Risky Business

In late 2008 I closed a loan for a young man in the U.S. military who had inherited some money and wanted to use it as a down payment on a new home. With his inheritance, the young man put about 50% down. He also paid cash for upgrades to the new home he had bought. This was a full income, full asset file--we documented his exact pay through the military and sourced his funds to close. He financed about $90,000.00 on his home. We closed in September; his first payment would be have been November first. With his military pay and housing allowance, he qualified easily to make the payment on a $90,000 loan, but for some inexplicable reason, he never made the first payment. We never knew why. The lender contacted me three months later to ask me to get in touch with him, which I attempted to do. The real estate agent went to see him. I talked to his commanding officer. Nothing that anyone could say seemed to impress on him the urgency of the situation. Whether he believed, as many people seemed to, that with the new administration he did not have to make a mortgage payment, or whether he believed that he had put such a big down payment on the house that making monthly payments was not important, I cannot say. I never understood why he simply refused to pay his mortgage.

I tell that story because there are inexplicable things like this that happen in the mortgage industry. Not everyone who defaults does so because of loss of a job, or loss of a paycheck, or loss of equity from the real estate crash. Some people just don't pay their bills.

Earlier this week, I talked about the provisions in HR 1728 which was passed last May by Congress which requires originators to maintain 5% interest in certain "risky" loans to improve underwriting. But HR 4173, the bill that passed the House and went to the Senate Finance Committee, takes these requirements one step further. In an attempt to prevent situations such as the one I just described above, the new law would require "a creditor or securitizer to retain 5% of the credit risk on any loan that is transferred, sold, or conveyed by such creditor or securitized by such securitizer." (Section 1503) The bill provides that a regulatory agency may require more or less than 5% risk retention for certain types of loans if it decides that this is necessary. This 5% risk cannot be transferred or sold; it must be maintained for the life of the loan.

The reason that the United States has the system of credit that we have today is that we have a system called the "secondary market" in which loans are originated by one party and sold to another. As part of that system, we have credit and underwriting guidelines which are uniform. We have anti-discrimination laws which make it illegal to apply the guidelines in a non-uniform way for people of different races and ethnicities, religious persuasions, sexual orientations, etc. The idea is that we underwrite all people to a standard, and if they pass that standard, they receive the loan. The presence of those standards allows us to package and sell those loans as asset backed securities, which in turn frees up more money for more loans.

Few realize that other countries do not have a system which even resembles ours. Several years ago, I read an article in one of our industry trade magazines about two mortgage professionals who were consulting in former Soviet States to try to help these now independent countries establish a mortgage system. They told about their experiences working with the woman who had been assigned to be the head of the mortgage department at a bank. When they asked her what guidelines she used to approve loans, she was incredulous. Her answer was that they did not need guidelines; if you were friends with the president of the bank you got your loan. If not, you didn't. There was no secondary market in which to sell the closed loans, so the bank had a limited amount of money to work with, which probably made the friendship standard a good one in their eyes.

That sounds primitive to us, because we take access to credit and capital for granted in the US, because it has been available to us for so long. But if we did not have a secondary market to sell the loans into, we too would have a system very much like that small area in Eastern Europe. Our system certainly is not perfect, but it has allowed for a growth in personal wealth and property ownership unlike anything that the world has seen in the past.

But in requiring creditors to maintain at least 5% of the credit risk of the loans, HR 4173 puts this in jeopardy by removing all of the small players from the industry and tying up the creditor's cash. The bill further requires (in section 1500) the sellers of these securities "at a minimum to disclose asset-level or loan-level data necessary for investors to independently perform due diligence. Asset-level or loan-level data shall include data with unique identifiers relating to loan brokers or originators the nature and extent of the compensation of the broker or originator of the asset backed security, and the amount of risk retention of the originator or the securitizer of such assets." It will "require disclosure on fulfilled purchase requests across all trusts aggregated by an originator, so that investors may identify asset originators with clear underwriting deficiencies." The unique identifier being described is the new federal license number required under the SAFE Act (see yesterday's post). How much money the originator made on the transaction can be a basis for not purchasing a loan. Other loans made by the originator which went bad can be a basis for not purchasing a loan. So you could have a licensed originator who has met all credit and financial requirements for keeping and maintaining a federal license, but if an investor on the secondary market decided that he did not like the originator's background, they could refuse to purchase an otherwise good loan.

In Section 1506, HR 4173 calls for a study on the effects of the new legislation to determine "an analysis of the effects of risk retention on real estate price bubbles, including a retrospective of what fraction of real estate losses may have been averted had such requirements been in force in recent years." Here's an idea for a study: The effects on the real estate market and housing prices when competition is gone, the secondary mortgage market has been effectively dismantled, and we are relying on a great smile and winning personality to persuade the originator at the bank that we qualify for a mortgage loan. To me, that's the riskiest lending of all.