Mortgage Lenders Pre-Collapse Risk and Control
Lenders review and adjust various factors in an effort to control and/or limit your risk on each loan. When making mortgage loans, risk comes from two main sources, owner (borrower) risk and market risk.
Market risk includes factors such as the originating interest rate and the possible increase/decrease in subsequent months due to an index-linked variable rate. For example, if a rate is locked at 6% for a period of months and could be lent during the course of the rate lock, for 8%, the bank is losing 2%. Another factor to consider is the value of the real estate (loan collateral). There is not much the lender can do, nor can the borrower, to predict or influence real estate values. If the value of the property goes up, the security of the loan looks better and better. However, if the value decreases, the security of the loan decreases.
Other factors include both the local and national economy. For example, loans made in Ohio’s rust belt during the heyday of the auto industry seemed very safe. As plants began to lay off workers and people had to move out of neighborhoods, the collateral value of the loans fell.
There are real risks associated with borrowers. The bank has a vested interest in the financial success of its borrowers. Banks try to limit their exposure. However, at the end of the day (or month!), the borrower must make their payments on time for the bank to remain profitable. Borrowers who don’t or can’t make their payments force the bank to take a hard look at late payments, collection models, foreclosure litigation, attorney fees, and eventual REO.
Lenders can try to mitigate any risk or potential loss in several areas. The most obvious variable is the interest rate. Riskier borrowers pay a higher interest rate. Less risky borrowers pay a higher interest rate. Believe it or not, different types of property are defined as more (investment) or less (owner-occupied) risky. I have always felt that lenders generally charge a higher interest rate to less qualified and needier borrowers. This could explain how interest rates above 20% are legally charged on credit card debt.
Another element that lenders use to control risk is the down payment. In the early 1980s, a borrower, unless they took out an FHA loan, had to provide a minimum of 10% of the purchase price as a down payment. And, if a borrower only had the 10% minimum down payment, Primary Mortgage Insurance (PMI) was required. The only way to eliminate the lender-required PMI was to increase the down payment to a minimum of 20%. PMI is mortgage insurance, paid for by the borrower, that protects the lender in the event of a loss.
“Creative financing” was alive and well between 2002 and 2005. Many lenders devised programs that allowed borrowers to purchase homes with little or no down payment. The risk potential of these loans has been realized and the real estate market, lenders and borrowers are all in the soup. The consequences will be felt for many years to come.
Lenders also seek to mitigate or control risk by adjusting the borrower’s term, preferring to lend the money with an adjustable-rate mortgage, and inserting a prepayment penalty for early payments.
Interest rate and payment terms are the most significant differences when looking at existing loans. These two factors are derived from the originating mortgage after evaluating the risk. We, as mortgage buyers, measure risk in essentially the same way as those who originate loans. Both we, the originators and the buyers, should look for the property in question in its “as is” condition, as it relates to both the wholesale value for short money and the retail value for long money. Local real estate market conditions should also be considered. In the case of short money, what is the spread on the foreclosure auction floor in the county where the property is located? Will investors on the sales floor take short money or will the lack of competition require us to take ownership to make a profit? Will substantial rehabilitation be necessary?
Is there a bankruptcy on file that would reduce or eliminate the ability to collect or perhaps undermine the security of this loan? How much of the total settlement amount can be recovered? Unlike the originating lender, we don’t need to consider the borrower’s credit score or debt-to-income ratio relative to the terms of the original loan (does the borrower make enough money to repay the loan?). Institutional lenders don’t own real estate because they don’t want to. They are in the business of lending money for profit. Their main goal is to lend money safely and get paid back in a timely manner, while charging interest margin for your troubles.
Loan to value is another consideration that allows the bank to control or mitigate risk. If a loan appears to be somewhat risky, and the underwriter cannot identify why, they have the option of making a counter offer. Instead of rejecting a loan, a lender can make a counter offer requesting a change in the value of the loan. For example, instead of lending 90% of the purchase price, they may approve the loan as long as the buyer adds to the down payment, resulting in a loan of 80% or 85% of value. This increases the security of the loan, minimizes risk a little more, and puts the lender in a better comfort zone.
During the “creative financing” period of 2002 to 2005, loan programs with repayment terms that were interest only or negatively amortized were offered (and accepted). A typical 30-year fixed-rate mortgage has a term of 30 years, is amortized over 30 years, and results in a zero balance. In other words, if a borrower makes all of their payments on time, the result will be the full payment of the original debt. If a loan defaults or is negatively amortized, it means the debt will not be paid because none of the payment amount goes to reduce principal. With negative amortization loans, the principal amount actually increases each month. Some of these loans were offered at interest rates such as half a percent or 2% interest for the first two years. This allowed borrowers to obtain a higher mortgage than they were actually qualified for.
In an effort to bring even more borrowers into the market, lenders created programs that were “no documentation” loans or “established” loans. What this meant was, the methods used to measure a borrower’s financial stability, ie employment history, income verification; verification of savings deposits, etc. they were not made What the borrower “stated” was believed to be true. Other programs emerged that were a hybrid between a no dock and a full doc. This type of loan is known in the industry as ALT A loans. Remember, the riskier a loan position, the higher the interest rate and the stricter the repayment terms.
With this in mind, the days of declared income loans and zero down payment mortgages have gone the way of the dinosaur. Lenders in the future will be forced to vet their borrowers more thoroughly, as the era of easy credit for all ends abruptly as quickly as it began. But, and remember you read it here first, the market for borrowers with less than perfect credit remains a major force in the market. The new gold will go to the lender who is the first to introduce a safe (for the investor) mortgage instrument that can reach those potential buyers firmly on the outer limits of mortgage approval.
