While you’ve been away…..the mortgage industry has been imploding. Over the past few years, it has been mentioned here and in many other places that the amount of money being offered to anyone with a pulse would erode the foundation of the mortgage market. If you follow financial news, it is occuring before your very eyes.
The most recent casualty is American Home Mortgage. Their demise has caught the attention of those of us in the real estate profession. They were not making their living off of questionable practices. They did not lend money to anyone that applied. A lot of their money was lent to borrowers with very good credit scores. A lot of their money was lent to people that borrowed more than the $417,000 conforming amount.
The $417,000 figure is important to note. $417,000 is the threshold for loans that can be funded by Fannie Mae, Ginnie Mae and Freddie Mac. Those three institutions regulate government backed loans. If a loan is greater than $417,000, it is refered to as a non-conforming loan and must be funded by private investors. These private investors are usually found on Wall Street.
Here is a basic overview of how loans are funded. There are two ways of funding – public funds or private funds. A mortgage broker or lender sits down with an applicant and takes an application. Information is checked, a credit report is reviewed and the information is entered into a desktop underwriting program which will direct the lender towards the best solution for their customer. They may and often qualify for more than one program. The solutions are presented and program is selected. If the amount needed for the first trust is $417,000 or less and all other necessary criteria can be met….the loan is most likely funded in concert with one of the aforementioned agencies. If the amount needed is greater than $417,000 and/or other criteria can not be met….the loan will be privately funded.
If the lender has its own resources, they may choose to fund the loan and sell it off to an investor. If the lender does not have their own resources, they shop the loan to the investors on Wall Street.
Someone once said “If you want to get to the bottom of anything, follow the money.” Mortgage lending is no different. It gets tricky when you involve investors and the stock market. It becomes a little more clear when we follow the money. No one is doing this altruistically, everyone wants to get paid.
For example purposes, I will use a $500,000 loan. The mortgage company offers the loan to a customer at a 6.75% rate and goes to Wall Street to seek funding of the loan. The investors on Wall Street figure that loan is worth $505,000 to them. The 6.75% return is a good one compared to what other investments are yielding and they will be receiving payments for a long enough period of time that they will show a profit on their $505,000 investment.
In this scenario, the lender can make the loan without having to charge any extra money. The lender is making 1% ($5,000) for processing the loan.
If a lower rate was offered, the investor would most likely pay less for the loan. An example might be the same $500,000 loan at 6.625% could only result in $502,500 and a 6.5% loan could only result in $500,000.
The lender has to make money in the process, so the lower rates must be paid for by the borrower. These are usually deemed “origination points”. In order to maintain the same revenue…the lender would probably charge 1/2 point on the 6.625% loan and a full point on the 6.5% loan.
If the borrower wants an even lower rate, we get into “discount points”. For instance, they borrower wants the loan at 6.25%. The investor may only offer $495,000 for that loan. The borrower would have to pay the additional $5,000 (one full discount point) as well as the origination point which in our scenario would be another $5,000. The borrower would have to pay $10,000 at closing to get the half point reduction in his rate, rather than take the market figure of 6.75%.
Everyone was fine with this system as long as mortgages were being paid on time.
Well, as we all know, that has stopped happening. Defaults on loans are increasing at an alarming rate. The investors on Wall Street have always measured the risk against the potential gain on any investment. The investors are constantly revising data and reviewing the current risk against historical analysis. The recent increase in mortgage default has increased their perceived risk. The increase in their risk has either lowered what they will pay for a mortgage or in some cases they have decided to not fund any mortgages.
Those that have continued funding mortgages have drastically reduced what they will pay. The $500,000 loan at market rate that was purchased last year for $505,000 may only bring $475,000 now. In order to make money, the lender would have to ask their borrower to bring $30,000 at closing (that’s 6 points and none of them discount the rate – they are all origination fee). The other choice is to ask for a point and lose the other $25,000.
Unfortunately, the lender is in a no-win situation. The majority of borrowers would balk at this request on the lenders part. Recently, the news of these cost came at the last minute. Investors do not lock in rates. Lenders lock in rates for a short period using their best guess as to what they will be able to sell the loan for at the end of the lock in period.
So last week, the good folks at American discovered that the loans that they had to close at the end of July were going to cost them considerably more than they could recoup. I will not get into the spiralling behind the scenes cost that all lenders and investors are seeing daily. American could not fund the loans. Closing their doors was their only viable option. Other lenders face the same predicament.
Lenders have billions of dollars of unsold loans on their books. These loans have been funded. They were funded by loans the Lenders took out from their banks. You see banks will loan money to lenders based on the revenue the lender anticipates receiving once they sell the loans. This revenue is the value of the loans that have not been sold. When the investors reduce the amount of money that they are willing to pay for loans, the value of the loans decreases. The lenders can only borrow a percentage of the value. When the value goes down, they have to immediately pay down the loan so that the amount due the bank is a percentage of the new value. It sounds a bit confusing to the layman, but it is very devasting to the lender. If they can not pay down the loan, they are in default and that usually triggers a series of events that culminates with the doors being closed.
It also begins the ugly cycle because now a bankruptcy judge has to sell the loans that were funded and not purchased. Investors usually do not pay top dollar for assets sold at bankruptcy. The value of the loans is decreased and the overall impact is yet another increase in risk assignation and the possible reduction of what investors will pay for new loans.
I don’t pretend to be an expert, this is just a general overview. I wanted to try and explain how the mortgage market is reacting and what causes a big company to go under.
The safest route for borrowers is to keep their loan a conforming loan and to provide all the documentation your lender requires. The statement “We fund all of our loans” does not guarantee that origination points will not be charged nor does it eliminate to possibility of discount points being charged. Consumers have to understand that almost all mortgages will be sold and the cost of that sale may be included at loan origination.