you were in real danger of not being able to scrape up that much cash—or increase your loan amount enough—to cover them and get a loan closed. This was (pre-RE bubble) a huge problem with refis. Refis are brokers’ bread and butter in low-rate environments, and it’s hard to convince people to refi for a 25 bps drop in rate—which people did—with that nasty cash requirement.

The solution was obvious: find a wholesaler who is willing to price a higher interest rate at a “premium,” and use that premium to “credit” the borrower, or to do the now-ubiquitous “no cost closing.” Of course it’s plenty of “cost”; it’s really just a “no-cash” closing. Obviously there are only certain actual historical rate environments in which this kind of thing will work in the prime lending world: if you’ve got borrowers wanting to “take advantage” of new, lower interest rates to refinance, you can’t always charge them the highest rate out there in order to produce enough premium to pay inflated closing costs with. It’s the kind of thing that might work in the beginning of a steep rate drop, like the 2002-2003 period, when existing loans on the books had a high enough interest rate that they could refinance into a current “premium” rate and still show a rate reduction. The trouble is, if you do too much of that on a wide scale—and the turnover in the entire nationwide mortgage book in 2002-2003 was enormous--it gets harder to do it again. Once the prime mortgage book had “reset” itself to very low current rates via a refi boom, it was hard to tempt them with a premium to current market, unless fixed rate mortgages hit 4.00%. They didn’t, so someone had to invent a mortgage product that seemed like a lower rate to borrowers but that also paid enough hefty premiums that closing cost inflation could be masked. The Option ARM, among others, stepped into the breach and here we are.

The comments to this thread will be choked with outraged mortgage brokers who will once again give you the same old story that “premium” closing cost credits are a god-send to us average schmucks who don’t have several grand sitting around to pay closing costs with, but who oughta get the benefit of lower rates just like the Big People, etc. They will tell you that there are too many “competitive pressures” preventing brokers and wholesalers from larding up settlement statements with both origination fees and a boat-load of “itemized” fees. They will tell you that there are all kinds of perfectly “legitimate” reasons why the final settlement statement you get has all these fees and charges on it that weren’t on the GFE, most of which are your fault for delaying the process or not following what you were told. They will tell that they shop around to get the best rate for you, and deserve to be compensated for that, but that it is the consumer’s responsibility to shop around for several shop-arounds so that they can assure themselves of getting the cheapest deal on the fees. They will tell you that while they don’t do it, retail lenders do it too, so we should stop picking on brokers.

My problem here is with the basic mechanism of, in essence, financing your closing costs in this way (by taking the higher rate to get the “credit” that reduces the amount of cash you bring to closing). It is simply ripe for abuse because there is (now) such a large segment of the borrower world who do not already have prime-quality fixed rate loans, who are desperately focused on monthly payment, not total cost over the term of a loan, and who simply do not have the basic financial skills necessary to do the cost/benefit analysis of fees versus interest rate, even if they could afford to pay three separate credit report fees at $40 a pop to several different brokers in order to amass several different GFEs so that they could find a way to save back the $80 in “wasted” fees and then some. Not to mention the fact that they are, as a group, generally the most susceptible to high-pressure sales tactics (this is true generally of a lot of people with heavy consumer debt and thus low FICOs; they are just incapable of saying “no” when the clerk at Macy’s offers “10% off today’s purchase with Instant Credit!”).

To be honest with you, too many people in this business do not fully understand its cost structure. There’s just a massive confusion all over the place about the difference between “financing costs that are paid up front at the closing of a loan” (as distinguished from interest charges that are paid in the future) and “settlement costs.” There are quite a few things you have to cough up money for at the settlement of a mortgage that are really “prepaid items,” not finance charges. For instance, the money you bring in to fund your tax and insurance escrow accounts. You have to pay real estate taxes and homeowner’s insurance anyway; you either pay it yourself once or twice a year or you pay it on the “installment plan” by paying your lender one-twelfth of it a month. In order to get an escrow account established up front, you’ll probably have to put two months or so worth of escrow payments in the account to start it out (because the annual bills will be due the first time before you’ve managed to make twelve payments, basically, given the lag between closing a loan and the first payment due date). Escrow funding is a relatively large-dollar item on most loans compared to things like a $75 tax service fee, but it’s not the kind of thing shopping around will do you any good with, since it is what it is (assuming lenders get their hands on a realistic estimate of RE taxes) and there’s no “markup” in it—it’s your money, the lender is just taking it up front as a deposit into your escrow account.

It is easy enough, unfortunately, to low-ball the estimated escrow funding amounts on a GFE while larding up on actual finance charges. If borrowers are only comparing this lender’s total to another lender’s total, they can be highly misled about who has the cheapest “closing costs.” And almost all lenders charge a higher rate (or more points) to borrowers who are allowed to get a “waiver” of escrow accounts. If you aren’t paying attention, you might be comparing a GFE from one lender that includes two months’ worth of tax and insurance payments in “closing costs” to a GFE from another lender that includes no escrow dollars but increases your interest rate by 12.5 bps.

The same thing goes, on a less expensive plane, with things like surveys and pest inspections. It might be a lender requirement that you get one of these things, and you might be willing to play dice with your hard-earned money by ignoring survey lines or signs of termite damage if you weren’t required not to by some lender. But the fact remains that (unless the lender is conspiring with the surveyor or exterminator/inspector to get a “kickback”) you’re paying for a real good or service there that doesn’t benefit the lender only. A tax service fee, on the other hand, benefits the lender and investor, not you. You will get your tax bills directly from the county; you don’t need to pay someone to track them. A tax service fee is a classic case of a “finance charge” in the regulatory sense: it is a cost you incur because you are financing the property, that you wouldn’t incur in a cash purchase of the same home. This is why mortgage insurance, unlike your homeowner’s insurance, is considered a “finance charge.”

There are other things you might pay at a mortgage settlement that are a little murkier, conceptually. You wouldn’t pay for a lender’s title insurance policy in a cash sale, but you would (if you were sane) pay for a title search and an owner’s policy. You wouldn’t pay for an attorney to prepare a deed of trust (a “mortgage”) in a cash sale, but you’d pay for a grant deed (otherwise you wouldn’t have legal ownership of the home you’re buying). Appraisal charges aren’t considered “finance charges” for regulatory purposes, on the assumption that a reasonably competent cash buyer would also get an appraisal, although I’m willing to bet that most people think of them as “finance charges” or things you wouldn’t have to pay if the lender didn’t make you and that benefit only the lender.

All this matters for regulatory purposes—the rules about how lenders disclose “finance charges” as distinct from “settlement costs”—but it also matters because there has for some time been something very important getting lost in discussions of “closing costs” or the cost of mortgage credit. A lot of those costs are real estate transaction costs. We have been hearing for years on end, during the boom, that people “who are only going to stay in the house for two years” shouldn’t be “having to pay for a 30-year fixed rate.” We don’t hear many people wondering why you’d buy a home in that situation in the first place.

The reality in most markets across nearly any time period you care to name is that it’s almost never worth buying a house to live in for two years. It pretty much requires a bubble for the RE agent commission and the title search and the survey and the pest inspection and the deed recording fee and so on, let alone the true “finance charges,” to pay for themselves in two years. But there has been a shift in rhetoric and terminology that seems to lump “transaction costs” into “financing costs,” allowing people to “make sense of” buying a house you plan to live in for only two years because you can find some lender who will let you finance the transaction costs through this premium-rate “closing cost credit” deal.

The reality of things is that no lender makes any money charging premium interest rates to recover costs it didn’t charge the borrower at settlement if the borrower pays the loan off in a short period of time (unless it was a really really big premium). This is where your “prepayment penalties” came from; it’s also where all these expensive post-settlement fees (like the notorious fee for getting a payoff quote or a release of the old lien in a refi) come from. The economics of making “bridge loans” (short-term loans) at “permanent loan” terms just doesn’t work if you don’t collect fees up front. You can get by with a small enough percentage of your loans behaving like that—credit card lenders can get by with a small enough percentage of people who pay in full every month, and Best Buy can get by with a small enough percentage of people who do the “one year same as cash” thing and pay it off before a finance charge is imposed. But nobody can handle everybody behaving like that. Not for long.

And it’s not just home buyers, it’s refinances. It simply isn’t rational for an investor to “pay up” for a high interest rate if said loan is going to refinance at the next little market bump. But people will refinance, these days, for amazingly small rate increments, for two reasons. First, loans are a lot bigger than they used to be, while incomes haven’t been growing. That means that the dollars at stake in monthly payment savings become more significant even with small decreases in the interest rate.

The second reason is where this gets into a vicious cycle: people refinance at the drop of a hat because they don’t pay the closing costs in cash. They either roll the costs into the loan—driving balances up over time and creating even further incentive to refinance again—or they get that “premium credit” thing, which means that the borrower has a built-in incentive to refinance the new loan as quickly as possible. This dynamic creates regular income for brokers who get paid for each refi, but it doesn’t always do much for investors.

A great deal of this business over the last several years of refinancing people out of perfectly affordable fixed rate loans into these toxic ARMs came about because there was no longer any way to price a premium-rate fixed rate loan at a lower rate than what the borrowers already had. However, the market was full of “dumb money” that would pay 105 for a “high quality” Option ARM—not to mention the “low quality” ones. Many people focus on “YSP” as broker compensation, and that’s a big issue. Some of the sleazier brokers took those five points from the wholesaler and the borrower didn’t see a five point credit on the HUD-1. My point, though, is to question whether the ones who did get a closing credit really got such a great deal.

Would borrowers have balked at doing the refi to start with if they had had to pay at least some of the closing costs in cash? Would they have paid a touch more attention to those prepayment penalties they were signing up for if it had occurred to them that the only way a “no cost closing” can be profitable to a lender is by extending the life of the loan long enough for the costs to come out of the interest paid each month? Would borrowers have been more likely to catch on to an ARM masquerading as a fixed rate or nasty ARM terms “hidden” in a big pile of legalese if they had a realistic sense of how low 30-year fixed rates are likely to go on any given day? There is something terribly wrong with lenders who give out misleading disclosures, and I don’t blame borrowers for lender sleaziness. But there is also something terribly troubling about the apparent fact that a lot of people thought they were getting a 30-year fixed rate loan at 1.95%. That is much too good to be true. Why didn’t it occur to anyone that that’s much too good to be true?

To see this as strictly a “disclosure” issue is to simply cop out, as far as I’m concerned, on the question of a very old-fashioned view of what loan officers and brokers were supposed to be doing, which is explaining things like the fee/rate tradeoff, the point of prepayment penalties, and the likely range of prevailing market rates on fixed-rate loan quotes. “Educating” your borrowers is just off the table. All we’re left with is “disclosing” loan terms that truly educated borrowers probably wouldn’t have anything to do with, and relying on borrowers to “shop around” in a market in which they still have no idea what the “going rate” is.

We’ve gone, just in my career in this industry, from taking three whole business days to get a GFE into a consumer’s hands, because we did them with adding machines and typewriters and snail mail, to taking three whole minutes to do that with only reasonably fancy technology, and back to taking three whole days again because there are too many intermediaries in the process (all of whom have to get paid). And HUD is, after years and years of this practice going on, finally working up a way to disclose premium-rate closing cost credits right when the terrible market distortions partially due to that practice are melting down the credit markets. Behind the whole thing lurks the ideology that regulators are not there to tell anyone what is an allowable business practice; they’re there to just make sure you “disclose” what you’re up to. It is aided and abetted by a “consumer advocate” lobby who frequently seems to believe that “complexity of disclosures” is the problem, rather than unrealistic expectations consumers develop based on the onslaught of marketing they get from the industry, which tries to tell you there is a free lunch if you act now.

Once you and I have recovered from this post, we’ll look at some of the details of the new proposed GFE. I do hope it will make more sense after this ramble.

by Tanta on 1/29/2008 11:02:00 AM

One of the hot topics of conversation lately is the idea of a mortgage “put option.” There seem to be more than a few people—including those who don’t exactly use the language of options contracts, like that weird couple featured recently on 60 Minutes—who are slightly confused about what the “optionality” of a mortgage contract is. There are also lots of folks who are wondering what will happen to mortgage pricing in general should a substantial number of folks decide to “exercise the put” on their mortgages. It seems wise to me to try to tease out what’s going on here.

First, mortgage contracts in the U.S. are not, actually, options contracts. You may peruse your note and mortgage at length now, if you didn’t do so when you signed them, and you will not find any “put” or “call” in there. Your note is a promise to pay money you have borrowed, and your mortgage or deed of trust is a pledge of real estate you own (or are buying with the borrowed money) as security for that note. That means, in short, that if you fail to keep your promise to pay the loan in cash, the lender can force you to sell your property at auction (to produce cash with which to pay the loan in full). Because the mortgage instrument gives your lender a “lien,” any sales proceeds are first applied to the mortgage debt before you get any of it.

People get very confused about this because it is often the lender who ends up buying the property at the forced auction. When that happens, it is basically because the lender simply wants to put a “floor” bid in the auction: the lender bids an amount based on what it is willing to lose (if any). Typically, the lender bids its “make whole amount” or the loan amount plus accrued interest and expenses. If someone else bids more than that, the lender is happy to let the property go to the higher bidder.

The lender might bid less than its make-whole amount; it might bid its “probable loss” amount. If the lender is owed $300,000 and doesn’t think it could ever end up recovering more than $200,000, it might bid $200,000 at the FC auction. The lender doesn’t actually want to win the auction; lenders are not really in the business of real estate investment or property management. However, the lender would rather buy the home at the auction and pay itself back eventually by re-selling the property later (as a listed property in a private sale instead of a courthouse auction) than let the property go for $50,000 (meaning the lender would recover only $50,000 on a $300,000 loan instead of $200,000). Nothing ever stops any third party from bidding $1 more than the lender’s bid and winning the auction (except, of course, any third party’s own inclinations).

We need to remember, then, right away, when anyone talks about “giving the house back to the bank” or “mailing in the keys,” we are already in the land of metaphorical language. The only situation in which “giving the house back to the bank” would literally be possible is if you bought the house from the bank (say, it was REO) and the contract explicitly gave you an option to sell it back to the bank, whenever you wanted to, at a price equal to your loan balance. Nobody writes REO sales contracts that way. In most cases, of course, you bought the house from someone other than a bank. You have no option to “put the house back” to the seller. You win only if it's "heads."

A “put option,” in the financial world, is a contract that gives the buyer of the put the right, but not the obligation, to sell something (a commodity, a stock, a bond, etc.) in the future at a predetermined price. On the other side of the deal, the “writer” of the put is obligated to buy the thing in question if the put buyer exercises the option. Some of you may already be a bit confused about “buyer” and “seller” here, but that’s an important point. You don’t get “free puts.” You buy puts. There is a fee or a “premium” that you pay for the option contract. If you do not exercise the option, the put-writer pockets that fee. If you do exercise your option, the put-writer pockets that fee (to offset his loss on the deal) and your gains on the ultimate sale of the thing are net of the option premium.

The point of a put is that you buy them when you want to be protected from falling prices: if you think there is a good chance that the value of something will fall in the future, buying a put that allows you the option of selling it next month at this month’s price might well be worth paying that option premium. But you do always pay an option premium and you do not get it back.

The opposite of the put option is the call option: it is the option to buy something in the future at a predetermined price. You buy calls when you think the value of the thing is likely to rise. You also always pay some premium or fee for a call.

Residential real estate sales and mortgage loans do not, actually, literally, have puts and calls in them. If you buy a home today, you assume the risk that its price may fall in the future. Your contract does not include an option for you to sell the house at the price you paid for it. Nor does the seller of the house have a “call”; the seller cannot force you to sell the house back to him at the original price if its value rises.

Your mortgage loan contract does not give you the right to simply substitute the current value of the house for the current balance of the loan: you do, in fact, risk being “upside down.” (The only time this isn’t true in the U.S. is with a reverse mortgage; those are written explicitly to have this kind of a feature, where the balance due on the loan can never exceed the current market value of the property. But of course reverse mortgages aren’t purchase-money loans.) Nor does the mortgage contract give your lender the right to buy your house from you for the “price” of the loan amount when that is less than its value. Mortgage lenders never do better than paid back. If the real estate securing your loan increases in value, that appreciation belongs to you (as long as you make your loan payments).

So why is it that people keep talking about “puts” and “calls” in terms of mortgage loans? That’s because mortgage contracts have features that can affect their value to the writer of the contract (the lender or investor) in a way that is analytically comparable, in some ways, to classic options. Options theory is applied to mortgages in order to price them as investments. (Strictly speaking, this is a matter of analyzing them so that a price can be determined.) The interest rate, then, that you get on a mortgage loan will depend, in part, on how the lender/investor “priced” the implied options in the contract.

The “implied put” in a mortgage contract is the borrower’s ability to default (walk away, send jingle mail, whatever you want to call it). We do not, generally, consider “distress” (that’s actually the formal term in the literature, for you Googlers) as an “implied put.” Some borrowers will fall on hard times and be unable to fulfill their mortgage contracts. This is a matter of “credit risk” and it is, analytically, a different matter of mortgage contract valuation. The “implied put” analysis is trying to capture the possible cost to the lender/investor of what we call the “ruthless” borrower. “Ruthless” isn’t really intended to be a casual insult; it is in fact the term we use to describe borrowers who can pay their debts but choose not to, because there is a greater financial return to that borrower in defaulting as opposed to not defaulting. It is “ruthless” precisely because there is not a contractual option to do this: the only way you can exercise the “implied put” is to default on your contract.

Many many people are very confused about this. When we talk about the “social acceptability” of jingle mail, what we are talking about is at some level the extent to which there is or ought to be some rhetorical or social “fig leaf” over ruthlessness. It seems to be true, after all, that most people are more likely to behave ruthlessly if they can call it something other than ruthlessness. (There are always people who have no trouble with ruthlessness; they often get the CEO job. Most of us have at least moderately strong inhibitions about ruthless behavior.) There is, therefore, a process in which the ruthless put is re-described in various alternative terms, or has alternative narrative contexts built up around it, such that it no longer “feels” ruthless. The borrower was victimized (by the lender, the original property seller, the media, the Man). The put premium was actually paid (“they charge me so much they can afford this”). The ruthless borrower is actually the distressed borrower (redefining what one can “afford” or what is necessary expense so that a payment you can make becomes a payment you “can’t” make).

Before anyone starts in on me, let me note that these fig leaf mechanisms are effective precisely because victimization, predatory interest rates, and truly distressed household budgets do really exist. They wouldn’t be very convincing otherwise. (Very few ruthless borrowers will claim it’s because of, say, alien abduction or something equally implausible.) I am not, therefore, asserting that all claims of predation or distress are “false.” I am simply pointing out that it is, after all, a hallmark of the not-usually-ruthless person who is nonetheless acting ruthlessly to rationalize his conduct.

I don’t offer that as some startling insight into human psychology. I offer it as an attempt to get some analytic clarity. When CR talks about lenders fearing that jingle mail will become socially acceptable, he’s not exactly saying that lenders fear that society will no longer stigmatize financial failure (“distress”). They are afraid that rationalization mechanisms will become so effective that true ruthlessness (which is historically pretty rare in home mortgage lending) will become a significant additional problem (in addition to true distress). And they fear this because, delusions to the contrary, those loans did not have enough of a “put premium” priced into them to cover widespread “ruthless default.”

In fact, the very language of options theory can function, for a certain class of ruthless borrowers, as the fig leaf. To say “Hey, I’m just exercising my put” is a retroactive reinterpretation of your mortgage contract to “formalize” the “implied put” so that you do not have to describe what you’re doing as “defaulting.” This strategy is apparently popular with folks who have some modest exposure to financial markets jargon and an unwillingness to lump themselves in with the “riffraff”—victims of predators and financially failing households and other “weaklings.” (Sadly, a lot of people who have a very high degree of exposure to financial markets jargon don’t need no steenkin’ rationalization. Like most sociopaths, they don’t understand why “ruthless” would be considered insulting or what this term “social acceptability” might mean. So if you’re hearing the “put” excuse, you are probably in the presence of a relative amateur.)

The other side of the problem in valuation of mortgage loans and mortgage securities is the “implied call.” The “call-like feature” in a mortgage contract is the right to prepay. In the U.S., all mortgage contracts have the right to prepay. (Some, but not all, have a “prepayment penalty” in the early years of the loan, but “penalty” here means a prepayment fee, not an actual legal prohibition on prepayment.) The reason the right to prepay functions like an implied call is that it gives the borrower the right to “buy” the loan from the lender at “par,” even if the value of the loan is much higher than “par.” If you refinance your mortgage, you are required only to pay the unpaid principal balance (plus accrued interest to the payoff date) to the old lender in order to get the old lien released. Unless the loan specifically has a prepayment penalty, you are not required to further compensate the old lender for the loss of a profitable loan. So a loan with a prepayment penalty has an implied call and a real call exercise price. A loan without a prepayment penalty, or past the term of its prepayment penalty, has a “free call.” (In the original lender’s point of view. There is always some price to be paid to get a new refinance loan; the borrower’s calculation of the value of refinancing always has to take that into account. Among other things, this fact results in mortgage “call exercise” being much less “efficient” than it is on actual call contracts, which makes the call much more difficult to value, analytically, for mortgages.)

While ruthless default might, historically, be rare, refinancing has been ubiquitous for decades now. It wasn’t always so easily available; your grandparents might never have refinanced a loan not because their existing interest rates were never above market, but just because there weren’t lenders around offering inexpensive refinances. In fact, refinances have been so ubiquitous for so long now that many people have come to think of the availability of refinancing money as somehow guaranteed. This isn’t just a naïveté about interest rate cycles, although it is that too. It is a belief that credit standards and operating costs of lenders never change, so that if someone thought you were “creditworthy” once, they’ll automatically think of you as creditworthy again, and that lenders can always afford to refinance you without charging you upfront fees.

People who price mortgage-backed securities have always known that the prepayment behavior of mortgage loans is impacted not just by prevailing interest rates, but also by the borrower’s creditworthiness, the lenders’ risk appetites, and the cost (time and money) of the refinance transaction. We were talking the other day about the prepayment characteristics of jumbo loans in comparison to conforming loans; the fact is that people who have the largest loans are the most likely to refinance at any given reduction in interest rate, since a reduction in interest rate produces more dollars-per-month in savings on a larger loan than it does on a smaller loan. Considering these types of things is very important to people who price MBS, because in fact prepayment behavior is both hard to “price” and absolutely critical to “pricing” mortgages as an investment.

MBS, unlike other kinds of bonds, are “negatively convex.” I have been threatening to talk about convexity for a while and I keep chickening out. It’s actually useful to understand it if you want to understand why mortgage rates (and the value of servicing portfolios) behave the way they do. The trouble is that convexity involves a whole bunch of seriously geeky math and computer models and normal people probably don’t want to go there. (I don’t even want to go there.) So as a compromise, this is a very quick and simple explanation of convexity.

The convexity of mortgages is a result of the “implied options” in them. Most people understand intuitively that the higher the interest rate on a loan, the more an investor would pay for that loan: if you had the choice today of buying a bond that paid you 6.00% and one that paid you 6.50%, you would probably not offer the same price for each of them. With a classic “vanilla” bond, the price you would offer would be a matter of looking at the term to maturity, the frequency of payments, the interest rate, and some appropriate discount rate.

The trouble with mortgages is that while they have a maximum legal term to maturity, they have an unpredictable actual loan life, because they have the prepayment “calls” implied in the contracts. The return on a mortgage is uncertain, because you might get repaid early, forcing you to reinvest your funds at a lower rate. On the other hand, the loans might just stay there until legal maturity, at an interest rate that is now below the market rate on a new investment. The problem, obviously, is that borrowers refinance most often when prevailing market rates have dropped (right when the investor might want the loans to be long-lived) and don’t refinance when prevailing rates have risen (right when the investor would like to see you go away). “Vanilla” bonds don’t behave this way. Vanilla bonds, like Treasury bonds and notes, are “positively convex.” Mortgages are “negatively convex.”

Here’s a comparative convexity graph prepared by Mark Adelman of Nomura (do pursue the link if you want more detailed information about MBS valuation). This graph plots three example instruments all with a face value of $1,000 and a price of par ($1,000) at 6.00%. The vertical axis reflects the change in price of the bond. The horizontal axis reflects the change in prevailing market yields. As you move to the left of 6.00%, you see that the price of the bond increases (it has an above-market yield); as you move to the right it decreases.

However, the three instruments do not increase or decrease in price in the same way. The 30-year bond has a steeper curve than the 10-year note, which is a function of the difference in maturities of the two instruments. The MBS isn’t just not as steep; it is a different shape. The 30-year bond and the 10-year note price functions create an upward-curving slope when you plot them against price/yield changes like this, and the MBS price functions create a downward-curving slope. The term “negative convexity” means, exactly, that downward curving slope.

What’s going on here is that when market yields fall (moving to the left in the graph), average loan life in an MBS pool will shorten markedly, as borrowers are “in the money” to refinance. At a relatively modest fall in market yields, the price of the MBS does increase (but the increase is much less than the increase in the other bonds). At a larger drop in market yields, the MBS price gets as high as it will ever get and then stops increasing at all. What happens here is that the underlying mortgage loans have become so “rate sensitive” that any additional decrease in market yield (increase in the spread between the bond’s coupon of 6.00% and current market coupons) is entirely offset by shortened loan life: loans will pay off so fast at this point that this “officially” 30-year bond really returns principal to the investor the way a 1-year or even 6-month Treasury bill would. No investor is going to pay more for the MBS at this point than it would for the very shortest-term alternative.

On the other side of the graph, you see that the MBS price declines more slowly than the vanilla bonds, although its curvature at this point is very like the 10-year. At this side of the chart, average loan life is increasing. (Mortgage bonds never go to zero prepayments or actual average loan life = 30 years.)

What all this implies is that, analytically, mortgages do have some sort of “option price” built in. (There is actually a name for this, the OAS or Option Adjusted Spread, a method of comparing cash flows of a mortgage bond across multiple interest rate and prepayment scenarios. It’s heavy math and modeling.) In the case of voluntary prepayment (refinancing or selling your home, basically), your “call” option has, in fact, been priced—it’s in the interest rate/fees you pay to get a refinanceable mortgage loan. Investors accept the uncertainty of mortgage duration by (attempting to) price it in.

All that, however, is about trying to price the full return of principal (which, in the case of a mortgage loan, is also the point at which interest payments cease). It isn’t trying to model the return of less than outstanding principal, which is what the “put” or ruthless default is. A refinancing borrower pays you back early at par. A defaulting borrower pays you back early at less than par. Standard MBS valuation models that were developed for GSE or Ginnie Mae securities (that are guaranteed against credit loss) do not “worry” about ruthless puts in terms of principal loss, since that loss is covered by the guarantor. What is causing some trouble these days with the “ruthless put” in the prepayment models is simply that this is an unexpected source of prepayment that isn’t correlating with “typical” interest rate scenarios. (We are seeing increased defaults in a very low-rate environment, because of the house price problem, which isn’t built into the prepayment models for guaranteed securities. Historically, prepayment models “expect” non-negligible numbers of ruthless puts only in higher-rate environments.)

It may help you to understand that we have been talking about how an investor might price an MBS coupon, which isn’t the same thing as the interest rate on a loan. In a Fannie Mae or Freddie Mac MBS, the “coupon” or interest rate paid to the investor might be, say, 6.00%. That means that the weighted average interest rate on the underlying loans in the pool is substantially more than 6.00%. There is the bit that has to go to the servicer, and there’s the bit that has to go to the GSE to offset the credit risk. The mortgages must pay a high enough rate of interest to provide 6.00% to the investor after the servicing and guarantee fees come off the top. In essence, then, MBS traders set the “current coupon” or the coupon that trades at par, the GSEs set the guarantee fee and/or loan-level settlement fees that cover the credit risk, the servicer sets the required servicing fee, and all that adds up to the “market rate” for conforming mortgage loans (plus mortgage insurance, if applicable, which is conceptually an offset to the guarantee fee).

One way of describing the situation we’re currently in is that borrowers are continuing the short loan life of the boom (which was made possible by easy refi money and hot RE markets) by substituting jingle mail for refinancing. That increases credit losses to whoever takes the credit loss (the GSEs and the mortgage insurers), decreases servicer cash flow (a refi substitutes a new fee-paying loan for the old loan; a default substitutes a no-fee-paying problem for the old loan), and makes everyone’s prepayment models go whacky-looking. This is one reason why it obviously wasn’t a good time for MBS traders to be told they’d be suddenly getting jumbos in their conforming pools; at some level the response to that could be summed up as “we don’t need one more thing that defies analysis.”

Ultimately, there is no way anyone can mobilize “social acceptability” as a defense against the ruthless put (even if you wanted to). The industry has, in fact, created the conditions in which it’s rational, and as long as it’s rational it will go on. Just as it was rational to buy at 100% LTV. The only possible way to get back to an environment in which ruthless default is rare is to abandon the “innovations” that give rise to them: no-down financing, wish-fulfillment appraisals, underpriced investment property loans, etc. The administration is currently pushing for increasing the FHA loan amounts and the FHA maximum LTV up to 100%. This is not likely to remove the incentive to take another reckless loan on a still-too-high-priced house. If we aren’t going to ration credit with tighter guidelines and loan limits, then it will have to be rationed with pricing: eventually the models will “solve” the problem by increasing the costs of mortgage credit. You cannot simply keep writing “free puts.”

by Tanta on 1/25/2008 06:06:00 PM

This probably wasn't what Congress had in mind, ya think?

NEW YORK (Reuters) - A key element of the stimulus package aimed at jump-starting the ailing U.S. housing market may have the unintended consequence of raising mortgage rates, said analysts studying the plan.

A federal proposal to increase the size limit on loans eligible for purchase by mortgage finance giants Fannie Mae and Freddie Mac has unsettled traders in the $4.5 trillion market for bonds backed by the "conforming" mortgages.

Increasing the eligible loans to $729,750 from $417,000 would change the characteristics of mortgage-backed securities, leading traders to exact a premium for increased interest-rate risk.

Borrowers with large, jumbo loans are more likely to refinance since their savings are greater for each incremental drop in rates than for a smaller loan. The loans will taint the bonds since traders don't initially know the make-up of the securities known as "agency" MBS.

Higher mortgage rates would make it even harder to unload already high housing inventories and existing homes on the market, delaying any housing recovery and potentially extending the U.S. economic slowdown.

Potential damage to the "to-be-delivered" (TBA) market -- the most actively traded agency mortgage market where investors can buy bonds before they are actually created -- prompted Wall Street dealers to call a special meeting with the Securities Industry and Financial Markets Association at 3:30 p.m. Friday, market sources said. A SIFMA spokeswoman would only say the group is in ongoing discussions with its members.

"The amount of money that investors are willing to pay for agency mortgages (bonds) could be lower if these loans are TBA deliverable and so mortgage spreads could widen," said Ajay Rajadhyaksha, co-head of U.S. fixed income strategy at Barclays Capital in New York, who will listen to the SIFMA meeting by phone.

Mortgage rates would rise for the "vast majority" of agency-eligible borrowers, he said.

When falling rates prompt refinancing of loans in mortgage bonds, investors can be hurt since principal may be returned to them at a price below market value. The investor is also faced with reinvesting principal in bonds paying lower rates.

MBS paying low interest rates have been hurt in recent days amid expectations the addition of many jumbo loans will boost supply in those coupons, analysts said. As much as $500 billion in jumbo loans could qualify, according to Barclays research.

Wall Street MBS traders last beat down SIFMA's door in October when the advent of the Federal Housing Administration's FHA Secure program threatened to taint TBA pools of Ginnie Mae securities. The dealers got their way -- Ginnie Mae created new "specified" pools outside of their TBA issues for FHA Secure.

"The street is on high alert," one mortgage trader at a New York-based primary dealer said in an e-mail.

Rajadhyaksha and other analysts, including RBS Greenwich Capital's Noah Estrin, expect the TBA market will be protected if Congress and President George W. Bush approve the stimulus plan as written.

"When you start throwing a lot of jumbos into a pool you spoil the fungibility of the collateral," said Linda Lowell, a mortgage market veteran and principal of Offstreet Research LLC. "That has made the market as liquid as it is. Home owners have benefited from lower mortgage rates."

TBA works the way it does precisely because "agency" loans are basically interchangeable: the normal variation just isn't wide enough to prevent traders from pricing deals before seeing the exact loan composition.

Certainly this problem can be solved by putting the LFKAJ* in their own pools--as with FHASecure. That might keep this plan from driving up rates for everybody, but it's not clear to me how it improves the spread on those LFKAJ-only pools. Hmmm.

*Loans Formerly Known as Jumbo

by Tanta on 12/12/2007 09:30:00 AM

The Wall Street Journal is troubled by Fannie Mae's recent imposition of a 25 bps "adverse market fee" for new mortgage production. "Mortgage Pain Hits Prudent Borrowers":

Fannie Mae, the giant government-sponsored mortgage investor, last week raised costs for many borrowers by quietly adding a 0.25% up-front charge on all new mortgages that it buys or guarantees. On a $400,000 mortgage, that would mean an extra $1,000 in fees, almost certain to be passed on to the consumer. Freddie Mac, the other big government-sponsored mortgage investor, is expected to impose a similar fee soon, according to a person familiar with the situation.
...
In a statement, Fannie said the new fee is needed "to ensure that what we charge aligns with the risk we bear." The National Association of Home Builders labeled the fee "a broad tax on homeownership." More than 40% of all mortgages outstanding are owned or guaranteed by Fannie or Freddie.

The fee is the latest in a series of moves by Fannie and Freddie that raise the cost of credit for some borrowers. Late last month, they imposed surcharges that affect mortgage borrowers who have credit scores below 680, on a standard scale of 300 to 850, and who are borrowing more than 70% of a property's value. For example, someone with a credit score of 650 would pay a surcharge of 1.25% of the loan amount for a mortgage to be sold to Fannie. On a $300,000 loan, that would mean extra fees of $3,750. The fee could be paid in cash or in the form of a higher interest rate than
would normally apply.

Fannie also is raising down-payment requirements for loans it purchases or guarantees in places where house prices are falling, which by some measures is most of the country. In these declining markets, lenders will need to cut by five percentage points the maximum percentage of the home's estimated value that can be financed. For instance, for types of loans that Fannie normally would allow to cover up to 100% of the estimated value, the ceiling now is 95% in declining markets.

"A tax on homeownership." I swear, if the National Association of Builders didn't exist, I'd have to invent them. For comic relief. Ditto with "a higher interest rate than would normally apply."

Here's the deal: if you are taking out a mortgage--any mortgage--in a period of time in which home prices are rapidly falling, the financial future of lenders and builders is uncertain, and bailouts are already on the table, you may wish to call yourself "prudent" because you're getting a conforming fixed and your FICO score is better than those subprime people's. You may, therefore, feel sorry for yourself because you'll pay that extra quarter.

Or, you can wonder if maybe you should wait that extra half-hour after lunch before entering the swimming pool. Whatever. I'd like to hear the case for the GSEs backing off on fees right now.

In the interests of maximum nerdage, I'd also like to point out that the "no maximum financing in a declining market" rule that is mentioned here is not "new." It has always been the rule. Fannie and Freddie are taking the opportunity presented to them by current events to remind everyone that it is still on the books. Some people may think it's new, but some people think a "declining market" is, well, new. Unheard of. Not normal, you might say.

We should note that this rule does not simply change a 100% maximum to a 95% maximum. There are many maximum LTVs, depending on occupancy, purpose, FICO, property type, loan type (fixed versus ARM), and so on. So there are those 90% cash-outs that will be 85% cash-outs, and those 80% multi-unit loans that will be 75%. Cue more howling from the "prudent."

by Tanta on 11/29/2007 12:45:00 PM

AP, via our Clyde:

MILWAUKEE (AP) -- The nation's leading mortgage insurer, MGIC Investment Corp., says it will raise prices and limit its coverage of loans made without proof of income to try to rein in growing losses. . . .

One of the bigger changes proposed announced Wednesday will limit the insurance MGIC offers people who have Alt-A loans, which generally require only limited verification of income.

MGIC will insure these loans only for people who are self-employed, the original market for them, Culver said. They have been used more recently by people who wanted to borrow more than they could really afford, resulting in losses for MGIC and other mortgage insurers, he said.

"We always thought it was silly, a wage earner who could show you a paycheck would pay a higher interest rate not to show you their paycheck," he said.

The company will raise prices on Alt-A loans, other loans worth 95 percent of a home's value and certain loans for people with low credit scores or small down payments. More specifics will be announced next week, Culver said.

You know, I actually believe that MGIC always thought stated income for wage earners was silly.

What is missing here is the explanation for why they went ahead and insured something this "silly."

by Tanta on 9/26/2007 08:27:00 AM

Well, you know what's in your cornflakes--I hope. Do you know what's in your ARM index? According to the Financial Times, the London Interbank Offered Rate may well mean Selected London Inter-Marginal Bank Offered Rate:

“The Libor rates are a bit of a fiction. The number on the screen doesn’t always match what we see now,” complains the treasurer of one of the largest City banks.

Such criticism is, unsurprisingly, rebuffed by those who compile the index each day. However, it highlights two other trends that have emerged in the money markets in recent weeks.

One of these is a growing divergence in the rates that different banks have been quoting to borrow and lend money between themselves.

For although the banks used to move in a pack, quoting rates that were almost identical, this pattern broke down a couple of months ago – and by the middle of this month the gap between these quotes had sometimes risen to almost 10 basis points for three month sterling funds.

Moreover, this pattern is not confined to the dollar market alone: in the yen, euro and sterling markets a similar dispersion has emerged. However, the second, more pernicious trend is that as banks have hoarded liquidity this summer, some have been refusing to conduct trades at all at the official, “posted” rates, even when these rates have been displayed on Reuters.

“The screen will say one thing but people are actually quoting a different level, if they are quoting at all,” says one senior banker.

Some observers think this is just a short-term reaction to the current crisis. However, it may also reflect a longer-term shift. This is because one key, albeit largely unnoticed, feature of the banking world in recent years is that many large banks have reduced their reliance on the interbank market by tapping cash-rich companies and pensions funds for finance instead.

The recent crisis appears to have accelerated this trend. In particular, it appears that some large banks have in effect been abandoning the interbank sector in recent weeks, turning to corporate or pension clients for funding by using innovative repurchase agreements.

This trend is bad news for smaller institutions, such as British mortgage lenders, because these, unlike large banks, generally do not have any alternative ways of raising funds outside the interbank world.

Almost all subprime ARMs, the vast majority of Alt-A ARMs, and a significant chunk of prime ARMs are indexed to 6- or 12-month (dollar-denominated) LIBOR in the U.S. (I'm still looking for a source of exact figures.) One of the ways LIBOR was "sold" to consumers who were used to old-fashioned indices like Constant Maturity Treasury (CMT) or Cost of Funds (COFI) was that it "lagged" these U.S.-centric indices on the upside, implying that LIBOR ARM rates would not rise as quickly. That was mostly nonsense then, and it may be pretty painful nonsense now if the interbank borrowing practices on which LIBOR is based shift such that it becomes a "penalty rate" for bank borrowing.

Prediction: If we "innovate" back to Treasury-based ARM indices (by pulling those dusty old CMT notes out of the drawer), it will be sold to you all on the basis that CMT is a "lagging" index.

by Tanta on 9/16/2007 10:41:00 AM

A new paper by Federal Reserve Board analysts I highlighted the other day contains some discussion of the issues of loan pricing and fairness to consumers. I encourage anyone who is interested in this issue to read the entire paper. However, I promised to write something UberNerdy about loan pricing, and this bit from the Fed paper provides me with a place to start:

As price flexibility has emerged in the mortgage market, so have concerns about the fairness of pricing outcomes. Such concerns generally fall into four broad categories. First are concerns about possible discrimination based on the race or ethnicity of the borrower. Such concerns are heightened because loan prices are not always determined strictly on the basis of credit risk or cost factors but can involve elements of discretion, in which loan officers or loan brokers may seek prices that differ from those on rate sheets or other techniques used by lenders to establish baseline prices.

Second are concerns about whether borrowers in the higher-priced segment of the loan market are sufficiently informed and whether they are willing or able to shop effectively for the loan terms most appropriate to their circumstances. For example, it may be difficult for borrowers to determine where they fit along the credit-risk spectrum.

For the moment I am going to largely ignore the first issue, of discrimination based on race or ethnicity. This is not because I don’t think it’s important; I do. But I don’t think we can really get there, in terms of understanding how pricing of a loan can be manipulated at the primary market level (in discriminatory or just equal-opportunity predatory ways) without getting a grip on how it works. What I will propose is that, indeed, it is very “difficult for borrowers to determine where they fit along the credit-risk spectrum.” Not only do borrowers, on the whole, lack the ability to size up their own risk, they don’t know how lenders price that risk. As long as information about “the market price” for certain risk factors is non-public, the public will not know whether the price it gets is the best on offer or not.

It is supposed to be the role of a mortgage broker to locate the best price for a consumer, since the idea is that the broker receives rate sheets from many wholesale lenders, and can choose the best-priced one on any given day or for any given kind of loan. This presumes that the broker is mostly motivated to offer a “competitive” rate/price to the borrower, not to maximize its own compensation by offering a worse-than-market rate/price to the consumer in exchange for higher fees from the wholesaler. The standard riposte of the brokers is that this kind of gouging can’t really happen, because the customers will “shop around” and know whether or not they’re getting the best deal. Or, at least, they should shop around, and if they don’t, it’s their own fault.

As I have argued before, this creates an odd conception of the broker’s role: the broker with access to all those wholesalers is supposed to be “shopping around” for you. If you go to another broker to get a “comparison” quote, you’re going to someone else who is “shopping” the same universe of wholesalers your original broker was, as a rule. So, in practical terms, what you would be “shopping” for here is differences in broker “markup” practices, not “best market rate.” Why you would pay a broker to “shop” for you and then do your own “shopping” is one of those things that beats me.

That’s my whole argument about “fiduciary” responsibilities in a nutshell: if the broker isn’t obligated to give you the best rate out there, what’s the point of using a broker? If you’re going to do your own shopping, why not shop a couple of different retail loan officers? Your loan is going to end up with the wholesaler anyway; you might as well skip dealing with someone who may not be around if problems ensue, or may not have regulators breathing down its neck about origination practices as a depository lender will (relatively speaking).

But in reality the whole “shop around” business is nearly meaningless when we look at this “risk based pricing” thing. You might know, from reading blogs or something, that, say, the Freddie Mac conforming fixed rate national average loan last week involved a rate of around 6.375% and 1.00% in points. Do you have any idea if you qualify for that? Are you “average”? Is the kind of loan you want “average”? If you were quoted a higher rate than this, would that mean that you are riskier than “average”? Says who?

It’s not easy to find lots of wholesale rate sheets on the web to do comparisons, because most wholesalers put them behind registration walls to keep people like us out. There are, however, a few exceptions, and I found this one. Please understand that I am not “picking on” this lender because I have any particular beef with Chevy Chase, although I will say this “Cashflow Monthly ARM” you encounter on the first page of the rate sheet is perfectly nauseating. Other lenders have equally or probably even worse products, of course, but CCB is dumb enough to make its rate sheet publically available.

Whilst we are on this subject, notice the verbiage at the bottom of the page: “These rates are solely for the use of mortgage brokers, correspondent lenders, and other arrangers of credit and are not to be distributed to potential loan applicants.” All rate sheets have words to that effect on them. You are not given a copy of a rate sheet like this, if you are a loan applicant, and invited to price your own loan. The better reason for that is that you need a “professional” to assist you in this complex process (i.e., we acknowledge you do not understand “where you fit along the credit risk spectrum”). The less better reason is that if you can’t see the rate sheet, you won’t know if you got a higher rate than the best one you qualified for in order to increase the broker’s compensation. In any case, if CCB doesn’t want to see some blogger go to town with its wholesale rate sheet, CCB can invest in a better (more protected) web portal.

I am not, in fact, going to get anywhere near that “Cashflow Monthly ARM” today. We’re just going to look at the pricing for a plain old vanilla conforming fixed rate. If that makes your eyes cross, then do think about how lost in the weeds people are over these toxic ARMs. If you get the hang of the fixed rate pricing, you can play around with how to determine the price to the customer on the goofy ARM. So we’re going to look at page 5 of the rate sheet (page 6 of the "All Other Property States" pdf), which you might want to print if you’re following along at home, although you will need a magnifying glass to read it. Please note that if you’re following the link, the discussion below refers to the “all other states” rate sheet dated 9/14/2007 at 10:00 a.m. If you are now seeing different numbers, you’re looking at an updated rate sheet.

The first thing you see is a rate/price matrix. Eventually you will see that CCB doesn’t use the word “price.” It calls this “premium.” If you know anything about bond pricing, this will drive you crazy right off the bat. If you don’t know anything about bond pricing, it’ll just keep you very confused. “Everybody” knows (uh huh) about this thing called “discount points,” which are a fee, paid at closing, expressed as a percentage of the loan amount. You pay discount points in order to get a lower interest rate (from the lender’s perspective, the points bring the yield on the loan back to up to market).

“Premium points” would be, logically, money the lender pays you to take a higher rate. Now, lenders don’t hand out premium points in cash to anyone. If you the consumer get “paid” a premium, what you are getting is a credit on the final settlement statement against your closing costs (such as your credit report and appraisal fees, title fees, etc.). The “no cost” loan works on premium pricing; “no cost” just means “no cash outlay,” because the costs are there but paid for with premium. However, you do not always get that premium: it can be paid to the broker, not to you. We call this “back-end points” or “yield spread premium” (YSP).

So, anyway, CCB calls everything “premium” instead of “price," which in itself tells you something about the mindset here. I’m going to keep talking “price,” because I have a point to make. Another thing you bond-people will notice immediately is that the prices on this rate sheet are expressed in a “retail” format, not a dollar price (or “buy price”) format. This varies in the industry. Most correspondent rate sheets (remember, that’s a lender buying a closed loan from another lender) use dollar prices, and some wholesale (broker) rate sheets do. (Dollar prices are things like “par” or 100.00, 101.00, or 99.00, which numbers mean “percent of face value” of the bond or mortgage. The equivalent “retail” or consumer price would be 0.00, (1.00), or 1.00, respectively. Subtract the retail price from 100 to get the dollar price, and remember to change the sign on the adjustments. If that last sentence confused you, ignore it.)

That means that CCB’s rate sheet expresses a premium price as a negative number and a discount price as a positive number. You may also notice that CCB quotes 15-day locks in rounded ticks (1/32 increments) and 45-60 day locks in even eighths. This means that at any given rate, the borrower pays around 0.187 to go from 15 to 45 days, and .125 to go from 45 to 60 days.

Most of the “risk based pricing adjustments” on this rate sheet are also quoted in even eighths, although you’ll notice that the LMPI and Expanded Approval (EA) adjustments are not necessarily expressed in eighths. I will observe that: eighth increments are “traditional” in primary market pricing, and when you see pricing in other increments, you are likely to be seeing pricing that was derived from a much more exact model. The LPMI adjustments are based on the actual cost to the lender of mortgage insurance policies; the EA adjustments are based on the guarantee fee or loan-level pricing adjustments Fannie Mae comes up with in its Desktop Underwriter AUS. The rest of this stuff, my consumer friends, is ballpark. I know; I’ve been in the meetings. For years. We’ve been charging a quarter of a percent for escrow waivers since before Windows was copyrighted. If you tell me that number comes from some fancy cutting-edge servicing valuation model that looks at exact current float costs and some razor-sharp analysis of marginal credit risk differences, I will laugh in your adorable nerdly little face. I’m sure we had some data when we first made that one up, but we used a sextant, not LORAN and certainly not GPS.

In order to see how this works, let us imagine that Tanta wants a loan: a $140,000 cash-out refi. Tanta’s LTV is 90%, the property is her principal residence, a 1-unit home, and she is providing full documentation of income. However, since she has no idea where her tax returns are hiding, she needs a 45-day lock. Her FICO is 655. Because her brother-in-law’s boss’s Avon Lady’s financial advisor said it had “tax advantages,” she asks for an interest-only loan with “no MI” (that is, LPMI). On the other hand, Tanta read on some website that you should never pay points, so she wants the “no point” rate. You may reflect on how far Tanta and her loan request are or are not “average.”

You can see right now that you have to supply a lot of information to a broker or loan officer these days to get a simple rate quote. Actually, you can’t even get a real rate quote without someone running a credit report on you, because you do not know your own FICO (and even if you think you do, your lender will get that information directly from the credit bureaus anyway). You are already handing over your Social Security Number and incurring cost to someone who will want to recoup it by making a loan, even if all you thought you were doing was “comparison shopping.” And we’re just guessing on LTV at this point; that value isn’t conclusive until some sort of appraisal or AVM determines the value part. But you’ll be in this process fairly deep by the time that happens. Remember that this is a refi request: do you know, really, what your house is worth today? Does Tanta?

So how do we go about quoting a rate/price here? Well, what your broker is likely to do is first add up all the price adjustments you would be subject to. Tanta’s loan gets the following (COR = cash out refi):

Loan amount: 0.125
FICO: 0.750
COR: 0.750

Total: 1.625

Since Tanta doesn’t want to pay points, we must find a 45-day rate that shows premium of at least (1.625). Let’s take that 7.375 rate: it pays exactly (1.625) in premium. So Tanta’s base rate is 7.375: we add 1.625 to (1.625) to get zero points. However, Tanta has some rate adjustments in store:

Interest Only: 0.25
LPMI LTV: 0.30
LPMI FICO: 0.10
LPMI COR: 0.10

Total: 0.75

Therefore, Tanta gets a rate of 8.125% (base 7.375 plus 0.75 adjustments) at zero points. Now, the trouble here is that the broker still has to make some money for going to all the trouble of taking Tanta’s loan application, so Tanta is highly likely to pay one or more “origination points.” Of the many things that makes Tanta a crazy person, indiscriminate use of the term “points” is one of them. Traditionally, the “origination fee” on a loan is the lender’s overhead, which includes commission to the loan officer or profit to the broker. Because it was traditionally expressed as a percentage of the loan amount, it is referred to as a “point,” but it is very important not to confuse it with a discount point: it does not “buy down” the interest rate.

Brokers (or lenders) don’t have to charge origination points; you can and people do just throw in a bunch of flat fees for this and that which end up being profit to someone. I bring this up in part to highlight a real problem in “predatory pricing” land, which is the concept of the “bona fide discount point.” Things have gotten so bad that we actually have to use that term, because you see loans where a borrower got charged one origination point and one “discount” point (they show up separately on the disclosures and settlement statement), but the rate didn’t get discounted appropriately. A whole lot of brokers seem to think that you can charge “discount points” without reducing a premium rate. A whole lot of consumers can never know whether this is happening or not, since, of course, the consumer doesn’t see this rate sheet.

You will notice that, in our example, we picked 7.375 as the “base rate” because we are an honest broker who will get compensation for this loan on the “front end,” by charging some kind of origination fee to Tanta. However, we could have chosen 7.50 as our base rate, which paid (1.750) in premium. If we had done that, after our price adjustments, there would be 0.125% of the loan amount to end up in someone’s pocket. If the broker applies it as a closing credit, Tanta’s closing costs will be reduced by that amount (she would, say, pay a 0.875 origination fee instead of a 1.00 fee). If the broker doesn’t give it to Tanta, it becomes YSP or compensation to the broker. If Tanta doesn’t know that 0.125 is on the table someplace, Tanta doesn’t know whether she should be paying 0.875 or 1.00 in origination fee (or the equivalent in flat fees). She also probably doesn’t know that it doesn’t have to be on the table, because she could have gotten that 7.375 base rate.

Does Tanta have any idea whether that 0.75 add-on for LPMI compares favorably to paying MI herself? Not unless somebody runs some “scenarios” and gives her the figures, carefully explaining the advantages and drawbacks of LPMI. Does she know whether CCB’s add-ons for LPMI are going to be the same at any other lender or not?

Does she understand that the biggest impacts on the price she was offered were her FICO and the fact that she’s taking cash out at a high LTV for cash-outs? If the amount of cash she’s taking is rather modest, does she know that it might not be worth it, considering that she might be able to save up that modest amount of cash in a fairly short time by doing a rate/term refi at a lower rate and therefore lower payment? On the other hand, does she realize that if she reduced her loan amount significantly, her loan amount adjustment would increase?

Does she know she’d get a better rate/price with 5 more FICO points? Is there a way for her to manipulate her FICO in the short term to squeeze 5 more points in? Is there a “credit counseling” company who would be willing to extract some fee from her for assistance in this matter? Will that fee be worth the rate/price break on a 660+ FICO loan?

If this whole rate quote blows up when the appraisal comes back, showing that unfortunately our LTV is over 90%, what will happen? Will the broker go back to Tanta and tell her she has to borrow less, which reduces any of the broker’s compensation that takes the form of a percentage of loan amount, or will the broker lean on the appraiser until a “better” number comes back (or fool around with the inputs on an AVM until it complies)? In the latter case, will Tanta even know that that is going on?

An important thing to bear in mind is that we just looked at one rate sheet by one wholesaler. For some if not most of you, this will be the only exposure to this sort of thing you’ve ever had. If you are now thinking something along the lines of, “OK, so 75 bps is a normal market price adjustment for a FICO in the 620-659 range,” you are making a logical error. It would be a profound logical error if you then assumed that a different wholesaler’s rate sheet with a higher or lower FICO adjustment were “overcharging” or “undercharging.”

The fact is, it depends on how you calculate that base price up in the rate/lock days matrix. A competitor of CCB’s could easily calculate a base price that is better, relative to CCB’s, by 25 bps. That competitor’s FICO adjustments could, then, be worsened by 25 bps, so the FICO adjustment for 620-659 might be 100 bps, not 75 bps, although the end price to the consumer is the same. Even those things that are fairly consistent throughout the industry—like the classic 25 bps adjustment for escrow waivers—can confuse the unwary: some lenders calculate the base price assuming that all loans have escrows, and then worsen the price by 25 bps if escrows are waived. Some lenders calculate the base price assuming all escrows are waived, and improve it by 25 bps if escrows are established. You might see the same value but different signs on different rate sheets.

A casual comparison of price adjustments across even a large number of wholesaler rate sheets will not tell you what the “going market price” of a given risk factor is; you have to analyze the base prices together with the adjustments to get that. “You” in this case are a broker or a loan officer; “you” are unlikely to be a consumer.

You must also remember that risk adjustments are tailored to the guidelines of the loan program being priced. Why is there no adjustment for cash-outs over 90%? This loan program does not allow an LTV that high, so it does not price one. If you wandered over to an Alt-A or subprime rate sheet, you would see additional risk adjustments because crazier things are allowed; you might also find very different values in those adjustments, because the “base price” is set very differently.

I’m guessing by now that you all have spotted the trouble with the idea that risk based pricing is “individualized”: it is, but what an individual loan gets are adjustments based on average performance of loans of that type. How reliable those calculations are will be a matter, among other things, of how a pricing model considers variables singly or in conjunction. In other words, these adjustments you see may be “net of” a lot of factors that aren’t obvious to consumers.

Let me observe that I purposely picked an example loan with a lot of risk-based adjustments on it, so you could see how the process works. But if you hypothesize a loan with fewer adjustments, you can see that a broker could end up with a lot more than 0.125 in YSP off of this CCB rate sheet (and there are, or at least were until recently, wholesale rate sheets out there paying a lot more premium—quoting much higher rates—than CCB’s. We are looking at a “post-turmoil” rate sheet.). It may seem counterintuitive to you, but quite often it is the borrowers with the best credit history and the most conservative loan terms who are most at risk for getting a high interest rate—as long as they stay ignorant about what “YSP” is and why it is showing up as a charge on their settlement statement.

It is perfectly true that a similar mechanism works in retail loan origination; in that context this additional premium is generally referred to as “overage” rather than “yield spread,” and it can, depending on the lender’s practices, be additional profit to the lender or additional commission to the loan officer or (frequently) a split. However, it is even less visible in a retail environment, since "overage" isn't disclosed on the settlement statement the way YSP is. On the other hand, depository retail lenders (so far) face a great deal more regulatory pressure to keep "overages" under control than brokers do.

But to get back to the question raised by the Fed analysts, does every borrower with good credit and conservative loan terms think of him or herself that way? Does the rest of the world, or a vocal subset of it, think that way? How widespread is the belief that minority and low-income people are almost always “subprime” borrowers? If you can make a 110-pound adult believe she’s “fat,” or a college student who gets a C believe he’s “stupid,” can you convince someone who makes $30,000 a year fixing cars and happens to have a Hispanic surname that a 655 FICO makes you “subprime”?

I think you can. If I tried to link to every media article that defines “subprime” as “loans to low-income people,” I would blow the server. A loan to a low-income person that the person cannot, patently, afford is certainly subprime. That is not the same thing as saying that all low-income people are “subprime credits,” but how often do you hear that distinction being made?

How often are prime-credit borrowers given subprime loans? Good question, and I am not making or endorsing a particular claim about an empirical matter for which I don’t have satisfactory data (see the Fed's analysis for the difficulties in sorting that out). I am pointing out that we have the necessary if not always the sufficient conditions for predation when we have “risk based pricing” that is opaque to consumers, and consumers who are not educated about what constitutes “risk.” We are not exactly making it hard for discrimination or predation to occur here.

We also have an industry which hasn’t done a particularly fine job lately proving that it really knows how to price risk anyway. Do price adjustments (of any amount) for FICOs “make sense”? Are they enough? Too much? Beside the point? Are you sufficiently convinced of the predictive power of a FICO score to want to justify pricing a loan on that basis? Particularly when an entire sub-industry of various forms of more or less “respectable” FICO manipulation has grown up around this practice? In the midst of all of that, are you confident that putting the onus on consumers to “shop around” still makes the most sense as a “solution” to the problem of pricing distortions? I’m not.