Originally posted 08/29/07
How is your summer going? Mine has been filled with typical family fare of a few vacations, spending time with the kids, swimming, seeing the summer movies, oh and spending a lot of time communicating with clients and consumers about what is happening in the mortgage industry and subsequent affects on the real estate markets.
Today and tomorrow I will post a two part segment on how the mortgage industry works and from that how this current crisis has evolved. In Part I the mechanics of the industry will be explained, in Part II how the mechanics created the domino effect that has the focus of the media and created some irrational behavior on Wall Street.
The media has been ecstatic over the credit crisis that started with New Century Mortgage’s inability to obtain financing on Wall Street. Since then, Wall Street took a problem and with the help of the media has created a crisis. If one thing has been very apparent the last several years it is that the media climbs all over itself to report negative news and editorialize its news reporting to put the negative spin on the front page and bury the statistics and objective analysis of the stats inside the story on page B23. The current situation in the mortgage and real estate markets are perfect for the editorials as news policies most major media outlets have been following. In the next few posts I will attempt to explain how one lender’s problem has become a national crisis dominating the news.
To understand the underlying trigger for the problem, New Century’s inability to obtain financing, one needs to understand how the mortgage industry operates; here is a somewhat simplified explanation of the process.
Like the health care system in the U.S. there are a lot of layers involved beyond the doctor/patient—or in this case loan officer/borrower—transaction. To start very few of the mortgages funded in the United States are kept by the lender that funds the mortgage—those loans that are kept by the funding institution are called “portfolio” loans. The overwhelming majority of mortgages are packaged by the lenders and sold in bulk on secondary markets. Lenders usually retain the servicing rights of the mortgages (meaning the collect the mortgage payments) and pass along the payments to the actual holders of the mortgages in the secondary market—less a servicing fee. The biggest and most well known secondary markets are Fannie Mae (Federal National Mortgage Association; FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation; FHLMC). Fannie and Freddie behave like brother and sister and most of their underwriting and funding guidelines are very similar. It is the underwriting and funding guidelines that are critical to our story.
Fannie and Freddie have established underwriting criteria and if a mortgage applicant is able to meet those criteria Fannie and Freddie will purchase the applicant’s mortgage from the lender that funds the loan. Example, Marcy and Chuck are purchasing a home for $500,000 and have down payment of $100,000 so they need a loan for $400,000. They meet with me and we complete a mortgage application package and obtain information showing their income, assets and credit report. This information is uploaded to Fannie Mae’s automated underwriting site and a credit approval with conditions is generated. With that automated approval, I can go to any of our lending sources that fund Fannie Mae mortgages and deliver the loan with the conditions (paystub, appraisal, bank statements, etc) and ultimately fund mortgage so Marcy and Chuck may move into their new home. For this example let us say that at the time Bank Lender Plus (fictitious), a national bank has the best rate for the mortgage Marcy and Chuck are applying for so that is where I send the mortgage and where we fund.
Bank Lender Plus upon receiving signed loan documents and all the approval conditions wires the $400,000 to the title company and the transaction closes. Where did Bank Lender Plus get the $400,000? From their depositors? No, the money is from either a warehouse line, essentially a line of credit where they borrow the money from one bank to loan to the borrower, or from reserves they have on hand from selling other funded mortgages to Fannie Mae. If the bank or lender is big enough the transaction involves the latter. Marcy and Chuck’s $400,000 mortgage will become part of a larger bundle of say $20 million worth of mortgages that Bank Lender Plus will package together and sell to Fannie Mae. Since all of the mortgages meet Fannie Mae guidelines they will purchase the mortgages and thus provide the cash for the next transaction. Fannie Mae gets its cash from interest and payments collected from loans it already holds and more importantly from investors who purchase Fannie Mae backed securities, essentially bonds that pay interest to the investors based on the overall rate of the bundle being put up. Got it? Let’s recap from the end of the transaction: Paul in Des Moines through his investment advisor invests $100,000 in Fannie Mae backed securities with a 5.75% return. His money, after some transaction fees, is sent to Fannie Mae who holds part of a $20 million offering of securities with a performance rate of 6.00% for Paul. Fannie also receives an additional $19.9 million from other investors for the same offering. Fannie then uses the $20 million to purchase a bundle of mortgages from Bank Lender Plus that were funded in July with a return of 6.125%. Bank Lender Plus takes part of the $20 million it has received and lends $400,000 to Marcy and Chuck at 6.25%. So Paul in Des Moines is actually funding part of Marcy and Chuck’s mortgage—thanks Paul!
In reality Paul is not the investor, but rather equity funds, mutual funds, insurance companies, pension plans, CalPers, etc are purchasing the Fannie and Freddie securities in very large blocks of millions of dollars. Since investors are looking for the best rate of return when balancing risk and return the interest rates they demand on the mortgage backed securities goes up and down every day depending on what other investment opportunities are offering. If the Dow is up ten percent and mortgages are paying five percent then more money will be invested in stocks and equities and fewer in mortgages, this will result in mortgage rates increasing to attract investment and eventually it will reach point where investors will sell stocks (causing prices to fall) and buy mortgage securities (causing rates to fall). So ultimately the rate for Marcy and Chuck’s mortgage depends on what is occurring in the economy and investment industries.
Our mortgage industry, and therefore our real estate industry, depends on investors to have confidence and trust in the mortgage industry so they will invest in mortgage securities and bonds providing the funds for American families to purchase homes. This has been occurring since Franklin D. Roosevelt established Fannie Mae as part of the New Deal to increase home ownership in the United States, since then Ginnie Mae (which purchases federally insured mortgages such as FHA and VA) and Freddie Mac were created. Essential to the tremendous percentage of homeownership in the United States are these secondary markets providing liquidity and funds for home buyers.
All that breaks down to this: Fannie and Freddie as secondary markets facilitate investors providing principal to borrowers who provide investors with interest payments. You give me $100 to buy a bike (principal) and I will pay you $6 a month (principal repayment and interest) for twelve months.
So why are we where we are today? I hope my next segment is able to adequately provide the answer.