Mortgage Hot Potato: How Many Mouths Can One Home Loan Feed?

If you ask the average person “Who holds the mortgage lien over your house?” they are likely to respond with “Countrywide,” “Wells Fargo,” “Goldman Sachs,” “Citi Mortgage,” or some other large bank. Once upon a time, when a person needed a home loan they would go to the bank and, after the borrower made a 20% down payment on the house, and after a careful evaluation of the borrower’s credit risk, the bank would approve and fund the loan. The banks held these loans on their balance sheets as assets and their motivation for extending credit was the interest income the mortgage generated. It was in the best interest of the banks not to lend to people who were too big of a credit risk or to people who could not reasonably afford to pay the loan back, because if the borrower defaulted, then the bank was in a position to lose a lot of money. Furthermore, it was in the interest of the borrower to avoid buying a house that he could not afford because if the bank foreclosed on him, he would lose his 20% down payment. This two species ecosystem may have been a bit boring, but it worked because both the creditor and the debtor had a vested interest in the long term success of the transaction.

But no ecosystem can stay the same forever and in today’s mortgage environment, a whole slew of fierce new beasts exist. They have adapted so well, and the landscape today is so complex, that few people even realize or understand that these creatures are there, or in what ways their presence has changed the game. So, from A to B, just what exactly happens when you borrow money to buy a home and how many mouths do you need to feed along the way?



It all starts with the three headed beast: real estate agents, mortgage brokers, and appraisers. The real estate agent and the mortgage broker are both supposed to work in the best interest of the borrower. The real estate agent is supposed to find the best home for the buyer’s needs at a fair price, while the mortgage broker’s job is to find the buyer an affordable and suitable mortgage product at a fair interest rate. However, both the agent and the broker are paid on commission, which creates a conflict of interest in the buyer-agent and buyer-broker relationships. It is actually in the best interest of the agent for the home to sell for as high of a price as possible, and in the best interest of the broker for the loan to be as large as possible. Since few people have sums of money that are comparable to the cost of a house, the size of the average loan usually goes up when house prices go up, so the interests of the agent/broker are in line with each other. How does the appraiser fit in? The appraiser is supposed to be a neutral party that provides a fair market value for a house. Increasingly, what has been happening is that appraisers, agents, and brokers have been working together, illegally, and manipulating house prices in order to fatten their commission-based paychecks. The agents and brokers put pressure on the appraisers to return an inflated house valuation, and if the numbers come in too low, that appraiser will never get a job from that agent or broker again. So now you’ve essentially paid a premium to the agent, the appraiser, and the broker. The fraud that exists due to the three headed beast goes much, much deeper but will simply need to be addressed in another article.

So what happens after you’ve borrowed too much to pay for a home which is probably worth less than you thought? The actual money for the loan did not come from the broker; it came from the lender for whom the broker works. However, lenders typically have very little money themselves. It is not unusual for a lender to only have enough money to fund a handful of loans. The lenders are not in business to hold your mortgage or to earn revenue from your interest payments. Lenders originate loans in order to sell them off to banks such as Wells Fargo, Bear Stearns, or Countrywide. The money received from the sale of the loans goes toward making new loans and into the lender’s pocket. The business can only survive by continuing to sell loans at a high enough volume to cover its costs and to make enough profit to justify their efforts. Notice that the key to being a profitable lender is high volume; lenders want to originate as many loans as possible so that they can sell as many loans as possible. The lender does not care if the mortgage is suitable or affordable for the borrower because the lender plans on selling the loan within a couple of months anyway. Lenders bear almost no risk in giving out a loan to someone. The only risk the lender faces is the “buyback clause,” which states that the lender must repurchase any loan that they sold to a bank if that loan goes into default within the first 6-12 months of purchase. The only thing the lender and broker need to worry about when giving someone a loan is whether or not that person can make their payments for the first 6-12 months. Notice now that when you get a loan you are also paying a premium to the lender, who must only provide the broker with interest rates high enough so that some bank will be willing to buy the loan from them later on.

Most people think that the banks are the end of the line for a home loan. The truth is that, while banks do keep a small percentage of loans on their portfolios, most home loans are once again sold to other entities. The reason for the confusion about who actually owns the mortgage note is that few in the general public are aware of what are called “mortgage servicing rights.” While the entity that owns the mortgage note ultimately gets the principle and interest, it is the entity that owns the servicing rights who collects the monthly payments from the borrower and forwards it to the note holder. The bank has an interest in keeping the servicing rights of a mortgage because whoever holds servicing rights gets to keep late fees as well as generate revenue by keeping mortgage payments in interest bearing accounts before forwarding these payments to the mortgage note holder. And since the banks too are selling your mortgage, they must only buy loans from lenders that have high enough interest rates so that they themselves can sell the loans off at a competitive price to their buyers. Notice also that, once again, the banks do not care about the long-term suitability or affordability of the loan because they are selling the loan and giving the risk to someone else.

Banks can sell off loans in two different directions. The first is to one of the government sponsored entities (GSEs). For mortgages, these are Fannie Mae, Freddie Mac, and Ginnie Mae. (These GSEs have an interesting history and there is controversy over their existence which may need to be discussed in future articles.) Loans sold to Fannie Mae, and Freddie Mac are called “Conforming Loans” and they currently cannot be larger then $417,000 for single unit residences in the continental US. Also, the borrower must qualify through one of two special underwriting software programs called “Desktop Underwriter” for Fannie Mae and “Loan Prospector” for Freddie Mac. Ginnie Mae purchases FHA and VA loans; special loans set up for low income individuals and veterans. Banks, in general, can only sell their “safe” and “low risk” loans to the GSEs. The loans that are not eligible for purchase by the GSEs are sold to investment banks.

The safe to relatively safe loans that have been sold to a GSE or an investment bank are bundled together and once again sold, this time to Wall St. as a vehicle called a “Mortgage Backed Security” or “MBS.” Basically, the loans are pooled together and chopped up into smaller pieces and sold as bonds. Some loans are just too risky and, if left in the form of an MBS, no one would be willing to take the risk of purchasing them. The investment banks don’t want these loans on their books either and thus was born a highly complex investment vehicle known as a “Collateralized Debt Obligation” or “CDO.” Basically, a CDO is a pool of risky mortgages that are divided into “tranches,” or a hierarchy of risk levels. When an investor purchases a CDO, she selects which tranch she wants to purchase into. The lower tranches have a high yield but are very high-risk, while the high tranches have a low yield and low risk. The people who buy into the top tranches get paid first, then the people in the next tranch, then the next, and so on. The people in the bottom tranch only get paid after everyone above them gets paid. The tranches are designed so that a higher and higher percentage of buyers would need to default in order for people to lose money in the higher tranches. For example: if 10% default, then those in the bottom tranch lose their money but everyone else gets paid; if 20% default, then those in the bottom two tranches lose their money but everyone else gets paid, and so forth.

So the end of the line for a mortgage is not the balance sheet of some large bank – it is in a pool of other mortgages that have all been used, abused, bundled, and chopped up and then sold to Wall St. investors. All MBSs and CDOs receive a credit rating from large ratings agencies such as Moody’s. Unfortunately, over the past few years these ratings agencies have done a terrible job rating these complex investment vehicles. These vehicles are relatively new and the models used to attach credit ratings to them were highly inaccurate because they assumed continued increases in house prices and used recent foreclosure rates which were artificially low because of the recent rise in house prices. Most MBSs and CDOs received “investment-grade” ratings, and with ratings like these, mutual funds, hedge funds, and foreign investors saw no problem in buying this debt.

The key thing to notice in all of this is just how many entities touch a single mortgage before it finds a home for itself. Each of these players takes a cut for themselves and then passes the risk to the next bigger fool willing to buy the debt. The middlemen do not care at all if the loan was ever suitable or affordable; all they care about is the size of the loan and the volume of loans they can sell. In effect, the middlemen are taking a cookie for themselves before passing the jar along and one must realize that whoever held the jar first (the borrower) had to be the one who filled the jar. The borrower pays for this orgy of middlemen through a higher interest rate and through upfront fees known as points. But also, the borrower pays for these middlemen with a higher risk of mortgage default and bankruptcy because all along the way there was no one telling him, “You cannot afford this loan.” Instead, everyone told him “Yes, yes, yes” because anyone in the system who said otherwise would have been less profitable and their business would not have survived the competition. And in a display of slight of hand that would make Lance Burton proud, the middlemen somehow manage to give – no, not give, but sell – the risky debt back to the general public. After all, is it not working Americans trying to save for retirement who put their money into mutual funds? So, in effect, if you bought a house recently and own a mutual fund, odds are you helped fund your own home loan and if you default not only do you lose the home but your mutual fund will go down as well.


The Moral of the Story and What Can Be Done:

Buying a home is probably the biggest financial decision you will ever make. Do not make this decision lightly. Understand that qualifying for a loan DOES NOT mean you can afford a home. Realize that the people you must deal with to buy the home have bills to pay and a family to feed and that their self-interests will not be the same as yours. Fork over the $250/hr to talk to a fee-based financial advisor to find out how much you can afford to pay for a house. Remember that real estate agents and brokers are NOT trained as financial advisors so do not ask for or accept financial advice from them. Also, do not let a real estate agent talk you into paying any more than you are comfortable paying. If something sounds too good to be true then it is too good to be true. Get a rate quote from multiple brokers before you decide who to go with but do it fast as interest rates change every day, sometimes many times a day. Have a lawyer read the loan documents before you sign anything and if a broker pressures you, then walk out. If you believe you were a victim of mortgage fraud then talk to a lawyer. Buying a home can be a great thing, but if something goes wrong it can become a nightmare, so make sure to educate yourself before making any decisions. In the end, you are responsible for your own wellbeing, so do not rely on others assuring you things will be alright. Protect yourself at all times. For absolutely excellent info on purchasing a home and the mortgage industry please read the Mortgage Professor at: http://www.mtgprofessor.com/Default.htm