"All Mortgage Money Comes From The Same Place"

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This sentence is a textbook illustration of the most effective way to lie. Tell the truth, but not all of it. Not that I'm trying to coach habitual liars, but I am going to deconstruct this astoundingly dishonest claim that I keep encountering. It's mostly used by less ethical loan officers trying to persuade someone not to shop around.

At the bottom-most level, all mortgage money does come from basically the same place. It's all investors looking for a return on their money in a historically well secured market where they are somewhat protected from taking a loss. It is the ugly surprise that this security isn't perfect that has a lot of investors in panic meltdown mode after they took it for granted for years, and now they are refusing every loan that's not essentially perfect because of the rude awakening.

What happens to it after that, and whose hands it goes through, matters a lot. Just like saying all water comes from the ocean doesn't mean it's all drinkable, just because all mortgage money comes from investors doesn't mean it's all equal. The lender and loan officer make a huge difference.

Consumers cannot, in broad, go directly to mortgage investors and request a loan. Most of the investors wouldn't know how to do loans if it bit them. They don't have the actuaries, the underwriters, the tools, and the networks to get the best value for their money. That's where the lenders come in.

I'm not going to get into all the details of CMOs and MBSes- Collateralized Mortgage Obligations and Mortgage Backed Securities - how they are sold, how to price them, yada yada yada. It's something I am not involved in, and I don't really need to know as much as I do. Even when I was financial planner, the nuts and bolts just aren't that important to most investment portfolios. Two important things to note: The higher the interest rate of a loan, the better the price the lender will get from the investors, and the lower the rate, the lower the price. The higher the default and loss rates is expected to be, the lower the price, and the lower the default and loss rates are expected to be, the higher the price. Default and loss rates translate to "How tough are the underwriting standards?" As with all other things economic, it's a trade off. Low interest rates at a lender usually means very tough underwriting, and fewer people qualify. High interest rates means relatively easy underwriting, and more people qualify. However the former means that there will be a lower default rate, while the latter translates into a higher default rate. In the end, the price they get for their loan packages will be comparable as higher rate translates into more money when the lender sells the loan but higher default means less.

What you really going on here is that the banks - the lenders - are the middlemen putting investors and consumers together. For this, they get paid. They get paid enough to pay for all those fancy offices and the executives' salaries and everything else the bank might have. Mortgage lending is big business. Lest it sound like I'm saying the fact they get paid is a bad thing, it's not. It makes the market far more efficient, as most individual investors can't afford an entire mortgage all at once, and individual borrowers would have a daunting problem in finding investors willing to lend money at a decent rate in their situation.

Each individual lender tries to hit a certain market segment. It works like branding in the consumer world, in that there are clients they are aiming at, and ones who are incidental to their business. Lending is a risk-based business, and the higher the risk to the lender, the higher the rate. What will happen the vast majority of the time with the vast majority of lenders is that they will sell the loans, whether or not they retain servicing rights. In other words, just because you have a loan with bank A doesn't mean they'll keep it. It is very rare for a lender to keep the loan. Even if they retain servicing (for which they get paid - and they're not even risking any money!), so that you keep sending that lender your payment, they don't hold the actual loan. Some lenders are interested in A paper, whether conforming with Fannie Mae and Freddie Mac, or nonconforming but to essentially the same standards. These loans are fairly uniform and highly commoditized, but lenders put their own stamps on them. One bank might have incredibly tight standards, but offer lower rates. They will have a record of fewer defaults, practically zero losses, and get a better price on their loan packages in the bond market. Another bank might be somewhat looser in their standards, and so not do as well on selling the loans. Those lenders will charge a higher price for their loans, in the form of interest rate, in order to compensate.

This phenomenon expands out progressively farther in the A minus, Alt A, and sub-prime lending worlds. A paper has noticeable differences between lenders, while the further down the loan quality ladder you go, the more differentiation you get between lenders. Almost all of them have their own niche, or niches, that they will underwrite to, trying for a mix of rates to borrower and underwriting standards for approval that results in fewer of their loans defaulting, and thus the ability to command a premium price in the bond market over and above what mostly equivalent lenders will give.

Below sub-prime is hard money. It's called hard money because before they fund your loan, they are recruiting individual lenders and syndicates who will hold your loan for as long as you have it. This is why hard money is typically multiple points up front, interest rates of thirteen percent and up, and three year hard prepayment penalties, as well as only going to about sixty-five or seventy percent of the property value at most. Without the lenders, every loan would be hard money.

No lender has the capability of running programs that are good fits for everyone. Some of them have a few dozen, some have only ten or twelve. This sounds like a lot, but it isn't. Every single loan type is a different program. Just to cover the most standard loan types for their market is usually between twenty and thirty different programs. Back when I originally wrote this, I could point to lenders with twenty-five or more different Option ARM programs. They're gone now (quite predictably) but they sure looked like they were doing well for a while on the surface.

This is where brokers and correspondents come in. There's an old saying about how "If the only tool you have is a hammer, pretty soon all the problems start looking like nails." You walk into a direct lender's office, and they has a couple dozen programs focused on one segment of the market. You're not an ideal fit for any of their loan programs, but so long as you can qualify for any of them, they are going to keep your business rather than refer you to someone else. They're hammering nails, never mind that your problem is a threaded bolt. They get you pounded into the board. Yes, you get a loan, but you could qualify for a better one if you wandered into a different lender's office.

Brokers have lenders wandering into their offices. Lenders who will give the brokers better deals than they give their own loan officers, because they're not paying for the broker's expenses, and the broker knows better than to be a captive audience. The fact is that brokers are usually capable of getting a deal that's enough better that they can pay their expenses and salaries, still have profit left over, and nonetheless offer the client a deal enough better than the lender's own branches as to be worth the trip. Brokers also shop multiple lenders, looking for a better fit. If you're a top of the line A paper borrower, someone that any major bank has a good program for, the broker can still get you a better loan, but maybe only by as little as an eighth to a quarter of a point. On a $300,000 loan, that's $375 to $750 in cost at the same rate for the exact same loan. If you're in a marginal A paper situation, the difference made is liable to be that you qualify A paper with a broker who knows where to shop, where you'd likely have to go sub-prime, with inferior options and a prepayment penalty, by walking into a bank office. You get into sub-prime situations, and I have seen pricing spreads of two and a half percent on the interest rate between the best lender for a given loan, and the rest of the pack. The fact that most subprime lenders are gone and the ones remaining have radically changed their business model only accentuates this. You can physically go to twenty or fifty different banks, fill out an application and furnish paperwork in each - or you can go to a broker.

(Correspondent lenders are brokers with one difference: They initially fund the loan before selling it to the lenders whose standards they met. The loan is still written to the real lender's standard, underwritten by their underwriters, etcetera)

The point is that no lender is both offering low rates and loose underwriting. As everything else having to do with money, it's always a trade off. The lenders charge higher interest rates, they get a better price for their loans. The lenders underwrite to tougher standards so they will have fewer defaults, and practically zero losses, they get a better price for their loans. The lenders need a certain margin to keep their owners happy, and a certain margin to keep investors happy, and neither one of those in the business of giving away money for less than it is worth.

The ideal thing for a given borrower is not an easy loan. Unless you're so high up on the ladder of borrowers (credit score, equity in the property, lots of documented income) that you'll qualify for anything easily. The ideal loan, where you get the best trade-off of rate and cost, is to find the loan where you just barely scrape through the underwriting process. With average loan amounts in California being about $400,000 now, chances are that any extra time and effort you spend will be handsomely rewarded when you compute the hourly costs and payoffs.

So you see the partial truth of the title statement, and the utter falsehood. All mortgage money pretty much does start out in the same place. Nonetheless, what happens to it after that, before it gets to the consumer, renders the statement "All mortgage money comes from the same place" incredibly dishonest.

Caveat Emptor

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About this Entry

This page contains a single entry by Dan Melson published on April 30, 2014 7:00 AM.

In Order To Deal With Looming Foreclosure, You Must Get Out of Denial was the previous entry in this blog.

Lenders Adding A Prepayment Penalty After Funding is the next entry in this blog.

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