Who Will Fill The Gap?

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rsz_barbara-perinobecky-walzakRule 20 took effect after a specified event or period of time, to enable borrowers with less income to make the initial, smaller loan payments. Some qualified borrowers according to whether they could afford to pay the lower initial rate, rather than the higher rate that took effect later, expanding the number of borrowers who could qualify for the loans. Some lenders deliberately issued loans that made economic sense for borrowers only if the borrowers could refinance the loan within a few years to retain the teaser rate, or sell the home to cover the loan costs. Some lenders also issued loans that depended upon the mortgaged home to increase in value over time, and cover the loan costs if the borrower defaulted.

Still another risky practice engaged in by some lenders was to ignore signs of loan fraud and to issue and securitize loans suspected of containing fraudulent borrower information. These practices were used to qualify borrowers for larger loans than they could have otherwise obtained. When borrowers took out larger loans, the mortgage broker typically profited from higher fees and commissions; the lender profited from higher fees and a better price for the loan on the secondary market; and Wall Street firms profited from a larger revenue stream to support bigger pools of mortgage backed securities. The securitization of higher risk loans led to increased profits, but also injected greater risks into U.S. mortgage markets.

Some U.S. lenders, like Washington Mutual and Countrywide, made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate mortgages and increasing their sale of higher risk loans. 21 Because higher risk loans required borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the higher risk loans, because once securitized, the AAA securities relying on those loans typically paid investors a higher rate of return than other AAA investments, due to the higher risk involved.

As a result, investors were willing to pay more, and mortgaged backed securities relying on higher risk loans typically fetched a better price than those relying on lower risk loans. Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the loans and kept the risk off their books. After 2000, the number of high-risk loans increased rapidly, from about $125 billion in dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or 34% of all loan originations in 2006. 22 Altogether from 2000 to 2007, U.S. lenders originated about 14.5 million high-risk loans. 23 The majority of those loans, 59%, were used to refinance

Ever since the take-over of Fannie Mae and Freddie Mac by the federal government, speculation about what will eventually happen to them has been rampant. While any active legislative issues were put on hold until the impact of the crisis lessened, there continued to exist an underlying knowledge that these entities were contributors to the crisis and that this issue remained unaddressed. In fact the Senate Permanent Subcommittee report on the financial crisis included the agencies in their general condemnation. Their conclusions were based on the fact that both Fannie Mae and Freddie Mac purchased large quantities of high-risk loans which created a secondary market for them, thus encouraging their growth and proliferation.

Recently legislators have begun to initiate bills that would address the “Fannie/Freddie” problem. The most widely discussed bill is one in which these agencies would be replaced with an entity not unlike the Federal Insurance Deposit Corporation (FDIC). This new agency, titled the Federal Mortgage Insurance Corporation (FMIC) would collect premiums from industry participants while taking on the role of “industry safeguard.” This entity would collect a 10% premium from lenders for loans originated and in the event of another drastic delinquency upswing, would protect the federal government by covering losses through the premiums collected. This legislation is supported by many, including legislators and private industry, but opposed by others, some of whom have large amounts of stock in both Fannie Mae and Freddie Mac. But while all this wrangling goes on in the halls of Congress and the back rooms of Wall Street, the reality is that this discussion has missed the mark on much of the central control functions that are inculcated into the fiber of what Fannie Mae and Freddie Mac are and what they do for the industry as a whole.

These agencies, along with HUD, have become the backbone of the industry. They provide not only a secondary market source, but have developed and maintained areas that are integral to the overall reliability and consistency of the industry. One of the immediate areas that comes to mind is Credit Policy and the associated underwriting guidelines. These agencies were the first to create a uniform approach to underwriting. The credit risk management foundation they introduced is still the basic source from which all guidelines flourish. Even during the days when individual companies were introducing their own guidelines, the fundamental methodology was based on these original practices. It was not uncommon to find company guidelines that included directives to source Fannie/Freddie Guides if the company guidelines were insufficient to answer questions. For underwriting managers intimately familiar with the agency guidelines, reviewing new lenders programs often disclosed that these were “just Fannie and Freddie guidelines repackaged.” As such there was no need to re-train specific underwriters for specific conduits or to isolate an underwriter’s knowledge base so as to eliminate the chance that guidelines would be accidently used for the wrong loan.

Also of extreme value to the industry was the ability of these entities to update the guidelines to reflect credit criteria relevant to what was going on in the industry. As credit risk direction changed, the guidelines followed and provided a sense of stability that everyone from loan officers to investors came to rely on. This stability has also provided a foundation as to what constitutes credit risk and promulgates a uniformity in loan underwriting that could not have been developed or sustained if the industry had to rely on direction from competing mortgage lenders.

Of course, underwriting guidelines are only one tip to this iceberg. Another area that is not readily acknowledged is the uniformity in documentation provided by the agencies. The 1003, Uniform Loan Application is seldom given any thought these days. It is just the accepted document for use when collecting and evaluating the applicant’s information for underwriting purposes. Yet everyone, even HUD, uses this form. Without this effort on the part of Fannie Mae and Freddie Mac would we still have numerous application forms that are unique to specific products or individualized by different lenders?

And of course, it is not just the application. Almost every standard form used in the underwriting and closing process is stamped as a Fannie Mae/Freddie Mac Uniform document. When states make changes to the requirements of legal documents or when the application has to collect more information for HMDA purposes, individual lenders do not have to take on the burden of making these changes since everyone acknowledges that this falls within the boundaries of Fannie and Freddie.

With all the talk from the regulators about ensuring lenders have a solid control environment in place, it has to be recognized that Fannie Mae and Freddie Mac were the first to hold their seller/servicers responsible. Because they established standards by which they would approve their clients, lenders who began conducting third and fourth party lending activities had a model from which to formulate their own requirements. As these origination sources grew, investors began to examine not only the approval process, but the ongoing monitoring of the approved lenders and actions taken to address issues found; just like Fannie Mae and Freddie Mac.

The establishment of the Quality Control function was first introduced by Fannie Mae in 1985 and Freddie Mac and HUD were soon to follow. These requirements have been used since then to establish a review program for not just sellers/servicers but the requirements have trickled down to those selling to conduits as well.

Of course Fannie Mae and Freddie Mac have generated a lot of contentious issues as well, including a belief that there was a fair amount of bias toward certain sellers which resulted in inequitable pricing and ultimately a competitive advantage or disadvantage. And while their approach to many of the internal operations of a mortgage operation were industry standards they repeatedly failed to permit lenders to develop their own approach or ideas on how most of the operations should be developed and managed. Overall, most would say that the good balanced out the bad and these agencies ultimately generated a unique approach to housing finance that was the envy of other countries.

So, if Fannie Mae and Freddie Mac go away, what will happen to this sense of continuity and stability? Will lenders take advantage of the lapse in credit risk guidance to create individual standards that will be absent the boundaries the agencies have established as sound underwriting? Will there be any uniformity in the approach to evaluating this risk? Will borrowers and lenders alike be left to find situational based guidelines that are developed only for a very unique set of circumstances? Or will the focus of the individually developed guidelines be biased on the risk/reward returns that each individual banking institution seeks.

While the final determination of what will become of these entities is still far off, the industry cannot afford to sit on its laurels and wait for that to happen. The ultimate fate of Fannie Mae and Freddie Mac will be the result of political aggrandizing and its outcome will be decided by those whose weight and control is greater than any of ours. However, what is important is that regardless of what happens legislatively or politically, the industry must be ready to assume some of the burdens that have previously been the prerogative of these agencies. We need to start thinking of how we will handle that burden and not wait until we are face to face with the problem. So to start the dialogue here are some ideas.

One idea may be to have an independent company take on the responsibility of all standard documents under the direction of the secondary market or whatever entity emerges from the political battle. This company would be the provider of the model forms and would take the responsibility of making changes as required. This company would be viewed as a resource to lenders, servicers and software developers alike.

The Mortgage Bankers Association needs to take on a larger role in establishing guidelines and directives to the industry. As the one unifying source of mortgage information and interaction with lenders from independents, retail banks, community banks and credit unions, this seems the appropriate place for this work to occur. As they have already established a “Risk Management” support staff and along with this infrastructure the move could be made rather seamlessly.

While the industry has a strong presence around quality control, we still have to define what quality actually is to this industry. Since Fannie Mae and Freddie Mac were concerned about the quality of loans that were sold to them, there was a gap when loans did fall under their purview. The industry needs to take on this task and tie the concept of quality to firm standards that could be used to measure lenders equally. Included in this could be some measure of the impact of creating loans that don’t follow guidelines; something like a lender score to go along with the borrower score that could be part of a risk-based pricing scenario.

These are just a few thoughts around what we might need to handle the functions for maintaining the inner workings of the industry’s infrastructure and making sure they continue. There are probably many more really good ideas that we need to consider. However one thing is for sure. What we don’t need is another federal bureaucracy running the industry. Those that do exist have demonstrated over and over again that they cannot keep up with the industry needs as it changes and grows; that they cannot handle change and in a rapidly changing environment such as mortgage lending. Relying solely on them would be tantamount to reversing mortgage lending back to the 19th century.

But what if we don’t take these steps? Are there lenders, bankers or others who would want to see that happen? Unfortunately there are. These are the players that don’t want anything to change because the way it is now is good for them. They are afraid of change. One example is the numerous quality control firms that conduct loan file reviews today. None of them do the work the same and the results are all different. There is no common determination of issues or standards and they compete only on price. The same can be said of most of the functions that are currently imbedded in the existing agency structures.

Franklin Roosevelt one said, “The only thing we have to fear is fear itself.” Many times fear causes people to become immobile, hesitant to make changes. However if we recognize that things are going to change and actively put in place a means and method for change we will all benefit. Our fear is not that Fannie Mae and Freddie Mac will go away, but who will take charge if and when they do. It is time that the industry begins to recognize the risk associated with how it will continue to develop and enhance what we do to the benefit of all companies and stakeholders in mortgage lending.

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