Transcript Standard Setting in High

Bailouts Seminar, Winter, 2009
The Consumer
Side of the
Mortgage Industry
Darius Horton
Anush Yegyazarian
Eunjoe Ahn
Cleve Doty
Adjustable Rate Mortgages
(ARMs)


Start with a teaser rate, typically < 2%.
Once the initial interest rate period expires, reset to an index +
fixed margin (for example, 2-3%) and adjust periodically,
usually annually.
 Common indexes include:




The rates on 1-year constant-maturity Treasury (CMT)
securities: estimated 1-year yields of recently auctioned
Treasury bills and notes.
The Cost of Funds Index (COFI): weighted average of interest
rates paid out on deposits, loans, etc. by financial institutions
in the 11th District of the Federal Home Loan Bank (CA, NV,
AZ).
The London Interbank Offered Rate (LIBOR): interest rate at
which banks can borrow funds from other banks in the London
interbank market.
Fully indexed rates are subject to both periodic and life-of-theloan caps.
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2
ARM Index Rates
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3
Theme and Variations

Hybrid ARMs offer a fixed rate for the first 3, 5, 7 or 10 years, then switch to
an adjustable rate.




An X/Y hybrid ARM is fixed for the first X years, then adjusts every Y years.
About 1.3 million subprime hybrid ARMs reset for the first time in 2008, and
FDIC estimates that an additional 422K will reset in 2009.
Interest-only (IO) ARMs allow the borrower to pay only the interest for
typically the first 3 to 10 years.
Option ARMs adjust every month.




Common payment options include interest-only, and a “minimum” payment
that’s often less than the amount of interest due.
Option ARMs have a built-in recalculation period, usually every 5 years. At
each “recast,” the new minimum payment will be a fully amortizing payment
and any payment caps won’t apply.
Loans can also recalculate at any time if the amount of principal owed grows
beyond a set limit, for example, 110% or 125% of the original mortgage
amount.
Fitch Ratings estimates about $29 billion in option ARMs will recast in 2009,
and an additional $67 billion will recast in 2010. Of this, about $53 billion is
attributed to early recasts.
Some ARMs carry prepayment penalties if the borrower refinances or pays
the ARM early, usually within the first 3 to 5 years (for example, 1-3% of 4
July 17, off
2015
the original mortgage amount).

Mortgage Loan
Performance by Interest
Rate Type as of Nov. 2008
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5
Alt-A Loans


Thought to be between prime and subprime in terms of risk. These borrowers
typically have clean credit histories, but prefer not to provide full
documentation for one reason or another.
The baseline: full doc.









Income verification: W-2, current pay stub, state/federal tax returns, Social
Security, veteran’s benefits, etc.
Assets verification: bank account statements; savings bonds, stocks or
investments and their market values; titles and deeds to property, etc.
Debt information: credit card bills, other loans, child support or alimony
payments, etc.
Desired purchase information: for example, proof of current market value of
property.
Stated Income Verified Assets (SIVA): stated income should be consistent
with verified assets and employment.
Stated Income Stated Assets (SISA): lender will still verify employment.
No Ratio: borrower doesn’t need to meet any qualifying debt to income ratio.
No Income No Assets (NINA): borrower qualifies based on credit score and
level of down payment; employment is verbally verified.
No Income No Job No Assets (NINJA): same as above, but no employment
verification.
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Summing up…
Income
Assets
Employment
Full Doc
Verified
Verified
Verified
SIVA
Stated
Verified
Verbal verification
SISA
Stated
Stated
Verbal verification
No Ratio
Not reported
Verified
Verbal verification
NINA
Not reported
Not reported
Verbal verification
NINJA
Not reported
Not reported
Not reported
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Scope of the Problem


Alt-A loans represent 20% of the current mortgage market. About 3 million
Alt-A loans totaling $1 trillion are outstanding, reports the Financial Times.
Mortgage Loan Performance by Borrower Type as of Nov. 2008:
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8
Comparing Subprime and
Alt-A Loans (Jan. 2009)
State
Total
Housing
Units
(2007
Census)
Number
of
Subprime
/Alt-A
Loans
% Owner
Occupied
Number
with
prepayment
penalty in
force
Number
with a
high LTV
ratio at
origination
CA
13,308,346
391,95
9
93.7%
98,661
666,38
6
80.6%
286,80
3
FL
IL
8,718,385
5,246,005
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Number
with
interest
only
Number
with
negative
amortization
% with
FICO <
600
% with
FICO >
660
115,076 112,556 351
25.1%
35.1%
141,70
2
103,26
3
232,84
6
201,87
1
0.8%
84.1%
88.7%
81,934
81,280
31,030
77
38.1%
21.0%
231,38
4
60.6%
45,632
41,173
50,478
40,138
1.6%
77.3%
120,71
0
90.9%
5,077
44,398
8,453
24
38.9%
19.5%
63,583
77.1%
4,014
18,718
16,687
7,348
1.6%
77.6%
9
Comparing Subprime and
Alt-A Loans, cont.
State
% w/a
payment
90+
days
past
due
CA
14.9% 12.6% 16.2% 41.5% 42.3% 44.6% 68.3% 59.0% 15.8% 3.5%
4.7%
9.6%
7.7%
38.3%
11.7%
25.7% 18.1% 45.1% 36.8% 41.4% 64.6% 57.7% 18.0% 3.4%
2.8%
7.6%
19.2% 22.3% 41.9% 35.7% 79.6% 57.1% 40.4% 4.4%
35.2%
FL
IL
% in
foreclosure
%
originated in
2007
%
originated in
2006
%
originated in
or
before
2005
% with
no or
low doc
% ARM
loans
% of
cashout
refinances
%
ARMs
resetting in
next 12
months
25.2% 37.9% 36.8% 82.9% 70.0% 46.0% 4.3%
%
ARMs
resetting in
12-23
months
6.1%
9.0%
12.0% 15.2% 16.3% 37.3% 46.3% 34.9% 73.0% 55.0% 17.4% 5.7%
July 17,
2015 8.9%
4.8%
22.2% 36.5% 41.3% 73.6% 50.6% 31.3% 6.7%
%
ARMs
resetting in
24+
months
2.6%
10
12.4% 43.5%
JUMBO Loans
Mortgages exceeding the conforming loan limits set by the
Office of Federal Housing Enterprise Oversight, and thus not
eligible to be purchased, guaranteed or securitized by Fannie
or Freddie.

Conforming loans top out at $417K in most parts of the country.
The stimulus package raised the limit from $625K to $729,750
in high-cost areas such as parts of CA, NY and HI.
 The median home price in San Francisco and NYC is $600K.

About 4% of all borrowers have non-conforming loans,
estimates First American CoreLogic. That %age rises in states
like CA, at 17%, and NY, at 8%.

Since 2007, the interest rate difference between conforming
and JUMBO loans has been about 1-2%. Before that, it
averaged about 0.2%.

Last month, “about 2.57% of prime borrowers who took out
jumbo loans last year were at least 60 days delinquent. They
July 17, got
2015 to that level within 10 months, the fastest rate since at least
11
1992.” —Bloomberg

Who regulates?



Mortgage lending in the United States is subject to a
diverse patchwork of regulations.
Most regulations are found in state law, or the common
law
Federal regulatory agencies operate on top of state law :





The Federal Reserve
The FDIC
The Office of Comptroller of the Currency
The Office of Thrift Supervision
The Federal Financial Institutions Examination Council
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The Truth in Lending Act



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Also known as Regulation Z
Its purpose is to “promote the informed use of consumer
credit by requiring disclosure about its terms and costs.”
Requires disclosures about the loan’s APR, fees, points,
term and pre-payment options.
Prohibits refinancing a mortgage within 1 year, unless “the
refinancing is in the borrower’s interests.”
Prohibits lending without regard to the consumer’s ability
to repay.
There is a presumption that the Act has been violated if
the lender engages in a “pattern or practice” without
verifying and documenting the borrower’s income.
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The Homeownership and
Equity Protection Act


Passed in 1994, this amends the TILA for certain high-cost loans.
It applies to:



It prohibits:




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
Any first lien with an interest rate 8 points (10 points for second liens)
higher than a comparable treasury bill.
Or any mortgage with fees higher than $583 or 8% of the loan
amount.
Balloon payments for loans with less than 5 year terms.
Negative amortization
Most pre-payment penalties.
Disguising high-cost loans as home equity loans.
It does NOT prohibit steering borrowers into more expensive loans.
As high as 61% of sub-prime borrowers would have qualified for
prime loans.
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The Community
Reinvestment Act


Passed in 1997, its purpose is to encourage banks to “meet the credit
needs of the local communities” while maintaining “safe and sound
operations.”
In practice, this amounts to a prohibition on “red lining.”





Banks would draw lines on the map around neighborhoods where
they would not lend.
The Act requires banks to meet the needs of “low-and-moderate
income neighborhoods.”
As well as the needs of women and minorities.
Only applies to deposit-taking institutions.
That means the CRA did not apply to many of the largest sub-prime
mortgage originators, such as Countrywide and Ameriquest.
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The Financial Benefits
Worksheet


Designed to ensure compliance with the TILA’s prohibition
on loans that are not in the borrower’s interests.
Add points for benefits such as:




Lose points for harms such as:

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Reducing monthly payment.
Reducing interest rate.
Cash out exceeds points and fees by more than 2 to 1.
Points and fees exceed cash out.
Re-financing loan within 1 year.
Could not approve loan with a score below 3, but in
practice, scores of 1 and 2 were quite common.
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Appraisals

Governed by Federal and State law:

Financial Institution Rescue, Recovery, and
Enforcement Act (FIRREA, 1989)

Title XI: Real Estate Appraisal Reform
Amendments
• Created Appraisal Subcommittee, which set
national appraiser standards matching those
created by USPAP (an ad hoc group made up of
appraisal professionals organizations)
• States still have a lot of leeway
Mar. 5, 2009
Consumer-side Fraud
17

Certification and Licensing Required

States set the specifics
Training varies from 75 to 165 hours
 Tests may be state-run or given through
qualified organizations
 Different categories of appraisers based on
training and experience
 Appraisers must renew their certification
every two years
 Guidelines require use of comparable
property nearby to help set values, plus
home inspection, written report

Mar. 5, 2009
Consumer-side Fraud
18

Fraud Easy to Do, Hard to Catch

Skewed incentives
Lenders and mortgage brokers often
required buyers and owners looking to
refinance to use one of their appraisers
 Appraisers paid per eval, need to keep
lenders happy to keep business
 In competitive market, consumers and
lenders wanted high valuations


Fines for violations, but little oversight

Mar. 5, 2009
Complaint required for investigation
Consumer-side Fraud
19
 Fraud Often Shameless
Appraisers lie
about property
or never visit
 Lenders send
e-mails and
faxes explicitly
telling
appraisers to
increase
valuations

Mar. 5, 2009
Condo appraised at $275,000 for
having extensive renovations,
including Brazilian hardwood and
granite countertops. Source: FBI
2007 Mortgage Fraud Report
Consumer-side Fraud
20

Recent (Dubious) Reform: Home Valuation
Code of Conduct, Effective May 1, 2009
Required for business with Fannie and
Freddie
 Championed by Andrew Cuomo after NY
investigations into WaMu, others
 Sought to lessen lender influence over
appraisers
 Problem: Empowers intermediaries called
Appraisal Management Cos. that have
skewed incentives and little oversight

Mar. 5, 2009
Consumer-side Fraud
21

Dubious Reform (continued)
 Some
of the same subprime players are now
AMCs

NovaStar Financial, disciplined in 3 states, now
an AMC called StreetLinks National Appraisal
Service (BusinessWeek, Feb. 5, 2009)
 Some

Mar. 5, 2009
banks run their own AMCs
Bank of America, Wells Fargo, for example,
have their own AMCs (BW, Feb. 5, 2009)
Consumer-side Fraud
22
The Consumer Side of the
Sub-Prime Mortgage
Market
Fraudulent Practices
FBI Suspicious Activity
Reports
FBI SARs




Up 31% from 2006 to 2007. (2008 numbers
unavailable)
Reports from financial institutions only.
The FBI suspects that lax lending
standards led to increased fraud.
Total annual estimated losses: $4 billion to
$6 billion (estimated by The Prieston
Group)
FBI SARs - Reported
Losses
Fraud Investigations
Fraud Investigations

FBI mortgage fraud investigations at the
end of FY 2007:
a
47% increase from FY 2006 and a 176%
increase from FY 2003.


56% of 2007 investigations involved dollar
losses of more than $1M.
L.A. led the nation for mortgage fraud
SARs (more than 2x as much as the next
worst city, Miami)
Fraud Schemes

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Illegal property flipping
Builder-bailout schemes
Seller assistance scams
Short-sale schemes
Foreclosure rescue scams (the new fad)
Mortgage fraud ponzi schemes
Other lending practices at financial firms
Illegal Property Flipping
• Fraudulent appraisal + straw buyer
combine to rip off a bank.
Builder-bailout Schemes




Builders fraudulently unload property in a distressed
market.
Example: builder has difficulty selling property, so he
offers incentives that are not on the loan paperwork. He
inflates the value of a $200,000 home to $240,000. The
bank gives a mortgage for $200,000, thinking that the
lender paid the builder $40,000, creating home equity.
The builder then “forgives” the home owner’s $40,000
down payment and keeps any profits.
The lender has no equity in the home, so it must pay
foreclosure expenses.
Seller Assistance Scams





Perpetrators find an anxious seller and offer to find a
buyer.
Perpetrator finds out how much seller will take.
Perpetrator finds appraiser to inflate home’s value, and
negotiates a sale (with mortgage) to a buyer recruited by
perpetrator.
Seller receives asking price for home, and perpetrator
receives “servicing fee” = difference between seller’s
WTA and inflated value.
When the mortgage defaults, the lender is stuck with
home that can’t be sold at inflated value.
Fraudulent Short Sale






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Perpetrator recruits a straw buyer to purchase a property.
Straw buyer secures mortgage for 100% of home’s value.
Straw buyer may refinance and obtain $30,000 for repairs.
Perpetrator pockets the $30,000.
Mortgage goes into default.
Straw buyer informs lender of default, and recommends
perpetrator as a potential buyer in a short sale.
Perpetrator purchases home before foreclosure in a short sale.
Perpetrator sells property at actual value for a profit, or
artificially inflates the value to create an illegal property flip.
Foreclosure Rescue Scams



Perpetrators contact individuals in danger
of foreclosure, promising help.
Perpetrators secure deed through promise
of help and sometimes a series of forged
deeds.
Perpetrators strip home of equity or sell the
home, pocketing profit.
Mortgage Fraud Ponzi
Schemes
• Meet Christopher Warren, age
27.
• Confessed to large-scale
mortgage fraud before fleeing
the country.
• Claims to have originated $810M in fraudulent MBS.
• Involved in $100M ponzi scheme at Loomis Wealth
Solutions.
• “Apprehended At Border With $70,000 In Cowboy
Boots, $1M In Swiss Bank Certificates” (see links)
Ameriquest



Nation’s largest subprime lender.
Supported many political campaigns; Deval
Patrick was on its board.
Ameriquest customers filed more complaints with
the Federal Trade Commission from 2000
through 2004 than did those of two of its biggest
competitors combined, the agency said – 466
compared with 101 for Full Spectrum Lending
(Countrywide’s sub-prime unit) and 51 for New
Century Financial Corp.
Ameriquest


Ameriquest employees “forged documents,
hyped customers’ creditworthiness and
“juiced” mortgages with hidden rates and
fees.”
Settlement: $325 million nationwide, $21M
in Texas.
Ameriquest


In court documents and interviews, 32 former employees
across the country say they witnessed or participated in
improper practices, including: “deceiving borrowers about
the terms of their loans, forging documents, falsifying
appraisals and fabricating borrowers’ income to qualify
them for loans they couldn't afford.”
“Whatever you had to do to close a loan, that’s what was
done,” said Brien Hanley, a former loan agent at the
company’s Leawood, Kan., branch. “If you had to state
somebody’s income at $8,000 a month and they were a
day-care provider, who's to say it wasn’t?”