Indulgent commentary: A little about the mortgage business . . .

Posted: February 8, 2011 in Indulgent Commentary
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Most people don’t realize how the mortgage industry works. There are some complexities that happen behind the scenes which is at the heart of how they make a profit. It also explains some of the funny business and de-regulation issues of banks that most recently was one of the factors that sent our economy spinning.

There are different stages to the life of a mortgage, from a bank’s or a mortgage company’s point of view.  In the beginning a bank makes a mortgage loan with a customer, who had to qualify for the loan.  Qualifications includes credit rating, employment, and other factors.  The bank can decide to keep that loan as their own, but that locks up capital that could be invested.  To sell a loan to an investor the loan has to meet specific criteria.   Some of that criteria specified by the investor include:  quality of the borrower, the loan to value ratio, existence of mortgage insurance and the location of the home.  If a loan is qualified it is sold to an investor. The bank retains a fee and frees up funds for investment.  The bank also has to decide if they want to manage that loan for the investor, creating its own portfolio of loans, or to sell the servicing of that loan to a third-party, such as a mortgage company.  As you can see with a mortgage loan there can be many parties involved, including the borrower, the originating bank, an investor, and a mortgage company for servicing.

Most of the time the investor is the U.S. government.  I am sure in the recent economy crisis, you probably have heard of Fannie Mae, who is the biggest investor in mortgage loans. 

After the investor buys the mortgage, the mortgage companies or banks services the loan for the investor and receives a portion of the interest money paid by the borrower on the loan, which is called a servicing fee.  During the life of the loan the mortgage company services the loan which includes activities like, processing payments, credit reporting, adjusting variable interest rates, determine escrow payments, payment of insurance, and payment of taxes. 

When I was a mortgage loan servicing manager in Texas it was unbelievable how many people didn’t understand  their mortgage.  The most confusing part of it was the portion of the payment that is designated for escrow.  There were many times I had to explain to a customer that the escrow portion of their payment was totally related to the cost of taxes and insurance.  Insurance could include home owners insurance, flood insurance and credit life insurance.  Around property tax time, we usually had many irate customers whose payment went up because their taxes went up. 

On one occasion we had a gentleman complain about his payment being increased.  Eventually his complaint was escalated to my desk, and I invited him to meet with me so we could walk through what was happening with his loan and explain why his payments had increased.  The man was an immigrant from another country.  He had taken out the mortgage loan about three years earlier and his payment was going up a couple hundred dollars.  So that he could understand why his payment increased, I showed him how both his home owners insurance and taxes had increased, which affected the escrow portion of his payment.  In addition he had a three-year adjustable rate loan, which also caused his payment to increase since interest rates were going up at the time. 

The more we talked, the more angry he got.  He just didn’t understand that the bank  didn’t do anything wrong, and he was legally bound to these terms when he took out the mortgage.  Suddenly he said that he was finished with the bank and he wanted to pay off the loan so he could sever his ties with the bank.  I thought this was odd because he was complaining about the payment increase and yet  he had enough money to pay off the loan.  I asked him to wait while I had one of my employees create a payoff quote. 

When my employee gave me the quote, I notices that it included a pre-payment penalty.  Consider the situation , I have an irate customer in my office, who was mad about an increased payment, and now I had to tell him he could pay off the loan but he would have to pay a prepayment penalty.  I told my employee to let security know what was happening.  Good thing I did, when I gave the news to the man he was furious.  He was muttering in his native language.  All of a sudden his English was not so good.  He also said, that when he signed the paperwork for the mortgage he was new in this country and didn’t understand it, nor did he read it.  I told him I was sorry that happened to him, but this was a legal obligation and he had to pay the prepayment penalty.  After cursing at me, he pulled out his checkbook and wrote a check for the entire amount due, which was well over $200,000.  He slammed the check down on my desk and walked out.  The scary part of this story is when we returned to work after the weekend, there were bullet holes in my window and in another window.  I have a feeling it was this guy.  Maybe not, but it is awful coincidental.

Another facet of the mortgage loan servicing business is when a mortgage loan is past due on payments.  If a mortgage loan goes delinquent it needs to be serviced with specific processes and associated timings, which are defined by the investors.  If the mortgage company misses a deadline in the delinquent process the loss goes to the mortgage company, not the investor.  In addition many mortgage loans have  mortgage insurance, paid by the customer, which reduces or eliminates any losses due to delinquency.  If everything is processed correctly by the guidelines of the investor, the investor takes the loss.

Earlier I mentioned the funny business that was a part of the decline of our economy for the last two years.  When I was a manager in the lending department, the guidelines that the investor, specifically Fannie Mae, were very stringent.  The loans had to have a loan to value ratio less than eighty percent.  All of the loans were required to have mortgage insurance. 

A couple of things happened which created a problem with this type of loan.  Property values did not keep rising and instead started to fall.  In addition at the end of the five years the customer could not afford the refinanced loan because it now included principal, interest and escrow in the payment.   These five-year loans were not intended as an easy way for a person to own a home. 

I suspect there were many loans made that should not have been made based on what the payments would be after five years.  As a result of all of this there was a huge number of foreclosures.  The foreclosures meant losses to the investor, the banks, the mortgage insurance companies, and the mortgage companies.  These customers had a mortgage loan on a homes whose values had dropped and were worth less than the principal balance owed on the mortgage.  The banks foreclosed on the borrowers and were stuck with all these homes.  The market for the homes had depreciated and the banks had many losses.  Borrowers were caught in the crisis of a foreclosure, and the mortgage industry could not take on the increased number of foreclosures with depreciated property values.

That pretty much explains why the banks were in trouble.  I also suspect Fannie Mae, a government entity, had reduced their requirements for investing in a loan.  As a result they took more of a loss as the investor. 

I also wonder how all these people qualified for the loans.  They were purchasing a home which was beyond their means.  The five-year interest only loan enticed the people to get the loan without a realistic expectation of what would happen in five years.  I suspect these borrowers were qualified to pay the interest payments for the five years, but were not qualified to make a regular mortgage payment after that five years.

Greed, deregulation and stupidity resulted in a bailout situation where Americans are paying to save these banks and Fannie Mae.  And all of this occurred in an environment that they themselves created. 

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