Friday, July 11, 2008

Mortgage Mess: An Insiders View

As a former mortgage professional, I have a little experience and some pointed opinions about the current mortgage mess. And possibly some solutions to prevent it from reoccuring.

First, a personal history. I worked as a loan originator from 2000 to 2005. I left the industry because I saw the housing slowdown looming on the horizon, and couldn't convince anyone that it was coming. No market can withstand price increases of 15 to 20% for long without imploding. My employers had their greed glasses on and couldn't see it, so I left.

Now, the reasons for the crash are many, but primarily greed driven. First, the real estate market was pushed to a breaking point. People panicked thinking that prices would continually go up, and they bought homes out of their ability to afford thinking they would never be able to in the future (an historically incorrect viewpoint). People also used their highly inflated home equity to buy toys (boats, personal watercraft etc.) instead of improving the home to increase value. And the government did little or nothing to control the runaway pricing of mortgage loans and zero-equity transactions.

Again, some historical background. In California anyone with a Real Estate Brokers License can become a lender. They are regulated by the Department of Real Estate (DRE) who has a ratio of employees to licensees of about 5,000:1. There is no way they can truly regulate licensees activities. These licensees are allowed by law to represent both buyer and seller in a transaction and can negotiate the mortgage loan for the buyer. Although the sales transaction has a commission limit of 6%, the loan has no limits unless it is a government loan(FHA or VA). Assume 4% on the loan (actually low for a 100% transaction), that leaves the broker making 10% on a transaction or $45,000 on a $450,000 home sale.

Secondly, 100% loans are generally made as two loans; a first mortgage and a second. This is known as an 80/20 (and the broker can make commission on both loans, with the 20% second paying a much higher percentage). The first mortgage is made at 80% of the purchase price and carries NO MORTGAGE INSURANCE. This means that the first mortgage lender is at risk for 100% of the loan. The second mortgage is at 20% of the purchase price, leaving the buyer paying nothing to the purchase but the costs of the transaction. He has NO EQUITY! So when the value of the home goes down, even fractionally, he has no motivation to keep the home. Combine these factors with "Stated Income" loans for self employed individuals in professions like gardeners, housekeepers and child care providers (where the income can easily be inflated) and adjustable rate mortgages with artifically low starting rates, and we had a disaster begging to happen.

Solutions are relatively simple, once the causes are identified. First, the States must fund their investigative branches to the point where they can actually investigate, and put some teeth into their fraud laws. Jail terms and serious (5 to 6 digit) fines. Make it illegal to represent more than one party in a transaction to reduce the greed factor. Require "live" underwriting for any loan outside of "plain vanilla". If there is no cash from the borrower, automated underwriting should be disallowed (I'm not a big fan of AU. It takes away the human thought process and assumes that the person who compiled the model was absolutely correct). 80/20, 100%, adjustable rate, interest-only and variable payment loans need a closer look than AU can provide. Provide for criminal and civil penalties for ALL parties to a transaction who can be proven to have knowledge or suspicion of fraud. Some of these deals got through simply because one person in the process thought "This ain't right but hey, it's not my problem!"

So, in order to prevent this from reoccuring we should demand from our State and Federal Governments the following;

1) Realtors may act as agent to only one party in any transaction; buyer, seller or lender.

2) All compensated individuals with access to transaction information shall be held individually responsible if there are indications that the transaction may be fraudulent. Any person who refuses to complete a transaction that appears to be fraudulent shall, upon reporting their suspicions to the proper authorities be held harmless in any subsequent criminal or civil action.

3) Lenders shall not use Automated Underwriting systems for final approval of any loan where the borrowers income is not factually established; or where the borrowers actual cash equity is less than 10% or the mortgage interest rate is not fixed for the entire term of the loan, except in cases of Government Insured loans (FHA/VA); or where the payment has a variable monthly payment amount; or where there the loan is not fully amortized over the term of the loan.

These simple propositions will greatly reduce the possibility of this kind of calamity ever reoccuring.

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