Impact of a Fed Rate Cut

What will happen if the Fed cuts the rate tomorrow? We've read about the overall effects. Lower short term rates may bring some stability to the bond market and lower long term rates will bring the cost of mortgage money down. It will further devalue our dollar making our exports cheaper around the world. By the same token, it will make imports more expensive and should encourage Americans to buy domestically produced products. It's generally hoped to stimulate the economy somewhat.

I want to look at the effects of a rate cut from the consumer's position. What is the impact of a cut in the Discount Rate to the average consumer? Most credit line mortgages as well as nearly all credit card interest rates are adjustable and are controlled by the Prime Rate. The Prime Rate moves in tandem with the Discount Rate. A rate cut by the Feds, as we had in September, has the immediate effect of reducing the minimum payments on nearly all credit line mortgages and credit cards. Since the average American carries a substantial amount debt, this increases the amount of disposable money available to most families at the end of the month. Americans have shown that given additional money, they are more likely to spend it than to save it, so this will encourage an increase in consumer spending. For the last few years our economy has been surviving on consumer spending and this helped keep the economy on track.

The downside of a rate cut is that it can fuel inflation. If you think back 20 to 25 years ago you will remember the problems we faced as a nation, because of inflation. We even went through a period of national price controls as a means to reduce the inflation rate. Double digit inflation was the norm and the goal was to force it into single digits. We've now gotten so accustom to a low inflation rate that the thought of inflation moving up to 4% is frightening.

Inflation erodes buying power but it does have a positive impact on people, companies or nations in debt. With the amount of outstanding debt in this country being so high, an argument can be made that inflation may actually be a good thing. I'm not suggesting that we develop a policy to encourage inflation, I'm just pointing out that if we begin to lose control of inflation there will be some positive effects in addition to all the negative ones.

There are no easy fixes to the financial problems we are facing. Until we all individually curb our spending habits and begin to take a long term view of our personal finances, we will always be in financial trouble. No government intervention will be able to get this economy back onto a strong foundation unless all Americans change their ways. There is no excuse for a negative saving rate for the citizens of the largest economy in the world.

The Basis of Today's Problems

We are now witnessing the convergence of three economic circumstances. First, the subprime meltdown woke investors up to the real risk in low-grade paper. This sent the financial markets into turmoil. Housing markets such as Las Vegas and Miami had already laid the foundation for a disaster, by over building and excessive investor speculation. Even without the problems in the financial markets, these housing markets were headed for trouble. Prices in both these markets have been softening since last year.

Secondly, the unemployment numbers in the real estate field will get much worse before teh situation begins to get better. Layoffs in this industry impact communities to a lesser extent than other industries. When GM or Ford cut back, the economies of entire cities collapse. The real estate/mortgage industry is spread out all over the country; there are no “company towns” in this field. People that have been laid off can move into other fields without much, if any, retraining. Real Estate agents and mortgage originators are essentially salespeople. They will move into selling some other product. Even the back-office personnel can be more readily absorbed into the workforce. I’m not trying to minimize the difficulty of these transitions but I want to point out that, for these employees it’s a less stressful transition than it would be for employees of a manufacturing plant or a research facility that had to shut down.

Thirdly, and perhaps most signigicantly, today’s economy is forcing America into finally facing its day of reckoning. Deficit spending on both the governmental and personal levels have reached the breaking point. People have been supporting their lifestyles with the equity of their homes and their credit cards. The housing market wouldn’t be in crisis if people weren’t using their homes as ATM machines. Whatever programs are developed to address the problems in today’s economy will be just band-aid solutions. Until the basic spending habits of Americans and their elected leaders become more realistic, we are going to move from one economic crisis to another. You can spend more than you make for only so long.

Laws need to be thought through

NY Times WASHINGTON, Oct. 22 — "House Democrats introduced legislation on Monday that would for the first time let homeowners sue Wall Street firms for relief from mortgages that the borrowers never had a realistic chance of repaying."

I don’t disapprove of the concept of holding people in the industry accountable for their actions. I do, however, have a problem with giving the consumer too much wiggle room.

I don’t have a lot of respect for subprime originators. I truly believe that the bad apples out-number the good by a large margin in this particular segment of the mortgage industry. I have a friend, Jim, who is a mortgage broker in Ohio, working exclusively in the subprime market. He started out working for a bank, eventually went out on his own and another bank bought his operation. I don’t know much about the way he conducts business but he did make an interesting point one day over dinner.

He raised the question, “When do you know a loan is a predatory mortgage?” Answer, “When the borrower misses his first payment!” His point is this. In most cases, the consumer is fully aware of the loan and it's terms and uses the loan specifically for a "bail out" scenario. As long as everything goes according to plan, the borrower moves towards getting back on his feet and repairing his financial situation. The borrower is satisfied with the mortgage, uses it for as long as it suits his needs and then as his situation improves, can refinance with better terms & rate, or sell the property and move on with his life.

But what happens when things don’t go as planned? The new job position that the borrower just took is eliminated or his marriage breaks up or a medical problem arises. The borrower can’t make his mortgage payment. The words "predatory mortgage" become the exit strategy for him to use to get out of a bad financial situation. People never blame themselves for their actions, it’s always someone else’s fault. A deep pocket lender then becomes an excellent target. "The broker should never have arranged for that loan," or "the broker should have known better."

You see my point. A law written that would be as one-sided as this one is, doesn’t do anyone any good. What needs to be written is a law that gets the thieves out of the mortgage business and at the same time permits a borrower to make a bad decision and deal with the consequences. Enacting a law that punishes the industry for all bad decisions does more harm than good. The net effect would be that there would be fewer options available for an individual to help himself out. This would not good public policy. We need to encourage the industry to develop mortgage programs and underwriting standards that would be difficult to abuse by originators as well as consumers, and at the same time afford consumers the tools needed to help them through bad financial periods in their lives.

We need to increase the level of quality of originator as well as hold him accountable for his advice. We also need to develop a means to verify that the consumer understands the potential consequences of his actions and is making an informed decision. We can't demand the industry prove that a borrower is making the right decision, especially in hindsight. The "right" choice is a subjective opinion. All we can hope to do is equip the applicant with the tools needed to make the decision that is "right" for them.

Be Careful What you Wish For

I'm hearing more and more industry commentaries, wishing for the days of old when mortgages were written by the local bank. The friendly banker knew the customer, gave the customer a mortgage and collected the mortgage payments until the mortgage was paid off. The concept being that in the event the borrower ran into financial trouble, the banker would be in a position to work something out with the borrower so the borrower didn't lose his home.

Most mortgages today are written by lenders that will then sell the mortgage into the secondary market. The job of the secondary market is to pool large numbers of mortgages together to create a diverse group of credit grades, geographical regions, interest rates and loan-to-values. This pool in then securitized. That is, bonds are then issued at various interest rates that represent the level of risk the buyer is taking on. A simple example would look like this. A pool of mortgages having an average interest rate of 8.0% is assembled. The servicer of the pool collects the interest payments from each borrower. Bonds, called Mortgage Backed Securities (MBS), are issued yielding 3 different interest rates; 6.0%, 8.0% & 10.0%. As the mortgage payments come in, the buyer of the 6.0% MBS gets paid first. Once that obligation is satisfied then the holder of the 8.0% security is paid. Only then is the holder of the 10% note receiving any money. The investor willing to take the highest risk (the last in line to get paid) is entitled to get the highest return on his money (in this example 10.0%).

The problem in the mortgage market right now is because the actual default rate of mortgages is higher than expected, so not only is the investor who bought the highest yielding securities not getting paid, the more conservative investors are not getting paid what they expected. This is the basis of all the turmoil we are now seeing in the mortgage market.
There is no direct contact with the investor who purchased the MBS and the borrower. To make matters worse, pooling by its very nature makes it impossible to create a link from any one borrower to any one investor. This makes any form of a workout with a borrower that's in trouble, impossible. It's from here that the desire to go back to the "good old days" of lending seems appealing.

Securitization of mortgages was not only encouraged by the federal government, they created the first organization to implement it, Fannie Mae. The reason for the creation of securitization is being overlooked in these recent media commentaries. To begin with, securitization allows consumers to borrow money at a lower rate. A banker who expects to hold a mortgage for 30 years, at a fixed interest rate, will need to charge a rate high enough to cover his long term cost of money as well as the long term effects of inflation. A banker today can close on a mortgage and keep it on his books only for as long as he wants to. He can sell the mortgage into the secondary market any time he feels it make good business sense for the bank.

The other big advantage of securitization is that it allows for more liquidity in the marketplace. A banker holding every mortgage he closes is limited in the actual number of mortgages he can write. His total amount of outstanding mortgages can't exceed the total amount of money that has been deposited in his bank. By selling closed mortgages into the secondary market he is able to continue to write mortgages well in excess of his depository base. This gives him the tools he needs to continue writing loans into the community he is serving, supporting all levels of the local economy.

Nothing in life is perfect. For every positive there is a negative and the mortgage market is no different. The mortgage model of the "good old days" had the advantage of personal interaction between the borrower and the banker, yet was limited in the number of people it could serve. Securitization enables the industry to service a greater percentage of the population and at a lower cost. Its drawback is that when trouble arises it doesn't have the flexibility to address the problems facing each individual borrower.

So be careful what you wish for. You will regret having your wish for the "good old day" granted if you find yourself seeking a mortgage and can't get one. Being turned down because you've harmed your credit or don't earn enough money is one thing. Being turned down because the bank has no money to lend is a totally different problem, one this country hasn't had to face for many decades. Hopefully we'll never go back to the "good old days."

The Piggyback Risk

Ever since the first FHA mortgage was written, lenders required an added level of insurance when writing a mortgage on a property that the owner had less than a 20% equity participation. FHA called this insurance MIP (Mortgage Insurance Premium). From the borrower's prospective, this required him to pay an additional upfront insurance payment in additional to the customary closing costs and an additional monthly insurance premium in addition to his normal housing expenses. From the lender's prospective, they could close on a mortgage in which the borrower had little or no cash investment in the property knowing that in the event of a default there was insurance available to absorb a portion of the lender's loses.

Learning from this government program, the insurance industry developed policies that lenders could use on non-government mortgages. Mortgage Insurance (MI) was offered to borrowers to enable them to purchase a home without investing 20% of of the purchase price. These MI policies have more flexibility than FHA's MIP. A borrower could elect to pay based on an annual policy, a monthly policy or can even elect to pay a higher interest rate on his mortgage and have the lender pay for the insurance. Instead of dealing with a flat rate for all mortgages , as in the case of MIP, private MI companies price the premium base on the risk profile of the borrower. For example, a borrower investing 15% of the purchase price carries less risk of default than a borrower investing 3% and is therefore entitled to pay a lower premium.

In addition to reducing the risk to the lender, MI also added one more level of underwriting approval on a mortgage application. Not only does the lender's staff investigate the details of the transaction and of the borrower's qualifications but the MI company also underwrites the application and is a second set of eyes looking over everything prior to a mortgage being committed.
In an attempt to offer borrowers more options in mortgage financing the industry developed a new program known as the piggyback. The piggyback is the utilization of 2 mortgages instead of one when financing a property. Although there are numerous reasons to do this, we are only going to look at one in particular. That is, using a combination of 2 mortgages to replace the need for MI. On the surface, there shouldn't be a problem here. The first mortgage is typically written as an 80% loan-to-value (LTV) and priced as a first mortgage should be. A second mortgage is then underwritten and priced as a higher risk loan. From the borrower's prospective this usually meant that the overall cost of the financing would be less that when MI is added onto a high LTV first mortgage. Saving a consumer money is a good thing so this became a popular mortgage program to be recommended by originators.

Unfortunately, the default rate on piggyback mortgages is proving to be higher than on first mortgages written with MI. Since there is no insurance company involved, the lender is exposed to all losses in the event of foreclosure.

The reason for this stems from the fact that insurance companies are better equipped to identify the magnitude of risk associated with an event and price the premium to suit. A mortgage written with MI added onto it wasn't generating more profits for the investors than a piggyback it was more accurately priced to reflect the risk of default. When lenders developed the piggyback, their analysis concluded that the higher interest rate they were receiving on the 2nd mortgage was adequate coverage for the projected performance of the mortgages. For a few years, their analysis proved correct. Market conditions changed and the default rate grew.
This is why we will be seeing tighter underwriting standards, as well as higher pricing, on piggyback mortgages going forward. Many lenders will likely stop accepting applications for piggybacks in response to the miscalculation of the risk associated with this form of financing.

Like most industries, the mortgage industry mirrors a pendulum motion. It swings towards more liberal underwriting standards until it goes too far. It then swings back to a more conservative period until is moves too far in that direction. It then begins the cycle all over again.

Responsibility

There has been a lot written in the media recently regarding the problems in the mortgage market. The tone of most of what has been written, has focused on the poor treatment of the homeowner/home buyer by the industry through the originator. The point of contact between the applicant and the mortgage market is the originator, making him responsible for most of the customer interaction. Problem mortgages occurred for a number of reasons. Right now I want to focus on the originator and the products he has at his disposal. We are not going to address the reasoning behind the formulation of the various products and their associated underwriting standards now, we'll do that at a later date.

The originator has a toolbox of programs at his disposal and it is his job to help the applicant decide what product best suits his needs. We need to keep in mind that I will be addressing originators working for a mortgage broker not a mortgage banker. There is an important difference. The originator working directly for a lender has a limited job description. His job is to explain the various products offered by his employer and then accept the application from the applicant. His job is information delivery, he is not serving as an advisor to the applicant.

The originator working for a mortgage broker has a higher level of responsibility. Not only is he expected to be able to explain the various products to the applicant but he is also there to aid in the decisions made by the applicant. It's important for a consumer to be aware of this difference. A consumer's expectation of an originator's scope of work needs to be in alignment with what the originator can do.

The industry, for the most part, has not done an adequate job in training and supervising its originators. This situation is in the process of being corrected through two main avenues. First, through government intervention. Up until now there were no standards for education, for an originator. It was left up to the employer to set his own standards. It seemed reasonable enough, after all the employer would ultimately bear the cost of any incompetence of an employee, so is motivated to set reasonable standards. Time has proven that this hasn't been the case, so each State is setting its own educational standards and is also doing background checks on originators before permitting then to conduct business. The second avenue is employers have learned that giving pricing flexibility to their originators is not sound business. It encouraged originators to price loans based on maximizing their personal profit, not based on competition in the marketplace. This resulted in applicants paying more than they should have for their financing when they trusted their originator. More bankers as well as brokers have moved towards more standardized pricing models.

The actions of these poorly trained and unprofessional originators are responsible for a portion of the problems we are currently facing in the marketplace. We'll never be able to calculate what percentage of the problems can be attributed to these individuals but they were not responsible for 100% of the problems. This is the subject of this post. The shared responsibility of the applicant and his originator.

For the purpose of this discussion the originator is working for a mortgage broker. He is knowledgeable and offers the same pricing model to all his clients. The applicant has his own particular goals and his own personal level of risk aversion. It's important to recognize that the originator and the applicant will have a different level of acceptable risk in their individual decision making process. Some people only feel secure working for a company & getting a regular pay check and full benefits. Others are more daring, owning their own business and never really knowing when their next pay check is coming. Some people have a lifestyle that carries heavy expenses every month, leaving less to pay a mortgage where other people are so focused on owning a home they will make whatever sacrifices necessary to own the home of their dream.

It is the originator's job to explain to the applicant, the details of the financing he/she is seeking, allowing the applicant to make an informed decision. When I'm training originators, I make a point of telling them they are the applicant's consultant, not his mother. It's not the originator's job to impose his opinion onto the applicant but to help the applicant understand the impact the mortgage payment is going to have on the applicant's personal life. It is the applicant's right to take whatever risk he feels comfortable with and only time will tell if he has made the right decision. If the applicant gambles and wins, he now can enjoy the benefits of the decision. If he gambles and loses, he then suffers the consequences.

The originator's responsibility is to supply the applicant with a clear understanding of what he is doing, make suggestions as to the recommended course of action and explain the potential consequences of the various courses of action available. His job is not to protect the applicant from making a bad decision, only warn him of potential shortcomings of the decision.
When the housing market is strong, all homeowners look brilliant. Even bad decisions turn out to be profitable ones to the homeowner. However, when the market takes a bad turn, the opposite occurs. What seemed like good conservative decisions do not turn out to be as profitable as they should and bad decisions become much worse.

It's at this point that a homeowner begins to look for reasons they got into trouble. When we are in trouble or facing a problem we reach out to find the reason it's happening. People will generally look outside themselves for the cause of the problem. They didn't make a bad decision, someone else told them what to do or nobody explained to them what could happen.
This attitude is wrong on a number of levels. If we don't look to see our own mistakes, we'll never learn from them and be destined to repeat the same mistake over and over. By blaming the mortgage industry for all the current problems, the availability of mortgage products will be drastically curtailed, limiting the options of tomorrow's borrowers. Originators who have been conducting business in a professional manner may be forced to leave the business, making it more difficult for a consumer to find good advice.

In order to minimize the damage of this housing correction and reduce the chances of it happening again, we need to examine all the contributing factors and address them. Everything from the government's drive to increase the homeowner percentage of the population, through aggressive underwriting standards from the lenders, to originators not doing their jobs properly right down to mistakes made by consumers. All aspects need to be considered not just the contribution made by the industry.

Introduction

The consumer has never dealt with a mortgage market such as we are dealing with today. Even industry veterans are having problems understanding it. I've always tried to give my clients a complete understanding of the home buying process and the skills needed to fit a particular mortgage into their lives. There is a library of articles I've written and courses that I teach at http://www.shelter-rock.com/. I invite anyone to visit the site to learn more. What I am hoping to accomplish here is to create a place for people to post any questions, concerns or comments they have regarding the housing market and through an ongoing discussion, we can all develop a better understanding as to what's happening.