Solving the Mortgage Mess

My Opinion

The half-percent cut in interest rates that the Federal Reserve made yesterday was great news for Wall Street, but does nothing to address the problems in the housing and mortgage industries. In fact, it rewards the people who got us into this mess by their bad behavior. However, it is a done deal, and now it is time to turn our attention to fixing the structural problems that got us to where we are today. Five actions by the regulators, at the Federal and state levels, would serve to prevent an early recurrence of the credit problems coming out of the mortgage industry.

First, recognize that mortgage brokers are the root of much of the evil that has occurred. Mortgage brokers are parasites that feed off all of the money that sloshes around a typical mortgage transaction, bleeding off a few thousand dollars from each loan. They add no significant value to either the borrower or the lender, and they inject a fundamental conflict of interest in every transaction that they touch. On a typical $200,000 mortgage loan, the broker may pocket around $6,000, depending on how gullible the customer is and how greedy the lender is. What does the broker do to earn that money? The honest and simple answer is nothing that the customer could not do just as easily himself. The broker “assists the borrower in completing an application.” The broker may also collect the income and other verification documentation required and then passes it along to the lender.

This is where it gets ugly, friends. In police parlance, this is sometimes referred to as the chain of control over evidence. In order for evidence to be admissible, it must be untainted by any broken links in the chain of control. If, for example the police evidence technician stopped at Dunkin’ Donuts on his way back to the police station after collecting evidence, and accidentally left the case with the evidence in the donut shop when he continued on into the police station, the chain of control would be broken. Even if the police officer returned just ten minutes later and retrieved the evidence case, there would be the possibility that someone might have tampered with the evidence while it was out of his possession and control. When a mortgage broker, whose livelihood is dependent on loans being approved and closed, is involved in taking an application or gathering documentation, the “evidence” that the lender uses to make the credit decision is by definition tainted.

Mortgage brokers only make money if lenders approve and close the loans that the brokers present. Brokers routinely alter income documentation, application information, and other documentation to increase the likelihood of approval. They coach borrowers to lie – to misrepresent crucial facts – on the application, telling them that everyone does it, and it is just routine and not important. Mortgage brokers pressure real estate appraisers, or in some cases, offer them inducements, to value the property that will secure the mortgage loan at the amount necessary to ensure approval by a lender. This is often referred to as “pushing the appraisal.” Appraisers that don’t go along get no more business from that broker. An appraiser who isn’t on good terms with the local mortgage brokers is an appraiser who is going hungry. Since it is extremely difficult to prove appraisal fraud, especially if it is only a matter of ten to twenty percent of the property value, there are rarely any consequences for such collusion between the mortgage broker and the appraiser.

Mortgage brokers lead borrowers to believe that the broker is looking out for the borrowers’ best interest. In fact, the opposite is true. Brokers often can get paid more if they put the borrower into a higher rate loan. So the broker is motivated by two goals: which lender will definitely approve this loan, and which lender will pay me the most money for bringing them the application. Borrowers can do a better job of shopping for the best interest rate by calling mortgage lenders directly. However, many don’t realize when they first start the process that the broker isn’t a lender, but only a middle-man who will, like a parasite, suck money out of the transaction and provide nothing of value in return.

All that mortgage brokers do is endanger the safety and soundness of the banking system, and put our entire economy at risk. All financial institutions chartered or licensed by the Federal or state governments should be banned from funding any loan transaction, either directly or indirectly, in which a mortgage broker is involved. All states should pass laws that prohibit mortgage brokers.

Second, recognize that people who cannot prove, or who do not want to prove, their income and assets in order to qualify for a mortgage loan are most probably misrepresenting their income in order to qualify. A huge problem in the so-called “sub-prime” segment of the industry has been these “liar loans”. Everyone involved knew that borrowers were vastly overstating their income in order to qualify to buy ever more expensive houses. And all of these liars flooding into the market were bidding up the price of housing, making it increasingly unaffordable for average, honest buyers. There is no good reason why a borrower will pay an extra half-percent interest rate for the privilege of obtaining a “stated income” loan (the income that the borrower states on the application is accepted without any proof or verification) – unless, 1) the borrower is cheating on his income taxes and doesn’t want the Internal Revenue Service to know how much money he is really making, or 2) the income stated on the application is fictitious – it is a number made up by the borrower, the mortgage broker, or both in collusion to qualify for a loan that the borrower really cannot afford.

The consequences of the millions of liar loans made over the past several years are now manifesting themselves in sky-high prices for housing in some areas, tens of thousands of foreclosures, bankruptcies among lenders and borrowers, severe stress on our entire economy, and individuals committing suicide and other acts of desperation as they find themselves unable to repay the debt they have taken on. The cost to society is simply unbearable. Yet, if nothing is done, two years from now, the mortgage industry will be right back to its old tricks – funding liar loans by the millions.

Federal and state regulators should ban all mortgage loans that lack any of the traditionally required documentation of income, assets, collateral value, borrower identity and legal residency status, credit history, etc. Lenders won’t stop on their own, though they have cut back lately due to the implosion in the industry. Like heroin junkies, they’ll be looking for another fix of liar loans as soon as they think no one is watching. If one lender does it, then all the rest of the lemmings will jump off the cliff right along with the first who re-opens the door to these liar loans.

Third, full appraisals by state licensed appraisers should be ordered by the lender for every mortgage loan. We thought we had plugged this hole in the system with the FIRREA regulations in the wake of the savings and loan debacle. But the regulators are asleep at the wheel on this one, as they have been on so many other factors that have led us to the current crisis. Pressured by the lenders that they regulate, those who are supposed to be policing the industry have instead capitulated to pressure from the industry to continually relax appraisal standards. At the peak of the insanity, “stated value” loans were growing by leaps and bounds as a percentage of total loan volumes. (With a stated value loan, the lender assumes that the property is worth whatever value the borrower writes down on the application form.)

New statistical models are being used to set a value for a rapidly growing segment of loans made by lenders. Lenders love them because they are relatively cheap, and the information is available in seconds, rather than days. However, these models feed off one another. The information that is used to derive a value for one property is the fictitious values used to make loans on other properties. The actual condition (and in some cases even the existence) of the property is never considered.

Federal and state regulators should immediately re-impose sanity on the valuation process, and require full, interior inspection appraisal reports to establish the value of all properties uses as collateral for mortgage loans.

Fourth, Adjustable Rate Mortgage (ARM) loans with teaser rates have suckered millions of borrowers into both purchase money and cash-out refinance loans that they cannot afford. Mortgage brokers set the hook, and then unscrupulous lenders reel in the unfortunate victims. Low and moderate income borrowers should never be put into ARM loans. Borrowers who are on fixed income should never be put into ARM loans. Lenders have attempted to justify the practice of making ARM loans to people in these circumstances as necessary to avoid discrimination charges by regulators. Regulators have supported lenders who have taken this stance, and thus have facilitated and enabled a blatantly predatory lending practice.

It doesn’t matter whether the borrower is a prime credit or sub-prime credit risk – putting low and moderate income borrowers, and borrowers on fixed income, into ARM loans is predatory. (An 80-year old widow may have an 800 FICO score, qualifying for a prime loan. However, if she is living on a small pension and a little Social Security check, putting her in an ARM with a teaser rate is predatory. However, because she is a "prime credit risk", no one is looking out for her best interest.) When the teaser period runs out, and when the interest rate goes up, the payment goes up beyond what borrowers can afford. Over the past several years, the tremendous inflation in home prices caused by shoddy lending practices meant that borrowers could do a cash-out refinance when the interest rate adjusted upward, into a new ARM, and take out enough cash to pay off their other debt and manage to keep on making their mortgage payments. (Of course, the mortgage broker who put them in their first bad loan had them on his calendar to call them up and offer them the cash-out refinance just at the time when he knew they would be getting desperate.) What the borrowers didn’t realize but should have was that they were only digging themselves into a deeper hole and postponing the day of reckoning. As a result, when that day arrived, they were in a much worse place than they would have been if they had faced up to their problem the first time the interest rate and payment adjusted – by getting into a fixed rate loan, selling the house and downsizing to something more affordable, or taking whatever other action was appropriate for their situation.

Federal and state regulators should prohibit lenders from making ARM loans and loans with “teaser rates” to people with low or moderate income and to all people on fixed income. Such loans are by definition predatory, and, once again, the too cozy relationship between lenders and regulators has resulted in no one watching out for the public interest.

Fifth, and finally, the rating agencies (S & P, Moody, etc.) have failed utterly to assess the true risk in the myriad bond issues that they rated. These rating agencies make their money off the people originating the loans and issuing the bonds. Why aren’t we surprised that their ratings are influenced by the people who pay their obscenely high wages? Their vaunted independence is a fiction. They have nothing to lose and everything to gain by facilitating a high volume of transactions. Their expertise has also been exposed as sadly lacking. The SEC and the Federal Reserve should launch a joint investigation and devise a plan for reigning in these market movers and bringing them under close scrutiny. There must be consequences for the disastrous mistakes that they have made over the past several years.

Oh, by the way, where were Fannie Mae and Freddie Mac when all this was going on? Mired deeply in their own accounting and other scandals, they nonetheless found time to be enablers and facilitators of the bad practices that have landed us where we are today. They both need to be stripped of their Federal charters and sold off to private industry, where they can come under the watchful gaze of a reinvigorated and robust regulatory service that is transparent and accountable to the public. The millions that Fannie and Freddie spend on lobbying and public relations have led many to believe that they are the solution to predatory lending and the mortgage mess, when, in fact, they are a big part of the problem.