Wednesday, October 17, 2007

Mortgage Broker's Role in the Sub-Prime Loan Debacle

by Nancy Osborne, COO of ERATE

Many in the mortgage industry admit to being caught off guard by the ferocity of what's occurred as a result of the meltdown in sub-prime lending, few predicted the global firestorm that has erupted and the fallout continues almost daily. Having been a mortgage broker in California for many years I'll be the first to admit that the reputation of the mortgage broker is parallel to that of the notoriously disrespected used car salesman. Luckily I've had the good fortune of working with extremely competent mortgage professionals who were in the business as a career and in it for the long run and not just to make a fast buck and then exit the industry when it cycled into a slowdown. With real estate being the type of referral business it is, the mortgage brokers I've known personally wanted to do a good job for their clients because they wanted the return business and more importantly they wanted clients to refer their family, friends and co-workers. Leading up to the implosion which occurred, most mortgage brokers I know believed that a day of reckoning would ultimately come and everyone seemed to recognize the outrageous risks that were knowingly being taken on, however the mortgage broker, just like the used car salesmen, is a middleman and while blaming the middleman may seem like directing frustration onto an unpopular and a deserving target, this could be impractical and might be counter productive to a real solution.

There are several fallacies in placing the blame primarily with the mortgage brokers. First you cannot paint all mortgage brokers with the same brush. All 50 states have different laws regarding the regulation and licensing of those in the mortgage industry, in fact some states have no licensing requirements for mortgage originators at all. Therefore it is difficult to blame them as a group because the profession varies so dramatically from one state to another. It is also important to point out that the two states in the country that currently have the highest rates of foreclosures have consumer protection laws which are polar opposite of one another. The largest state on the west coast, with the highest rate of foreclosures, is thought to have very strong consumer protections in place and the mid-western state, falling into second place, is considered to have about the weakest. So it appears that finding consumer safeguards in the area that was lacking may be misguided as well. Most helpful might be to start by examining the basic economic fundamentals of supply and demand as well as reviewing the common denominators that existed within the sub-prime marketplace.

First where did the supply of the sub-prime loans come from and why would any lender want to finance such risky loans? The primary reason why is because the lenders had investors who were willing to take on the risk in exchange for a higher yield or return. If investors were knowingly willing to take on the risk of buying these bundled sub-prime mortgages as mortgage backed securities (referred to as Collateralized Debt Obligations or CDO's) because they were willing to accept the trade off of greater risk for higher yield, then lenders were willing to make these loans as long as they had a market where they could sell them. It is also thought that the agencies assigned the task of rating mortgage-backed securities may have played a significant role in this mess by not accurately evaluating the risk levels associated with these mortgage-backed investment vehicles. These agencies are now being compared to the public-accounting industry and the problems a few years back which contributed to corporate disasters such as Enron. As time passes we’ll see what comes to light and what direction this argument takes.

Next let's examine the underwriting guidelines of the lenders who both underwrote and funded sub-prime loans. Lending guidelines amongst large national lenders are somewhat standardized in various markets throughout the country. Inherent in the word "guideline" is that lending principles were developed and implemented by both a lender along with knowing and willing investors who agreed to buy these loans on the other end to free up more capital for the lender or mortgage banker. It is important to note that a mortgage broker does not normally fund loans and requires a wholesale lender or mortgage banker to perform the lending functions of underwriting, funding, selling and arranging for the servicing of the loans they originate. A mortgage broker is as a loan originator, which means they perform the so called upfront lending functions of advertising and marketing to potential buyers and homeowners interested in refinancing and then process loan applications for delivery to a mortgage banking or wholesale underwriter. From there the underwriter is the person whose job it is to evaluate borrower risk and adhere to the lender's and investor's stated guidelines. Technically a mortgage broker cannot decline a borrower's loan application, only an underwriter is permitted to do so. The system of credit scoring is another essential element of a loan which is supposed to serve as a standardized reflection of individual borrower risk and the decision to underwrite and fund the loans of low fico scoring sub-prime borrowers was strictly that of the funding lenders and their investors.

Next is the demand side of the sub-prime equation coming from the borrowers themselves. Admittedly I have seldom seen a borrower who wanted to purchase a home and was told no by one lender who simply did not move onto another lender until they got the "yes" they were looking for. Also, I have never met someone I would classify as a "stupid borrower", regardless of education level. Of course some borrowers are savvier than others but most who’ve entered the real estate market are smart enough to grasp the difference between a fixed rate and an adjustable loan. Wanting to participate in the American dream of home ownership, along with the expectation that real estate prices would always continue to climb, played a key role in motivating borrowers to get into homes they couldn't truly afford or worse, those greedy borrowers who attempted to purchase more than one home at a time, in hopes of "flipping" them and making a huge profit. As long as values and prices kept rising consumers were not complaining about lending guidelines being too lacking in restrictions. How many of the borrowers who purchased multiple homes claimed all were to be "primary residences" so they could secure the most favorable financing and tax treatment? And how many of the now defaulting borrowers put misleading or blatantly false information on their loan application in order to obtain a loan?

The critical flaw from a borrower's perspective regarding sub-prime loans is that unlike that of the prime lending arena, it is far more difficult for the sub-prime mortgage consumer to shop for a loan and to compare rates and programs. In many cases the rate is not definitively calculated until the loan is underwritten and all of the risk factors associated with the loan have been reviewed. This is where the consumer is left in the dark and the unscrupulous (or sleazy) mortgage broker could take advantage. If a borrower is unable to easily compare and confirm that the rate they are being offered is fair, this puts them in a dangerous blind spot where a mortgage broker can abuse an unsuspecting borrower by making thousands, in some cases ten of thousands, of dollars from a single loan. Mortgage brokers making five figure commissions on conforming loan amounts should be seriously called into question and forced to justify such seemingly usurious practices. Note that mortgage brokers are required to disclose their commissions on the mortgage lending disclosure agreement which regulations require to be presented to a borrower within three days of receiving a loan application. However the problem inherent in sub-prime vs. prime lending is that sub-prime borrowers are not usually permitted to lock in their rate until the loan is approved and ready for loan documents to be drawn. This is due to the individual risk factor involved with each loan and the fact that a sub-prime underwriter may have to review a complete borrower file before determining the rate. This leaves a sub-prime borrower "rate vulnerable" in that the broker is left unchecked and may change the rate at the time the loan is ready to be locked and loans documents are ready to be drawn. In many cases dishonest brokers may have "pulled a fast one" on sub-prime borrowers at the time of loan closing by putting them into a higher interest rate loan (resulting in greater commissions to them) and then falsely blaming the rate change on the funding lender's underwriter. The only way a sub-prime borrower may be able to confirm they are receiving a competitive rate would be by applying for financing with more than one broker or lender.

Clearly this is a complex problem with plenty of blame to go around. However hastily pointing the finger at the mortgage brokers who originated these loans could be a gross oversimplification of a complex problem. The answer may be to make the sub-prime loan process more transparent so borrowers can confirm that the rate they are being offered is fair. In prime lending the interest rate is reduced to nothing more than a commodity because a borrower can easily shop rates and terms from one lender to the next and will also ultimately choose to close their loan with the broker offering the best rate and terms. Sub-prime borrowers need a level playing field of comparison to make rate and loan program decisions on their own, something they have had no way of doing. However having the ability to shop and compare prices would not have likely prevented the loan debacle from erupting. The flaw is with the loan programs themselves and this is something the mortgage brokers had little to do with but profited from generously, and in many cases shamefully.

The solution to eliminating the multiple problems in sub-prime lending, and with it the potential for abuse, may be to have the government mandate how the sub-prime lending arena functions under a system very similar to that of the way FHA and VA loans operate currently. This will standardize the process and potentially protect all parties to the transaction against elements of abuse. It is unfortunate that the competitive market forces allegedly at play in the private sector were unable to make this happen without the government's interference. Back to the used car salesman analogy, recall that in the automotive world they have "Lemon Laws" which protect new car buyers who get stuck with mechanically unfit vehicles. Perhaps the sub-prime borrower requires similar protection. This may be a safeguard refinance borrowers already have on their primary residence, which is the right of rescission, or so-called "cooling off" period, which occurs after the loan documents have been signed by the borrower, but before the loan can fund, so that consumers have a three day time frame to re-think the loan before the lender is permitted to request the loan funds. It may also be time for sub-prime borrowers to benefit from this added safeguard as well.

The information contained on this article is provided as a supplemental educational resource. Readers having legal or tax questions are urged to obtain advice from their professional legal or tax advisers. While the aforementioned
information has been collected from a variety of sources deemed reliable, it is not guaranteed and should be
independently verified. Copyright ©1999-2007 ERATE

Nancy Osborne,   Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.

"I am addicted to Bloomberg TV" says Nancy.

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