One of the most convoluted elements of mortgage banking is how pricing or rates are determined. The process involves the individual mortgage, the sale of the mortgage to an investor, the pooling of a number of mortgages into a Mortgage Backed Securities, and – in some cases – the repackaging of MBS’s into creative products such as Interest Only and Principle Only securities. Ultimately the performance of the initial mortgage, and each of the following creations derived from these mortgages, directly affects the overall profitability of the mortgage pools. This complexity is the main reason the mortgage industry works the way it does.
The real estate and mortgage industry has undergone astounding upheavals during the past 30 + years, including two complete lending meltdowns, one in the late 1980’s and one from 2006 through 2009.
There were others crises but these were the two true disasters. In each of these extreme cases, absurd loan qualifying policies were implemented and outlandish lending practices became commonplace. After each bust played out the industry went back to conservative practices for a number of years, only to be relapse down the line. Interest rates reflected the loss of confidence in the mortgage banking industry by the financial industry and carried over into the availability of credit.
Mortgage interest rates are a function of a number of factors that combine to make a market out of real estate lending. Most important in the interest rate calculation is the “cost of money” or risk free rate. This rate varies depending on whether the loan is a fixed rate or ARM. The ARM for instance, is determined by one of various Indices, such as Libor, and then risk and profit demands are added. In the past most mortgages were purchased and sold to the government through an individual mortgage being purchased by FNMA, FHLMC, GNMA, FHA, VA, and Rural Home. These mortgages were then packaged into securities. After establishing a risk free rate, a security’s rate is determined based on its financial risk, or the probability that the loans will be paid back on time. The third element is the profit and cost of doing business. This calculation also varies with whether or not the loan is a fixed rate or an adjustable rate mortgage. The interest rate is a function of the factors above and then the ultimate price in combination of all the loans in a group of mortgages called a Mortgage Backed Security (MBS).
The overall process of pricing a group of mortgage loans is also known as securitization, and it comes at the end of the pricing process. Until the 1990’s MBS’s were almost exclusively an FNMA and FHLMC product. However, in the 1990’s private label securitization began with large banks and Wall Street, and was combined with the emergence of Subprime and Nonprime loans. In these loans the risk averse lending standards were relaxed for both the borrowers’ willingness to repay, and the standards of risk judgments used to establish their willingness and ability to repay.
Risk has always included a close review of credit reports to judge a borrower’s willingness to repay by looking at how past debt obligations were handled, then applying these findings to the proposed loan. The big, hairy questions: has the borrower paid on time and has the borrower handled similar levels of credit? Credit is the initial variable in determining how credit-worthy the applicant was. In general, credit is judged by a series of scores determined from past credit performance. There are three companies that handle the bulk of credit reporting, they are:
The scores judge the individual through a range of scores from 300 to 850. Although most credit is reported on one or more of these credit repositories, there are instances when a debt is not reported, which complicates the process. Each credit report judges the credit score for each individual. Lenders compile these scores into their own rating, which is then used to determine the willingness of the borrower to repay. The credit score is a significant factor in pricing a loan since the risk of non-payment is a critical factor in calculating interest rate. Credit is a major variable in the process used by lenders to judge a borrower’s ability to repay a loan, but it’s not the only one. Other factors include income/employment, assets, and appraised value, all of which play a role in calculating risk and ultimately interest rates.
In the late 1980’s the mortgage banking industry collapsed. This is commonly called the “Savings & Loan Crisis” and was driven by qualifying guidelines and product parameters largely used by the industry agency leaders of Fannie Mae and Freddie Mac. These parameters included no-income, no-asset, and essentially no-credit history loans. These were totally new product variables since historically it was impossible to write a mortgage without verifying income or assets. Decreasing credit standards gave lenders far less information on the degree of risk or a borrower’s ability to repay the mortgage. These changes were coupled with appraisal standards that violated long-established industry guidelines for establishing value. The result? A then-unprecedented implosion of the industry at large.
After the meltdown was over, Fannie Mae announced that they would never again accept no-income or no-asset check loans. This return to prior policies continued until approximately 2000, even in situations where there was actually some value recognizing no income check loans, particularly for Self Employed borrowers. New guidelines essentially threw the baby out with the bathwater and tightened regulations so that no-income loans could not be used in any instance.
As the late 1980 to 2005 period continued, non-agency lenders (banks, private industry, and Wall Street lenders) took over an increasing percentage of lending, high balance loans grew, and the pressure to loosen standards became almost insurmountable. The loosening of the guidelines on agency product grew along with of the same practice for non-agency loans.
The driving force in the non-agency product was the growth of a market in pooling these loans into Mortgage Backed Securities sold to non-government lenders. These securities were often segmented into products that met the risk that various investors were willing to take, such as Subprime, Interest Only, or Principal Only. Risk avoidance was enhanced by the credibility that was provided through due diligence firms that rated the securities. The lead reviewers for these were generally Standard and Poor’s or Fitch and Moody’s. They were not, however, rating the anticipated performance of individual loans, but instead groups of loans rated as pools and judged together. Often the individual MBS pools were then aggregated together to form a Super Pool making it more difficult to judge loans individually and resulting in the normal process of risk determination becoming largely ineffective.
At the same time that the MBS market was evolving, the dangerous subprime market was coming into being. These loans were given to borrowers with poor credit, high Loan-to-Value, and poor scores in criteria normally used to judge the risk profile of borrowers. These loans were also pooled and assembled into MBS’s. The SubPrime MBS and the regular MBS pool were sometimes combined together and priced as one because the due diligence firms rated the Subprime pool as AAA along with the normal MBS pools.
A great resource for learning more about this is the book-turned-movie The Big Short.
A major factor in assessing the ability to repay, besides credit, is the borrower’s income, and whether or not it’s sufficient to repay a loan. The factors used here are pay stubs and W-2’s to verify that the borrower made sufficient income to repay and that the income was stable. This was judged by looking at income and duration of employment for a two year period. Of course this is a problem for Self-Employed individuals and commission-based earners as their income may be naturally boom-and-bust, or come in a variety of forms other than a traditional W2.
Another major factor in the ability to repay is the borrower’s possession of sufficient savings to close the loan and provide required reserves. Borrowers must have sufficient verifiable income each month to pay the mortgage, and/or the savings to pay if there is a shortfall on any month. In addition, the borrower must have funds to cover the down payment and to cover closing costs. Having sufficient funds for both traditional loans and for self-employed borrowers has been a persistent problem in lending.
Interest rates are determined by the “risk free” rate, the required profit, and by the qualifying rate that loan analysis results in, this includes income sufficient to make the monthly payments, the availability of sufficient assets to close the loan and validate reserves. Appraised value must also be supported by the appraisal, and the resulting loan to value must be sufficient to satisfy any required risk. Furthermore, the “risk free rate” is determined by a number of factors, most frequent are various indexes acceptable to the specific lender.
We founded EMF specifically to address the unmet needs of self-employed borrowers. We believe that traditional loans are ignoring a key segment of our population: our economic drivers. If you’re self-employed or earn via 1099, EMF can help you get a loan. Contact firstname.lastname@example.org or 800-584-2442.