by Calculated Risk on 1/10/2008 01:01:00 AM

A few people have asked me about this article from the LA Times: Lender stung by fears on finances

Delinquent loans create huge liquidity problems for loan servicers like Countrywide because the servicer becomes a middleman between the borrowers and the people who bought their loans.

When the borrower misses payments, as a record number of Countrywide's borrowers are doing now, these contracts require that the company advance those missed payments to investors until it's clear that the amounts won't be recovered.

With Countrywide having a $1.5-trillion servicing portfolio, that puts tremendous strain on its cash flow, Cannon said.

UberNerds already knew all this. From Tanta (February 2007): Mortgage Servicing for UberNerds

... the other side of “float” for the servicer is the usual requirement that the servicer advance interest (and possibly principal, although that’s less common) to the investor when it is “scheduled” to be due but wasn’t actually paid by the borrower. You’ll see, for instance, the term “scheduled/actual” used to refer to a servicing arrangement. That means that the servicer must pass through all scheduled interest each month, whether collected from the borrower or not, but only actually collected principal. Most deals these days are S/A or S/S. (A/A exists, but it’s like “with recourse,” which we talked about on a prior thread. It takes a very well-capitalized, high-risk tolerance investor to accept an A/A deal; most of the ones I see these days are old Freddie Mac MBS that are down to six loans each and just won’t die until the last payment is made.)

Having to advance scheduled interest offsets the float; it’s another way to balance the incentives. It really starts to matter when we get to this thing called “nonaccrual.” Basically, a usual servicing contract will require the servicer to advance interest until the loan is more than 90 days delinquent, after which it is placed in “nonaccrual” status, meaning it is deemed uncollectable and no more interest has to be advanced.
...
Even if the servicer no longer has to keep advancing scheduled interest, though, it has to keep paying property taxes and insurance, if the borrower isn’t paying it, until the property is sold. It also has to cover the other expenses in a foreclosure (unless the contract specifies that the investor or mortgage insurer will advance for certain costs) until the final payday.
emphasis added

You can access Tanta's UberNerd series from the menu bar: The Compleat UberNerd

I believe the top five servicers are, in order, Wells Fargo, Countrywide, WaMu, Citigroup and Chase.

by Tanta on 12/23/2007 12:48:00 PM

A question arose the other day about balloon mortgages. Balloons are one of those things that have been around, in one incarnation or another, for at least a hundred years in this country, but they were not, by and large, a popular form of (first) mortgage structuring in the big boom of the 2002-2006 period. So we’ve really never talked much about them, our attention having been taken up by the various forms of ARMs. However, you don’t get promoted to Mortgage UberNerd Eagle Scout (Marbles and Piracies Division) until you know what a balloon is. Talking about balloons is also a good excuse to think about a few underlying issues with how mortgages are structured and, crucially, how they get restructured. That last thing is sort of a big deal these days, so it seems apropos.

First, a technical definition: what is a “balloon”? It is a loan that matures before it amortizes. In case that didn’t clear it up for you, let’s start with amortization.

Amortization, in the context of loans, is a mathematical formula that generates a substantially level payment sufficient to reduce the principal balance of the loan to zero with the last installment. Strictly speaking, we call this “full amortization.” The important thing about amortization is that it is more than just some structure that involves periodic repayment of principal.

You could design a loan that requires the borrower to pay the full interest due on each installment, plus some arbitrary amount of principal, say $100. Given a big enough loan, it could take centuries to pay that off, and most people want to retire before that. Certainly most lenders don’t want a loan on the books that long; there aren’t that many houses that have an “economic life” long enough to provide security for such loans throughout their terms. If you simply declared an arbitrary “maturity date” (legally, for mortgages, this is the date that all remaining principal outstanding under the note is due and payable), say 30 years from the first payment date, you could have a situation in which a large chunk of principal is still outstanding on the maturity date. A $200,000 loan, for instance, with a $100 per month principal payment for 30 years would have a balance due at maturity of $164,000. We would call that a “balloon” payment, the metaphor being that the final installment on this loan swells up like a big balloon in comparison to the prior installments.

However, such a loan, with an arbitrary principal payment, is not much like the modern balloon loan, although in the very distant past such loans were made. In the very distant past (just before and during the Great Depression), most mortgage loans were balloons of this type or were interest-only loans with very short terms (a year was common). Why were IOs and balloons the only loans available back in the day? You have to remember that this was long before the invention of the ARM, or a mortgage loan that can “reprice” its interest rate to market without having to actually pay off an old loan and start a new one. Banks and thrifts that funded mortgage loans with deposits had the same problems back in the old days with interest rate risk that they have now: if you make a very long-term loan at a fixed rate of interest, you might find at some point before that loan pays off that prevailing interest rates paid on deposits have increased on you. You therefore have a loan out there earning you, say, 5%, and depositors expecting you to pay them 6%. That is called a “negative interest margin” or “the road to bank failure,” depending slightly on context. Even if you are not experiencing pressure on deposit rates, back in the thrift days of loans funded exclusively with deposits, you might find (It’s a Wonderful Life) that you just have all your assets tied up in slowly-repaying loans when your depositors want cash from you. That’s the classic “liquidity” problem. You will want to bear it in mind in any discussion of whether “the end of securitization” might come, or might be a bad or a good thing.

Offering only short-term loans that had to be renegotiated (refinanced) every year was a way to manage the asset-liability problem and keep things sufficiently liquid. It was, therefore, like the modern ARM, a form of risk-shifting: the interest rate and liquidity risk was taken off the banker and placed onto the borrower. It (more or less) kept the banks solvent and liquid, but it rather famously created a nasty trail of foreclosures when suddenly borrowers just couldn’t find a lender to renegotiate those maturing loans, and didn’t have the cash to pay them off. (Sound familiar? Yep.)

Without straying too far into the history of the mortgage in the U.S., suffice it to say that the big innovation coming out of the New Deal legislation that formed FHA and, subsequently, the old Federal National Mortgage Association (which turned into Fannie Mae, the GSE, rather later) was the fully-amortizing long term loan. At first the new thing was the 10-year loan, then the 20-year loan, then the 30-year loan. (Several decades later, you notice, we’re on the 40-year and even 50-year loan.) So this thing that Americans think of as the “traditional” 30-year fixed rate loan isn’t, in the big picture, all that old.

It required the invention of FHA and FNMA because somebody had to take that long-term fixed interest rate risk and tied-up capital off the banks and thrifts, which were still (the thrifts, at least) mainly deposit-funded. (Note to those who keep insisting that the New Deal-era invention of the government mortgage agencies started the whole problem: this was an attempt to put risk where it could be withstood. We had just gone through a Great Depression which had more or less conclusively proven that individual middle-class citizens have a hard time taking on risks that even well-capitalized financial institutions cannot absorb. The real “road to hell,” in my view, crystallized in 2004 when Alan Greenspan told consumers to go ahead and take ARMs—take interest rate risk—at a time when fixed rates were much more to their benefit. We put the risk exactly on the weakest party, the small-time homeowner, which some of us consider voodoo economics. Ahem.)

This fancy new loan product that FHA and FNMA started buying up had a cool new feature: amortization. That is, full amortization. Not only was the interest rate fixed for the life of the loan, and not only was the life of the loan much longer than in mom and dad’s generation, and not only was the monthly payment stable, but the monthly payment was enough to bring the balance of the loan to zero at the end of the term (whereat one could have a “mortgage-burning party”). We take amortization of loans so much for granted these days that it’s hard to grasp what an “innovation” this was in residential mortgage lending.

It was not, however, a free lunch. The old balloon and IO mortgages actually had, adjusting for home prices and interest rates, a lower monthly payment than the newfangled amortized loans, on the whole. That is, exactly, what pushed the “standard” term from 10 years to 20 years to 30 years, and lately to even longer. The math of amortization is pretty simple: the more scheduled monthly installments, the smaller the installment payment. From the lender’s perspective, those longer terms, while making it possible for more and more people to handle mortgage payments (especially those returning GIs after WWII who were busy creating the Boomers), also made the interest rate risk of those loans harder and harder to bear.

One solution to that problem was to drag out the old balloon concept, and apply it to an amortizing loan. This is the “modern balloon” that we know these days. You calculate a fully-amortizing payment for a loan over a 30-year term—so the borrower gets the benefit of the lower payment based on the long loan term—but you arbitrarily make the maturity date of the loan occur before—sometimes very much before—the point at which the loan amortizes down to zero. For a while, in the 80s and 90s, the popular balloon product was the seven-year: the loan payment reflected a 30-year amortization, but the maturity date was seven years after the first payment date. Because the rate of principal payment in this method is the same as for a plain old 30-year fixed loan, the borrowers who got a seven-year balloon were not racking up equity any more slowly than their neighbors whose loans didn’t balloon. In fact, they probably racked up equity slightly faster, since the balloons were offered with a slightly discounted interest rate (to encourage people to take them). All other things being equal, the lower the interest rate on a loan, the “faster” it pays down principal, and so the lower the total interest charges over the term of the loan.

Detour for beginners: I know some people get confused over the concept of amortization “speed.” A 30-year FRM at 6.00% and a 30-year FRM at 7.00% will both pay off completely in 30 years. “Speed” here is not a matter of time to maturity. It is a matter of the slope of the balance curve. A $100,000 loan will have a payment of $599.55 at 6.00% ($500 in accrued interest for the first month and $99.55 in principal), and a payment of $665.30 at 7.00% ($583.33 in accrued interest and only $81.97 in principal). The amount of the payment does not change over time, but since the balance is declining each time some principal is paid, the accrued interest is less each month and therefore the portion of the payment devoted to principal paydown is greater each month. After seven years of payments, the 6.00% loan has a balance left of $89.639.39 and the 7.00% loan has a balance of $91, 147.41. The formula for amortization always assures that the payment is sufficient to cover the full interest due (plus some principal); so when there is more interest due (because the rate is higher), more of the monthly payment is devoted to interest in the early years of the loan. We therefore say that the higher-rate loan amortizes more “slowly” in its early years.

The actual rate discount on seven-year balloons was less than 1.00% in most cases. Of course the difficulty in calculating the appropriate discount was (and is) complicated by the availability and attractiveness of refinances generally. We all know that a plain old 30-fixed rate loan doesn’t have to stay on the books for the full 30 years, as long as there is someone willing to make a refinance loan. In periods in which prevailing mortgage rates are declining, the average life of a 30-year mortgage loan easily can converge on seven years (or actually any balloon term you can think of). In such an environment there is no point (to the lender) in discounting a rate in exchange for the borrower accepting a balloon term: the lender concludes that any loan it writes is likely to pay in full in less than seven years or so, balloon term or no balloon term. (Right when the lender might like those loans to stick around, since they yield more than a new loan would.)

Another way to say this is that lenders don’t need to write balloon terms onto loans when they expect fast prepayments of loans generally. That is actually one reason why if you just started paying attention to mortgage matters in the last few years, you may not have heard much if anything about balloons. They go out of fashion in low-rate fast-prepayment periods, and the one thing you can say with 100% confidence of the period beginning in 2003-2004 is that we had low rates and fast prepays. As a matter of fact, some of us old farts remember when the legal maturity date on a balloon loan was referred to as its “call date.” A balloon has an imbedded call in the sense that the lender is calling it due before it fully amortizes. In the absence of prepayment penalties (which was mostly the case in the mortgage world until recently), every mortgage has an embedded “put”: the right of the borrower to prepay in full by refinancing. The point is that lenders don’t need to protect themselves with calls in periods of time when borrowers are busy exercising their puts. The prepayment penalty (which is conceptually kind of the opposite of a balloon, in the sense that it tries to keep a loan on the books longer while the balloon term functions to force it off the books sooner) will arise in a market environment, theory predicts, exactly when balloons will fade away.

Probably the most important development in mortgage history that killed the balloon as a popular option was the ARM. (It was actually only in the 1980s that all financial institutions, including the thrifts, were finally allowed by law to offer ARMs.) The old balloon—the pre-Depression loan you had to refinance every year—existed in an environment in which there were no variable rate loans offered to consumers for mortgage loans. In essence, the balloon structure was what allowed the interest rate on the loan to “float.” The trouble, then and now, is that one can never guarantee that there will be a lender ready to make a new loan in the future when the balloon matures. If no one will make you a refinance loan and you can’t pay the thing off, you lose your house.

The modern ARM was not invented in order to shoe-horn consumers into artificially low payments. Nor was it invented to give borrowers the “opportunity” to benefit from falling rates in the future. That’s all marketing materials we developed after the fact to keep loan officers busy; sadly, there are too many loan officers and brokers who haven’t been in the biz very long or have never studied its history, who are perfectly willing and able to confuse marketing with the real straight dope. The modern ARM was invented to avoid the major problem with balloons, the risk that there is no refi money available at maturity, while maintaining the major benefit (to the lender): they make the borrower absorb the rate risk.

The original residential home mortgage ARM (things were a bit different in commercial lending) was a simple one-year or six-month deal. Whatever the interval, the rate adjusted at each interval from the very beginning. That’s a tough loan for a lot of folks, especially first-time homebuyers. (Yes, we knew that fact a long time ago. We “forgot” it in the latest craze.) The big mortgage product innovation in the early 90s was the “hybrid ARM.” That’s the one that is a hybrid of a fixed rate and an ARM: you get your rate fixed for three or five or seven or even ten years, then the loan turns into a 6-month or (originally) one-year ARM after that for the next 27 or 25 or 26 or 20 years. Like the balloon, these loans could (in certain market environments) be discounted from the competing 30-year fixed rate. (NB: it is extremely difficult to discount a 10/1 ARM; that is really only possible in occasional and fairly brief rate periods. That’s why you see them pop up every now and again and then quickly disappear. Most of the time, given typical prepayment patterns of 30-year FRMs, there is no way a lender can offer a better rate on a 10/1 (or even at times the 7/1) than on the FRM, so they just come off the rate sheets, like the balloons do.)

The important difference between the hybrid ARM and the balloon is that the ARM does not, legally, have to be refinanced at the end of the initial period, because the hybrid ARM still has a 30-year maturity date. The borrower may not want the loan after it starts adjusting, but the borrower is not forced to refinance it or else pay the entire balance due. In other words, the hybrid ARM had a built-in “fallback position” for the borrower. If you ignore, for the moment, the question of whether a borrower can afford the rate adjustment, compare the likely fortunes today of a borrower who took an “Alt-A” balloon five years ago, versus a borrower who took a 5/1 ARM. The ARM borrower may be pretty unhappy right now about how his payment has increased, and how he can’t find a lender offering any way to refinance it. The balloon borrower, however, is in foreclosure: he isn’t facing a higher monthly payment, he’s facing coughing up 70% or more of the original balance of the loan in cash or else, so it’s practically speaking else, since it’s quite likely nobody is writing the same kind of Alt-A loans now that they did then. In this sense, ARMs are “safer” for consumers than balloons.

Of course it didn’t take lenders long to start innovating the balloon. Heretofore I have been describing what we in our charming way call the “bullet” balloon: this loan is simply due and payable on its maturity date, or else it’s see you in foreclosure court. Fannie Mae and Freddie Mac, in particular, were getting some pressure from the industry in the 80s to buy balloon loans, but they, in their actually quite frequent more-pro-consumer-than-the-bankers mentality, hesitated over the “bullet” part. This was not stupid on their side, whatever hogwash the industry was insisting on at the time. So they came up with what Fannie called the “conditional right to refinance” and Freddie called the “reset option.” I will here use the term “reset,” hoping it doesn’t cause too much confusion with the concept of ARM resets. They’re not exactly the same thing, by a long shot.

The “reset option” balloon offers a possible, but not guaranteed, extension of the loan past its balloon date. Regardless of Fannie Mae’s use of the term “refinance” in this context, these loans weren’t actually refinanced at the balloon date; they were modified. But the modification happened under contractual terms and conditions. The standard deal, as spelled out in an addendum to the old bullet balloon note, said that the loan could be reset if the home was still owner-occupied, the borrower had made payments on time for the last 24 months, there were no subordinate liens, and the rate on the reset was not more than 5.00% (five points) higher than the old rate. If you met all those requirements, the lender would simply modify the loan so that 1) the maturity date was extended to a full 30 years after the original first payment date and 2) a new fully-amortizing payment was calculated on the outstanding balance at the balloon date over the remaining term at the new interest rate. In other words, it became a regular old fixed rate loan. This is very different from an ARM reset: not only does an ARM just reset to a new ARM (not to a permanent fixed rate), but the ARM reset is unconditional (as long as you are making payments, it doesn’t matter if you still occupy the property or you were once delinquent or anything else).

The balloon note addenda that lenders used generally specified a formula for determining what your rate would be if you exercised the reset option; it was typically 0.375-.625 (a spread) over the Fannie Mae or Freddie Mac 60-day required net yield for mandatory deliveries of 30-year fixed rate mortgage loans (a kind of index, or more properly a baseline “market” mortgage rate), rounded to the nearest eighth. In practice, that worked out to a rate that was generally somewhat higher than what you could get with a regular refi, but since it usually required you to pay only a modest reset fee ($100-$250 or thereabouts was typical), it was in those days a lot cheaper than refinancing. The limitation on how high the new rate could be compared to the old rate was a way of forcing a loan that would suffer severe payment shock in a reset to have to be processed as a full refinance, with complete new underwriting and a new appraisal and all that.

The restriction on subordinate financing was less a credit risk issue, actually, than it was a function of the legal issues of mucking around with an existing mortgage. Modifications are cheaper for everyone involved than refis, because they don’t involve paying off an old loan in full and processing the release of the old lien. You just file a new document in the land records that supercedes (some of) the terms of the old recorded mortgage (like changing its legal maturity date), but you keep your old lien priority because your old lien is still out there. That won’t work if someone has filed junior liens subsequent to your old first lien balloon loan: your modification could mean (at least in some jurisdictions) that your loan suddenly becomes a second or third lien instead of staying in first position. If a balloon borrower had one or more junior liens, he or she would have to do a full-blown refinance and either take enough cash out in the new loan to pay off those junior liens, or refinance the second lien as well with a different or the same lender, or convince the junior lienholders to execute a thing called a subordination agreement that “moves” those junior liens back into junior position when the new refinance loan is recorded (back in first place).

I bring all that major mortgage trivia up because this problem of junior liens has become quite an issue lately with “workouts.” We’ve seen some reports of borrowers who are trying to use the FHASecure program to refinance their resetting ARM first liens, but who are of course so far underwater with their second liens included that they can’t, in fact, borrow enough in the refi to pay off the second lien (that is, to roll two loans into one new one). But FHA will not let itself get to second lien position, so these borrowers are struggling to get their second lien lenders to execute subordination agreements. (Refinancing the second lien isn’t really an option, since second liens are so dangerous right now that they’re hard to get, and when you can get one the new interest rate would be even more exhorbitant than what these borrowers are currently paying, and the whole point is to keep the monthly payment affordable.) There seem to be some people who assume that this problem is occurring because second lienholders would rather foreclose, and are—gasp!—being “pressured by the government” to work things out with a subordination agreement. Nothing could be further from the truth: these second liens are so far upside down that they wouldn’t even recover costs in a foreclosure, let alone any principal. As far as I can tell, the problem with getting a subordination agreement is an operational one: either the second lien lenders are just understaffed (or have recently hired staff who never lived through a bust and hence have never seen this old-fashioned thingy called a “subordination agreement”), or the second liens were securitized and nobody knows who has to execute the subordination or where to send it or it’s piled up at the trustee or, you know, the usual chaos created by securitization of loans outstripping operational capacity.

Of course things don’t always work out that way: historically, one of the problems with the resetting balloon was that the RE market was a little better than it is today, and so a borrower who did take out a junior lien might find that in fact, the junior lienholder has no particular interest in subordinating because it could quite possibly recover its loan fully in a foreclosure. In that case, the borrower isn’t allowed the reset option, and is stuck trying to find a refi lender who will lend enough to pay off all liens. In some cases, you had (a few years ago) borrowers who had taken a conforming dollar balloon, but who had then, as the property appreciated, taken one or more junior liens that brought the total indebtedness into jumbo territory. So when they went to refinance, they went from conforming rates to jumbo rates, and from purchase rates to cash-out rates (if the junior liens aren’t sufficiently seasoned, this kind of refi would be priced as a cash-out). If there were also market movement in there, the rate shock on the new loan could really suck. If jumbo lenders just weren’t interested in making cash-out refis at the time, it would more than suck.

I hope this provides some context in which you can fully understand the disingenuousness of the subprime lenders who claimed for all these years that the 2/28 ARM was about helping those poor folks by offering a “recuperation” loan. The idea being that the borrower could rack up a clean 24-month payment history during the fixed period (as we’ve seen, that 24-month payment history is a key part of defining eligibility for a “prime” refi or reset) and then refi into a cheaper loan; if the borrower didn’t “recuperate” his payment habits, the “worst” that would happen is that his monthly payment went up. Really, to claim that is to say that the 2/28 is a better deal than a two-year bullet balloon. Well, yes. That’s true. If you don’t remember anyone offering two-year bullet balloons all over the place before the invention of the 2/28 ARM, you’re with me. Subprime lenders used to offer straight 30-year fixed rate loans, or at worst a five or seven year balloon term on a 30-year amortization. In comparison to that, the 2/28 is hardly a super dooper deal. In the real world, outside the marketing department, the point of the “2” in the 2/28 was that that was only as long as the lender was willing to deeply discount the rate far enough that the borrower could qualify at the start payment. The part about the “2” being coincidentally equal to the usual “recuperation” period is something we liked to keep telling you to convince you that we’re just here to help you.

Finally, you may also hear mention of balloons in the context of workout options. There are lots of different ways one can work out a past-due loan. One possibility is to take the amount by which the borrower is past due, add it to the balance, reamortize the loan over the remaining term, and get the borrower started on the new payment. That works only if the borrower can stand the marginal payment increase, and many borrowers just can’t. So an alternative way of handling this is to add the past-due amount to the balance, but not recast the payment. In essence, that creates a balloon payment at the end of the loan (on its original maturity date), because the monthly payment is now not enough to bring the balance to zero with the last scheduled installment (while it is enough to cover at least interest due, so it doesn’t create negative amortization). The argument for doing this is, of course, that maturity is usually a long time away and that gives the borrower plenty of time to recover financially and either start making higher voluntary payments down the road (to bring the loan back onto its original amortization schedule) or sell the home or just have enough in reserves at maturity to pay off the balance in cash.

That was a very practical solution back in the old days when people started out in amortizing loans at not-so-deeply-discounted initial rates. The problem we have now is that too many people started out in “workout” loan terms. For borrowers who were making only interest payments to start with, you’re got a lot of them who can’t handle any amortized payment on any balance. (That goes extra-especially double for Option ARM borrowers who have been making even less than full interest payments.) For these borrowers, you would have to go beyond capitalizing a past-due balance, and actually create an even bigger balloon by calculating a new payment on a ridiculously long term (while not moving the maturity date out). Some of these loans started out with a payment calculated on a 40-year term with a balloon maturity at 30 years. To work them out would require calculating that payment on 50 or 60 or 70 years, which just keeps making that final balloon bigger and bigger or else it gets to the point where it does create negative amortization (if the rate is too high and so the recast payment can’t cover all interest due). So it might work out OK if in fact the borrower is committed to long-term homeownership; it will do nothing for a borrower who tries to sell in a year or two because all that principal is still due and payable when the property is sold.

Eventually these “workouts” start to resemble the old pre-Depression ticking time bomb balloon. They might not legally force the issue every 12 months, but then again the American population is used to a whole lot more mobility—the employment scene has become structured to require it—than their 1920s forebears. As far as I’m concerned, to think that “ballooning” these loans is a workable strategy for getting a sizeable number of borrowers out of the soup rests on a pretty Pollyannaish view of how long it will take for home values to recover: I think we’ll have to “balloon” more principal than eventual return to home price appreciation can “disappear,” even if you could talk investors into accepting such a very slow rate of principal return, or avoid blowing to Kingdom Come some of these securities which rely on fully-amortizing mortgage payments to keep the cash-flow to investors working out as planned.

We have observed before now that a lot of these whacky mortgage products—IO, neg am, balloons—just don’t work out in the mass market. They “work out” insofar as they imply a savy borrower with the ability to save substantial amounts of money (and therefore make periodic voluntary principal reduction payments or one lump-sum cash payoff). The economy hasn’t put most of us in that position (stable or increasing earnings in excess of the cost of living creating piles of disposable cash to prepay mortgages with) in a long time, even when it wasn’t busy inflating home prices out of reach. The current situation with “toxic” mortgages was brought to you courtesy of an ideological fixation on “free markets” and lenders not being “paternalistic” about the mortgage choices they offered or withheld from certain borrowers, as well as a covert agenda (I’m talking to you, Dr. Greenspan) to make borrowers think they were getting a deal (rate risk) that the banks wouldn’t take if you paid them. As is usually the case, that’s all just fine and dandy until it blows up, then the free marketers scurry to the government looking for help getting out from under a pile of exploding loans. That’s hardly surprising, given that anyone who willingly put borrowers into loans like this is, objectively speaking, a sociopath. If you expected them to take their licks like grownups, you don’t understand much about the essential dynamics of sociopathology.

And, predictably, we start talking obsessively about disclosures again. Of course loan disclosures can always be improved, but there gets to a point where some loan products are just simply so complicated that there isn’t any easy, clear way to explain them fully to most people. This is nature’s way of saying you shouldn’t offer those loans to most people. I have personally been known to get rather impatient with people who start nattering on about those stupid borrowers who took loans they didn’t understand (like balloons or IOs or OAs or whatever dumb thing we’re talking about). They weren’t supposed to understand them. By that I do not necessarily mean that they involve math-like concepts that are over a lot of people’s heads, although sometimes the weirder ones do. I mean that borrowers weren’t supposed to understand themselves. We were all supposed to look in the mirror and see the upper-middle-class people on TV sitcoms or financial-planning infomercials who will always be able to make those voluntary principal payments or handle those balloon payments or—snort—“invest” the principal portion of the payment in some fantabulous risk-free deal that made mortgage financing free after taxes or whatever that long song and dance is. You can write any pristinely clear mortgage loan disclosure document you want, but if the world keeps telling you it is your patriotic duty to confuse yourself with your economic betters, it won’t do you any good. To some extent, what we need are clearer “disclosures” of our paycheck math and our “necessary” expenses. As that would not likely reinforce a nation of optimistic spenders, it isn’t on the table as a priority. So we’ll spend inordinate amounts of regulatory time and energy teaching people what a balloon loan is and stuff like that. If you close your eyes you may be convinced that it's just spring and the world is puddle-wonderful.

by Calculated Risk on 11/08/2007 05:59:00 PM

Tanta wrote another incredible and timely post this morning: WaMu and The Rep War

IMO Tanta's posts on the mortgage industry are the most informative anywhere, and I suggest checking them out at Tanta's The Compleat UberNerd (a directory of her posts). These posts cover Mortgage Servicing, Private Mortgage Insurance, Reverse Mortgages, Mortgage Backed Securities (MBS) and much more.

You can also click on the The Compleat UberNerd in the menu at the top of the blog to access this directory.

Felix Salmon, at Market Movers on Portfolio.com had this to say yesterday about Tanta:

"Tanta is one of the best financial writers in the world, and explains complex ideas with wit and great clarity."

I couldn't agree more. Enjoy her posts!

by Tanta on 10/19/2007 09:30:00 AM

Given the questions in the comments to yesterday's post on seller-funded down payment assistance (DAP), I thought I'd offer a very simplified example of what the issue is. Yes, this is simplified; FHA loan calculations are pretty complex, even though they aren't as complex these days as they used to be.

Currently, FHA requires a minimum cash investment from borrowers equal to 3.00% of the contract sales price. The effective LTV can still exceed 97% even with a 3.00% investment, because borrowers can finance a portion of allowable closing costs, including their up-front mortgage insurance premium (UFMIP), in the loan amount. (FHA borrowers with a base LTV of more than 90% also pay an additional mortgage insurance premium in the monthly payment of 0.50% annually.) The current UFMIP with 3.00% down is 1.50% of the loan amount.

The administration's proposed zero-down program would have UFMIP of at least 2.25% and a monthly premium of at least 0.55%.

FHA does allow the borrower's down payment to come from gift funds provided by relatives, employers, governmental agencies or true charitable organizations. The point here is that 1) these are supposed to be true gifts with no expectation of repayment, not disguised loans, and 2) they may come only from parties who do not have an interest in the transaction.

Property sellers may contribute up to 6.00% of the sales price to an FHA borrower without affecting the appraised value of the property, but this contribution may be applied only to closing costs and points, repairs, etc., not to the minimum investment (i.e., the down payment). If the seller contributions exceed 6.00%, the excess amount is subtracted from the sales price of the property (as a "sales inducement"), which lowers the maximum loan amount accordingly. HUD has never allowed property sellers to directly provide funds for the minimum 3.00% down payment.

The seller-funded DAP programs get around this problem by having the property seller contribute the down payment funds to a "nonprofit" company which then "gifts" the funds to the borrower. Sellers are generally charged a fee of at least $400 for "processing" their contributions. Every reputable study (non-industry-sponsored) of the resulting loans (like this one) shows that 1) the sales prices of the properties are inflated by the amount of the "assistance" and that 2) the loans default at least twice as often as those with bona-fide gifts from a disinterested party. Even worse, because they are processed with the standard UFMIP charged to loans with a 3.00% down payment, this additional risk is not offset by a higher premium.

Here's how it works. First, here's a "typical" FHA loan with a 3.00% down payment (we'll assume that the seller pays closing costs other than UFMIP in cash, just to keep things simple):

• Original list price: $100,000
• Contract sales price: $100,000
• Appraised value: $100,000
• Required borrower down payment: $3,000
• Base Loan Amount: $97,000
• UFMIP: 1.50% or $1,455
• Total loan amount: $98,455
• Effective LTV (based on original list price): 98%

Here's how it works with a typical seller-funded down payment:

• Original list price: $100,000
• Contract sales price: $103,505 (list price plus $400 processing fee, divided by 0.97)
• Appraised value: $103,505 (or any amount above that, as LTV is calculated on the lower of appraised value or contract sales price)
• Required borrower down payment: $3,105 (provided by the seller via the DAP)
• Base loan amount: $100,400
• UFMIP: 1.50% or $1,506
• Total loan amount: $101,906
• Effective LTV (based on original list price): 102%

If the DAP loan were treated as the same risk as the proposed zero down program, you would get UFMIP of 2.25% or $2,259, resulting in a total loan amount of $102,659 and effective LTV of 103%. That would actually produce a higher loan amount than a true zero down program would, because of that $400 "processing fee" to the "nonprofit" (zero down base loan amount of $100,000, UFMIP of $2,250, total loan amount of $102,250, or $409 less than the "assistance" loan).

What happens if the appraiser refuses to play along with this scheme? Well, that would create a problem: the maximum loan amount is calculated on the lesser of the sales price or appraised value, and so the borrower could not borrow enough to pay the inflated sales price if it were greater than the appraised value.

What if the seller simply reduced the contract price by $3,505 (the cost of assistance plus processing fee)?

• Original list price: $100,000
• Contract sales price: $96,495
• Appraised value: $100,000
• Required borrower down payment: $2,895
• Base Loan Amount: $93,600
• UFMIP: 1.50% or $1,404
• Total loan amount: $95,004
• Effective LTV (based on original list price): 95%

The problem with that last scenario, of course, is that the borrower still has to come up with a down payment. The whole purpose of seller-funded DAPs is to get borrowers with no funds into loans, not merely to facilitate legitimate seller concessions.

Does it really matter whether gift funds come from an interested party? Yes, it does. A party without an interest in the transaction has no incentive to induce or persuade the borrower to pay more than the fair market value of the property; in fact, a distinterested party has an incentive to assure otherwise, since the lower the appraised value and contract sales price, the less the third party has to contribute. Government agencies and true nonprofits who provide such assistance are known for being mean and skeptical reviewers of appraisals and sales contracts, you see. (They also generally have income limits and other rules designed to keep speculators and other non-needy folks out of their programs.) Seller-funded DAPs avoid all that "red tape" and "excessive processing time."

I personally have never had any enthusiasm for the proposed zero down FHA program. But even it is better than the DAP scam. Those who claim that DAP loans provide a benefit to borrowers without funds are making no sense even if you grant that making loans to people without even minimal skin in the game is a good idea: the DAP programs simply keep contract sales prices inflated, channel fees into the pockets of "nonprofits" who provide no other service than laundering money, and result in lower insurance premiums than FHA should be getting for loans with riskier profiles. If you care at all about the long-term survival of the FHA program, you would be doing everything you can to protect it from this kind of damage.

By their own logic, the Congressional defenders of DAPs should be pursuing the zero down program, and/or funding for true nonprofits and local governments who provide forms of down payment assistance that don't inflate sales prices and that offer real, useful homebuyer counseling services. One of the arguments for DAP is that it is available for borrowers who aren't lucky enough to have family, an employer, or a local agency or true nonprofit who can provide gift funds. That's right: if you aren't lucky enough to receive a true gift that enables you to buy a market-priced property, you can be thrown to a bunch of sharks who will provide you with a "gift" with a hidden price tag. This is a good thing, since owning an overpriced home and making the higher payments is, I guess, a major blessing.

Supporting DAPs means supporting property sellers--particularly but not limited to builders and developers--and the "entrepreneurs" who form "nonprofits" to extract fees from naive homebuyers, not to mention loan originators who pocket higher commissions, with the risk being carried by government insurance. It is, precisely, the kind of sleazy, conflict-ridden, self-serving "initiative," overtly "faith-based" or its sort-of secular equivalent "dream-based," that thrives in an environment where regulation is dismantled or unenforced and "government" is bashed with one hand and milked with the other. It is an "innovation" just like plainer, older-fashioned forms of money-laundering are "innovations." It takes a profound ideological blindness to march behind the DAP banner in the name of "helping first time homebuyers."

by Tanta on 9/28/2007 09:46:00 AM

Via Mr. Coppedge, I see Accrued Interest has a nice UberNerd (AccruederNerd?) on CDO structures that I missed first time around, with a follow-up here that will warm the heart of any poor downtrodden credit analyst who got stomped on by the quants. I recommend it; it makes a point I've tried but dismally failed to make clearly, which is that the big issue for a lot of these deals is timing of default, not level of default. If you're still confused about how a relatively low level of early default can hurt much more than a comparatively higher level of later default on a structured security, this post will certainly help you.

For contextual purposes, here's a set of charts from Moodys that you may ponder. (These are MBS/ABS issues, not CDOs, but they'll be the collateral in a lot of CDOs.) Notice how the slope of the 2006 vintage changes in just six months, as more of the deals in that vintage get old enough. Notice also that this chart is based on original balance (so the numbers won't match anything you see quoted based on current balances), and that the comparison is the 2000-2001 vintage. That's a meaningful comparison because, until 2005-2006 came along, the 2000-2001 vintages were about the ugliest anyone had seen in a long time.

by Calculated Risk on 9/26/2007 01:07:00 PM

My apologies to Tanta, this is my version of an UberNerd post: How to graph housing prices.

The NY Times included a graph of real house prices based on the Case-Shiller index in the following article: They Cried Wolf. They Were Right.

Click on graph for larger image in new window.

The graph has several interesting events annotated, including when economist Dean Baker sold his condo in May 2004, and Fed Chairman Ben Bernanke's comment in Feb 2006 that Fed policy makers "expect the market to cool but not to change very sharply".

Unfortunately I think this graph is somewhat misleading and technically incorrect. So I'd like to use this graph to illustrate how to graph housing prices.

This graph is based on the quarterly S&P/Case-Shiller® U.S. National Home Price Values. The S&P/Case-Shiller® index is for nominal house price (not adjusted for inflation).

To adjust for inflation, the NY Times used the CPI from the BLS. This is a slight technical error; an economist would adjust the Case-Shiller index using "CPI less shelter". Admittedly the differences are minor.

Setting Q1 1987 to 100, the NY Times calculated prices fell to 92 in Q4 1996. Using CPI less Shelter, prices would have only fallen to 93 (minor difference).

However, the NY Times calculated prices peaked at 171 in Q1 2006. Using CPI less Shelter, the peak was actually 176, about a 3% difference.

The other problem with the NY Times graph is the choice of scale without warning the reader. IMO the starting value for the y-axis should be clear. This graph is fine if the reader understands that the graph shows the changes in real values, but not the relative absolute values.

Click on graph for larger image.

The second graph shows the same data with the scale starting at zero (the blue line is the NY Times calculation of real values, the shaded area is the technically correct calculation).

But even this graph could mislead the reader. Will prices return to 100 (the Q1 1987 price)? Unlikely. First, 1987 was chosen because that is one the Case-Shiller index starts. We do not know from this chart if prices in 1987 were too high, too low, or just about right.

Second, real prices for houses do increase over time - perhaps on the order of 1% to 2% per year. Using 1987 as a starting point, a 2% real return would have put current real prices at 150; a 1% annual return would put the current value at 122.

What people really want to know is what will happen to nominal prices in the future. But the focus on real prices helps predict changes in future nominal prices. I'll have more on this later.

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.

by Tanta on 9/12/2007 09:30:00 AM

I saw another media piece on ARM resets this morning. The last time we posted on ARM resets, there came to pass some confusion about the differences among the various published numbers. My very simple purpose today is to help everyone understand why you can, legitimately, get very differing numbers, and what questions you should ask of any data so that you can understand what you’re being told.

It comes down to several questions: Are we using originations data or outstandings data, and if the latter, from what point in time? Are we looking at all ARMs, or just securitized ARMs? (Do note that investment bank sources generally focus on securitized ARMs only, because the performance of securities is their concern, not necessarily the performance of all mortgage loans.) Are we looking only at first reset, or at all resets? What prepayment and cumulative foreclosure assumptions are we using?

Here’s a very concrete example to flesh out the issues. You have a hypothetical 2/28 ARM portfolio of $1.2 million original balance. It contains 12 $100,000 loans, one originated per calendar month of 2005. Each loan will have a first rate adjustment in each calendar month of 2007. The “12-month reset projection” for this pool, considering only the first adjustment, is very simple: each month, 1 loan resets, for a dollar amount of $100,000 per month or $300,000 per quarter.

But what if you do not limit yourself to just the first reset? The 2/28 will, if it does not prepay, reset every six months after the first reset. If we assume no prepayment, then, and include subsequent adjustments, we get 1 loan resetting in January-June, but 2 loans resetting each month from July-December. Starting in July, there is 1 loan hitting its first reset and 1 loan hitting its second reset. If you simply counted resets, you would show 2 loans in July-December, for a balance of $200,000 per month. If you tried to total up the monthly balances for a year, you’d end up showing $1.8 million in resets on a $1.2 million portfolio of loans. You could say, in a certain context, that $1.8 million in resets are scheduled for 2007, but that is not saying that $1.8 million worth of loans are “at risk.”

And, of course, not every loan will survive on the books after its first adjustment. It could pay off voluntarily (refi, home sale) or involuntarily (short sale, foreclosure). If you wanted to take a vintage of originations and project out a reset schedule, you would have to make projections of prepayment and default. If you started with current outstandings, you would already have your prior prepayments and defaults removed from your pool, but you would still have to project these into the future, unless your goal was a “what if” scenario that involved no loan paying off or defaulting until its reset date.

Even if you wanted to do that, there’s no reason to assume that all reset-related defaults will be due solely to the effect of the first adjustment. It is the most wicked reset for the borrower, but the ugly fact of the 2/28 ARM is that borrowers who survive the first adjustment, possibly just barely, will get another smaller one in six months, and then another one in another six months, until the loan reaches either fully-indexed (then-current 6-month LIBOR plus margin) or its lifetime cap (usually start rate plus 6.00 points). Given the depth of the teaser discounts, the hefty margins, and the movement in LIBOR since these loans were originated, there is no reason to think many of them won’t keep adjusting upward every six months for two years until they hit indexed or capped. So the borrower who just barely survived the first reset might go down at the second one. The borrower who more comfortably survived the first reset might go down at the third one. There is a point to “cumulative” projections of resets.

However, you would still have to adjust these numbers further. You would also project index values forward (to guess when caps will come into play and loans would stop adjusting), and you would have to take into account varying margins. I could assume for our hypothetical pool that all loans have the same margin, but in the real world they don’t.

You will, therefore, see differing presentations of reset volume, and those differences may have a lot to do with prepayment speed assumptions, underlying index movement assumptions, or the weight of caps and margins in a particular pool of loans. That does not mean that someone is lying to you, although you may or may not find the underlying assumptions reasonable (assuming you can figure out what they are).

Today, Reuters reports this:

About $75 billion in adjustable-rate U.S. mortgages are going to reset in the fourth quarter, most of which will emerge next month. Of the loans resetting, around 75 percent are subprime mortgages.

As far as I can determine, this $75 billion number includes only the first reset of any ARM (the date on which it changes from “fixed to floating” rate), based on Q207 securitized outstandings, and has no prepayment adjustments. If you assume even conservative prepayment speeds, the actual number of resets will be lower. However, if you “add back” subsequent adjustments for loans that survived their first adjustment, the raw number of resets is higher. The Bank of America chart CR posted several weeks ago shows securitized plus non-securitized, which is why it has such large numbers compared to the Reuters number. I believe, but cannot verify, that it also includes only the first adjustment.

There is no “right number.” There is only a number in context.

by Tanta on 9/07/2007 04:47:00 PM

Earlier today I asked, rhetorically, how many mortgage loans are brokered, and opined as how it’s a tough question to answer. Some of you expressed interest in what the difference is among the various “origination channels” in the mortgage business. Those of you who couldn’t care less have your fellow readers of this blog to blame, not me. I just work here.

First of all, the picture is complicated by the fact that there are two basic mortgage markets: the primary market and the secondary market. Some terms tend to shift in meaning between the two, as does the perspective (say, from “buyer” to “seller” or “lender” to “investor”). Furthermore, some terms have regulatory meanings that make sense to insiders and cause hopeless confusion among civilians (like the dreaded term “origination.”) So some questions simply do not get short answers, unless you want to stay puzzled for a long time. It’s faster just to read a longish post, trust me.

The primary market is where loans get made in the first place. The secondary market is where loans that have already been made get bought and sold. Is this always an easy distinction to make? Nope. It used to be, when loans were always made by lenders who used their own capital: the primary market involved a borrower and a lender, and you could ace the quiz on that with no effort. But we wouldn’t be having this blog post if that were still the case.

“The lender,” technically, is the party whose name appears on the note after the words “I promise to pay to,” “I” in this case being the borrower. The “original mortgagee” is the lender, who receives the pledge of the property (the mortgage) from the mortgagor (the person who owns that property) as security for the loan. Once the secondary market kicks in, we usually refer to a subsequent owner of the note as the “noteholder,” since that party now has legal rights to that promise to pay, but was not actually the original “lender.” The mortgage can get assigned to the noteholder or to the noteholder’s servicer (for legal reasons having to do with facilitating a servicer acting as party to foreclosure proceedings).

Notes can be sold without servicing rights (called “servicing retained” deals in the secondary market), or with servicing rights (called “servicing released”). Servicing rights previously retained can be subsequently sold separately (“bulk servicing sales”). A “servicer,” strictly speaking, doesn’t actually own anything other than rights to service the loan for a fee, unless that servicer also was the original lender and kept the note, or bought the note and the servicing rights together. You can actually have a “subservicer,” who does the day-to-day servicing work (collecting payments, losing people’s tax bills) for a fee, but who doesn’t actually own the servicing rights (those appear as “MSR” or mortgage servicing rights, an asset, on someone else’s balance sheet, that someone else being the “master servicer” who pays the subservicer for the grunt work, performs the higher-level managerial work, and pockets the difference between the subservicer’s fee and the total “servicing fee” on the loan). That’s all secondary market stuff, though: the original lender is the “servicer” also until such time as that lender transfers the servicing to some other party.

You would think that the “lender” is actually the party who cuts the checks after the borrower signs the note, but that would be that olden days kind of assumption. The fact is, we have also separated out the functions of “funding” loans from “disbursing proceeds of loans.” The “lender” is the party who “funds” the loan, but in the primary market a borrower will generally receive the disbursement from a settlement agent or attorney. The lender wires funds to the settlement or escrow agent, who then doles it out to the property seller, the appraiser, the county recorder’s office, the borrower, etc. A lot of people think that their broker was a "lender" because they got the money from a title company and didn't realize that the title company didn't get it from the broker, but from a "wholesale lender."

In the old days when mortgages were exclusively made by banks and thrifts, the money the lender used to fund the loan was the lender’s own capital: it came from deposits and equity and other quaint concepts. That didn’t mean that loans weren’t sold on the secondary market. The whole idea of the GSEs arose because depositories had huge portfolios full of tied-up capital in 30-year loans, with a deposit base of demand accounts and short-term CDs. Many people still assume that the whole point of the secondary market is to transfer credit risk, but actually its major function has always been to provide liquidity. Remember that the GSEs buy the good loans, not the trashy stuff. It wasn’t that banks necessarily wanted out from under risky loans, at least until this subprime and Alt-A business started. It was that they needed that capital back to lend again, at a new market rate that kept up with whatever they were currently paying depositors.

However, depository lenders have been unable to absorb the entire primary market demand for decades (there aren't enough deposits to fund our mortgage appetite). The original innovation was the “mortgage banker.” That term confuses people because it has “bank” in it, but a mortgage banker is not a depository. It is a company that raises short- to intermediate-term capital, generally through borrowing in the capital markets, to fund mortgage loans with. It then sells the loans it makes in the secondary market. Its profits come from the spread between its cost of borrowing and the interest rate on the loans, while it owns them; the gain on sale or the spread between what it funded the loan for and what someone else will pay for it; and fees paid by borrowers. So a mortgage banker is a “lender” in our sense here, even though it lends borrowed money. (Remember that a depository is also, in a certain sense, lending borrowed money: it just “borrows” money from depositors, not from the capital markets.)

The term “warehouse line of credit” is used for short-term revolving loans made by capital market participants (money center banks and investment banks, mostly) to mortgage bankers. As loans are made, they are funded with warehouse money with some kind of haircut (meaning that mortgage bankers have to have some capital in the game, but often not much more than 2.00%-3.00% on a given prime-quality loan). The loan stays in the warehouse as “inventory” until it is sold to a secondary market participant. The proceeds of the sale pay off the warehouse line, with the excess to the mortgage banker as revenue. There are other ways for mortgage bankers to fund loans, like repo facilities and commercial paper and other things that have not been kindly treated in the marketplace lately. Suffice it to say that it all makes sense as long as the line stays open, the loans keep getting sold, and the spread stays positive. When warehouse lenders increase the rate they charge on warehouse borrowings, mortgage bankers either raise rates to consumers or go out of business. It’s particularly nasty when warehouses have floating rates, the loans have a fixed rate, and the mortgage banker has to hold them a lot longer than intended because the secondary market is not functioning “normally.” Like, um, now.

In any event, depository lenders are almost always able to be mortgage servicers (whether they want to or not). Not all mortgage bankers have servicing capability, at least in terms of long-haul servicing. Most small-to-middlin’ mortgage bankers these days use a subservicer to handle the loans while they’re in the warehouse, and when they finally sell the loan, they sell the servicing rights too. Most small-to-middlin’ depositories do that as well. Brokers have no servicing capability whatsoever.

Most mortgage bankers and depositories sell loans to the GSEs, but the GSEs do not buy servicing rights, and they don’t service loans (except occasionally for boo-boos they have to buy out of securities or take over in the event of a servicer failure). It is possible to do something called a “concurrent trade,” where a mortgage banker or a depository sells the notes to the GSE at the same time it sells the servicing rights to someone else. That someone else can be a mortgage servicing company, like Ocwen or GMAC Servicing, or a full-service mortgage banker or depository that also services, like Countrywide or Wells Fargo. But concurrent trades take a lot of talent and money (you have to hold the loans as inventory as they trickle in via closings until you have a “bulk” or pool to sell) and have some risk. Out of this problem developed the correspondent business.

Much easier than a concurrent trade for the little bankers and banks is the correspondent sale: you sell the whole loan, servicing released, to an “aggregator” or “conduit,” basically a bigger banker or bank than you are, who in turn sells the notes to the GSEs and keeps the servicing rights itself. That gives you a way to unload loans in a single transaction instead of two. It also allows you do to “flow” sales. The big aggregators like Countrywide and Wells Fargo and so on have “correspondent” programs that involve their buying loans one at a time as they are closed by the lender, or in small groups we affectionately (sort of) call “mini-bulks.” Flow is attractive if: you want those loans to keep revolving out of a smallish warehouse line as quickly as possible, and you don’t have a permanent servicing platform so you’d like to get them sold, ideally, before even the first payment is made.

Correspondent lending got so popular that even big banks, who don’t have to sell their servicing and who can afford to carry big inventories, got into it. The short version of this was the dawn of the “full product line” lender. You could offer your bread-and-butter products (usually GSE stuff or prime jumbos or construction loans for your portfolio), but also all the odd stuff like the Option ARMs and balloons and subprimes, which you could throw off, as they were originated, as a correspondent of some other big bank that specializes in whatever loan type we’re talking about. For a while there in the last few years, all kinds of small and large banks and bankers made OAs, but the overwhelming majority of them ended up at a few aggregators like WAMU, CFC, GreenPoint, etc. It became very, very uncool to be a “monoline” originator: everybody had to offer every weird or unusual or stupid product out there, because no one wanted to see a customer go elsewhere if your “product line” wasn’t big enough. Of the many nasty consequences of that, the fact that the “unusual” loans were so frequently screwed up, because they were made occasionally by lenders who didn’t specialize in them, is not the least of it. Not for consumers, it’s not.

The thing about a correspondent transaction is that, strictly speaking, it is the sale of a closed loan. The correspondent was the lender who funded the loan, and who owns all of the risk of that loan until the future sale is transacted. Remember the uproar over “EPD repurchases”? That’s all about how correspondents sell loans so quickly these days that the buyer is frequently taking the first or second payment. So if the first or second payment doesn’t get made, the correspondent has to actually repurchase or buy back the loan. In the bulk market, the loans are usually past the first 3-6 payments, so EPD warranties often don’t come into play on the bulk transaction itself. But if, say, Fannie Mae bought a bulk deal at 5 months loan age from CFC, who bought the loans on flow from Podunk National at 2 months loan age, and it turns out that a loan missed payment 6, Fannie can force the loan back to CFC who can force it back to Podunk. At each stage there is argument, delay, and a painful price to par/recapture of premium. The whole process can go on for a year as all the chained loan purchases get reversed. "Lawyers in Love" is the tune playing in this background.

We do not generally use the term “correspondent” to refer to sales of loans to Fannie and Freddie, just because. The F’s use the term “seller/servicer” to refer to the parties from whom they buy loans. What is crucially important is that the F’s don’t buy loans from brokers. If you are a GSE counterparty, you are a "lender." You have capital from somewhere, and sufficient net worth to take a loan back or make other warranties or indemnifications.

Technically, nobody buys loans from brokers, because brokers don’t close loans. Now we’re getting back to the primary market. The basic concept is simple: a broker is not a lender; a broker is an intermediary who brings together a borrower and a lender for a fee. What an elegant, straightforward concept. You don’t think we left it at that, do you?

The issue is what you will hear referred to as an “origination channel.” The trouble is that there are both primary and secondary market “origination channels.” There is also a “front end” and a “back end” to the primary market. So we’re going to start at the beginning, with a lender, as defined above, looking for a borrower.

In the old days, the depository lenders had “loan officers.” They were actually officers, and they actually decided whether to lend people money or not. In and around the 1980s, an idea arose that “loan officers” should primarily be “salespeople,” not credit underwriters, because they could reel in more borrowers that way. We took them off salary, put them on commission, and sent them to sales seminars in which everything they ever knew about evaluating credit risk was rinsed out of their brains in a deluge of sales tactics and lead generation and unspeakable “motivational” rhetoric. This resulted in a horrifying pile of terrible loans.

So we took the “officer” part out in reality, if not in name. “Loan officers” became pure salespeople, who turned over their applications to underwriters, who were salaried and paid a lot less, in most cases, than the loan officers. These underwriters were stuffed into cubicles in “back rooms” where they were expected to uphold the institution’s credit standards in the face of an aggressive sales force who didn’t get paid unless the underwriter caved in. Since loan officers were paid on volume, not profitability or loan quality, the LO just wanted to get to the closing table as often as possible. The underwriters got paid whether the loan closed or not, but they quite often didn’t get paid enough to want to be beaten to a bloody pulp by salespeople and branch managers and production vice presidents. Generally the underwriters reported up to the chief credit officer, who reported to the CEO. The loan officers reported up to the senior production manager who reported to the CEO. The CEO settled arguments based on either the good of the company or the bonus pool.

Having turned LOs into salespeople, it wasn’t much of a stretch to wonder why you needed to employ them at all. The RE market was already chock-full of real estate brokers and commercial loan brokers; why not mortgage brokers? Now, it seemed to some of us that the broker model made sense in the primary RE market, and in commercial lending, both of which are complex markets in which a buyer or borrower might need some real expert help finding a seller or lender, or vice versa. The earliest mortgage brokers were, exactly, in subprime or “hard money” lending, because those were also “illiquid” markets. Once you brought brokers into the very liquid, ubiquitous-bank-branch-on-every-corner residential mortgage market, you were, really, doing something weird.

My view is that what we did was transform the concept of “broker” (intermediary) into little more than “piecework contractor loan officer salesperson thingy.” Mortgage bankers and depositories both began to have two different “channels” for getting borrowers in the door: “retail,” which meant their loan officer employees brought the applications in, and “wholesale,” which meant that independent brokers brought the applications in. The retail loan officers got paid a commission by their employer (the lender). The brokers got paid some kind of fee by the borrowers or the lenders or both. A lot of this started with depositories who wanted to make loans in markets they didn’t have retail branches in. A lot of it spread when depositories closed retail branches because it was cheaper to buy applications from brokers than to pay and house, in a brick and mortar office, a bunch of loan officers who were getting benefits even when they weren’t making much on commissions in slow periods.

Because God hates us, some brokers started doing enough business to incorporate themselves, and then hire their own salespeople, whom they proceeded to call “loan officers,” even though they were brokers who didn’t make loans and were not officers of the corporation. Worse yet, some actual lenders with actual loan officers started “brokering” a percentage of their pipelines. The comments above about the “full product line” apply here: some lenders decided that, rather than being a correspondent for the weird stuff, they would sell an application to another lender, not a closed loan.

By the late 90s, we started to get significant amounts of “direct lending,” which is the third major “channel” in the primary market. This is the website or loan-by-phone deal where the borrower’s information gets zapped directly to the underwriter, leaving out either the loan officer or the broker entirely. At one point that was going to revolutionize the business, make mortgages cheap and painless, and achieve world peace in our time. Then the dotcom bust and the operational problems caused by trying to get consumers to navigate complicated applications and disclosures and stuff that they patently didn’t understand transpired, and so while direct lending isn’t dead, it isn’t anywhere near the largest “channel.” Had we insisted on knowledgeable, well-trained, fiduciary loan officers and brokers, that would have been OK. Once we got to the point of handing out broker licenses to shaved monkeys who don’t know how to use the F-keys either, you could wonder why direct lending looks so unworkable. (Hint: confused borrowers don’t do a good enough sales job on themselves.)

At some point in all of this, those bigger brokers got even more uppity than wanting to hire their own loan officers. They also wanted to act more like lenders than was good for any of us. The more respectable excuse was that the broker wanted to provide “full service” to customers: instead of just taking the application and handing it off to the wholesale lender, the broker wanted to order the appraisal, issue the commitment letter, schedule the closing, and basically do everything but the actual underwriting (which the wholesaler doesn’t “delegate” to a broker) and the coughing up of funds to close with. The less respectable reasons were that brokers saw more fee-extraction opportunities, and also wanted to “private label” the process, or make it look to the consumer as if the broker were really the lender, since it appeared that the broker did all the work, and the documents like the commitment letter were issued in the broker’s name instead of the wholesaler’s. Among other things, this kept consumers confused about whether they could have gotten a better deal going directly to the local Wells Fargo branch instead of dealing with a broker for whom Wells Fargo was the wholesaler.

Eventually it got to the point where brokers actually wanted their names to appear on the note and mortgage, which is a bit of a problem, since that’s supposed to be the lender. This is that thing called “table-funding” which you might see in analysis of “origination channels.” You could think of table-funding as the process of collapsing the timeline of primary-to-secondary market transactions to about a minute. What it means is that, at the “closing table,” the borrower signs the note made out to the broker, the broker endorses it over to the wholesaler, and the wholesaler provides the funding. The loan actually belonged to the broker for, like, a minute. But that was long enough to make the borrower think that the broker was the lender, and for the broker to collect a lot more fees than it would otherwise.

Table-funding is not a particularly efficient way to do things (and you pay for that inefficiency, my consumer friends). So many bigger brokers-become table-funded “lenders” progressed to getting their own warehouse lines and becoming mortgage bankers. Many of them, right now, exist in some odd mongrel status, brokering applications here, table-funding loans there, warehousing loans elsewhere, all at the same time. They are either broker-bankers or banker-brokers or correbrokerlenders or something. An industry that cannot tell you where subprime ends and Alt-A begins will not be able to tell you who “originated” the loan in all cases, either.

The problem with that term “originated” is that once you get these layers of lenders and funders and other parties, you get “channels” within “channels.” Take Wells Fargo. Wells has “retail” and “wholesale” channels, meaning some of its loans come from its own loan officers and some come from brokers. But it also buys “correspondent” loans. When it reports to regulators on its “intake” activity, it considers all those loans “originations.” The correspondent, however, also considered the loan its own “origination.” One of the joys of dealing with, say, HMDA reporting, is separating all that out so that loans aren’t double-counted.

Now, Podunk National might be a correspondent of Well Fargo’s, but Podunk might have originated the loan as retail or wholesale. If the latter is the case, this is a “brokered” loan (in Podunk’s “channel”) that became a “correspondent” loan (in Wells Fargo’s channel). Wells Fargo could put the loan in its portfolio, sell it as a whole loan to an insurance company, securitize it privately, securitize it with the GSEs, etc. With or without the servicing rights going along with it. And so on. It is perfectly possible and even frequently the case that you have a loan that was brokered to Pissant Mortgage Company, who sold it on a correspondent flow basis to Medium Dog Bank, who sold it on a bulk servicing retained basis to Big Dog Bank, who sold it to Lehman, who securitized it. Everybody counted a loan in their own “originations” or production.

I take it we now understand why it is so hard to answer the question, how many loans are brokered? You can’t do it just by “business type,” because some mortgage bankers and even depository lenders can broker applications, and some outfits that are primarily brokers have the odd warehouse line. You can’t do it just by looking at “wholesale originations” reported by big mortgage bankers and depositories, because some of those will include correspondent loans that were originated by a retail loan officer. Some outfits are more careful about distinguishing between “wholesale” and “correspondent,” and some call everything “wholesale” (they drive me crazy). And yes, the answer is that the regulators have never really forced anyone to report all of this in a way that lets us sort it out. They could, and I do hope the current chaos in the business gets them interested in doing so.

What this means is that you can drive down to your little local community bank or credit union and end up getting a brokered loan, or a loan sold on the secondary market on a correspondent basis after it is closed. You can go to some giant wholesaler like Wells Fargo and get a retail loan officer to make you a loan that Wells keeps in its own portfolio and services forever, too. If you’re brave, you can go to a website and take your own application (be sure to give yourself good advice), after which you will have contact not with a broker or a loan officer but with a “customer service representative” who may or may not share your continent. Oh yes, and every time the servicing on your loan is sold you’re supposed to get a RESPA notice that warns you in time for your payments to get directed properly. If you don’t get one, you should report somebody to HUD. I hope you know whom to report. Don’t be surprised if you call HUD and get . . . a customer service representative.

Surely this is enough for today. In a future installment, we will discuss how the compensation works—points, prices, this “YSP” thing—and why it matters from a risk perspective whether a “problem loan” was “originated” by a broke broker or a correspondent with some net worth the investor can go after.