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Questions and Answers Question: What made you decide to write this book? Answer: I had two motivations. First, I felt there was a more in-depth story to be told. The mortgage industry has a lot of moving parts – from brokers to rating agencies. They’re all interconnected and to fully understand what went wrong required a more in-depth look. The second motive has to do with the solutions. Watching Congress and the Federal Reserve propose fixes for the industry, I felt that many of the proposals were coming up short. So I wanted to address them from the insider’s perspective. Question: One of the things that you talk about was the decision to sell your interest in your company more than a year before the industry imploded? What prompted this decision? Answer: About three years after we opened, we saw a disturbing trend. Slowly, our end investors started to relax their underwriting guidelines, which meant the risk was increasing. When this happens, something has to offset the risk. In the mortgage industry this comes with offering a higher interest rate. Instead, the opposite happened. As the Federal Reserve began to raise rates, thus increasing the cost of money, subprime rates stayed relatively flat because companies like New Century initiated a price war. Eventually, we reached a point where the industry was no longer managing risk effectively and thought it was time to get out. Question: You mention that there is a more in-depth story to be told, can you elaborate on some of these things? Answer: I went back and took a look at the loans that came from mortgage brokers, which were our customers. I estimated that 70% of the loans were somehow fraudulent. Most of them were not the extreme cases you read about, but more subtle forms. I like to use the example of occupancy fraud. A borrower tries to purchase a rental property in the same town he owns his primary residence, but he doesn’t have the 10% down payment that’s required. So the broker provides an application indicating the borrower is buying the house as a primary residence. These loans are riskier for the investor and thus, require most skin in the game from the borrower. When they have nothing invested, there’s less motivation to hang in there when the markets start to falter. Question: Seventy percent is a huge number. What do think contributes to that? Answer: You have to look at how the industry works to understand that. Brokers have virtually no liability. If a loan defaults, the only time the broker is on the hook is in the case of fraud. But that poses another problem. Proving it. As a lender, we saw subtle forms of fraud, misstatements here, a doctored piece of documentation there, but you couldn’t always prove would did it – the borrower or the broker. Even if we can prove it, the options are limited. Most brokers have minimal financial resources, which makes it hard to collect for damages. In the end, most lenders would just cut a broker off from doing business, which allows them to inflict damage elsewhere. Question: You also point out that the smaller acts of deception can often cause the most damage. How does that work? Answer: We had one loan where a person was doing a stated income loan but he wasn’t even employed. He had a buddy, who owned his own company sign a verification of employment form stating that he was employed there. We ended up having to foreclose on the property and ended up losing $75,000 by the time it was finished. Question: Are you saying that 70% of all brokered loans were fraudulent or deceptive? Answer: No. The key is to understand that this figure applies to subprime loans. When a borrower walks in with good credit, good income and a down payment, , there’s less of a need to manipulate information. On the other hand, a typical subprime loan is faced with challenges – weak credit, limited income, and a host of potential issues. What we found was an inverse relationship between the amount of fraud and qualify of the borrower. The more credit-challenged the borrower was, the higher the incident rate of fraud. Question: You’ve devoted an entire chapter to how creative financing works. From what most of us have read in the media, it seems that a lot of people were just qualified under a stated income loan. But from what you write about, there appears to be a lot more to it. Tell us how creative financing works? Answer: Your statement about stated income loans is accurate and I don’t want to discount that fact. . One of the reasons we’re in this mess is due to the fact that Wall Street investment firms made it easier to finance borrowers by loosening up the loan requirements. But creative financing is really a process whereby a borrower, who on the surface doesn’t qualify, is massaged, to fit the guidelines. For example, lets talk about credit repair. There’s an entire industry that exists to help consumers repair their credit. For some, it’s a valuable service, in which they are trying to clear up things that weren’t their fault or are incorrect. But in most cases, these companies are performing cosmetic surgery. They use the tools of their trade to help artificially inflate a borrower’s credit score. Just because you paid $500 and your credit score is 50 points higher doesn’t make you a better risk, it just means you’ve cheated the system. Question: You mention that automated underwriting played a significant role in helping borrowers who wouldn’t have qualified to get approved. How did that work? Answer: A borrower with good credit will get their loan approved through an automated underwriting system. This means the broker takes the loan application and credit report and runs it through a program to get a decision. Until the early part of this decade most subprime lenders didn’t have this type of technology available. So here’s how it used to work. A broker shows a lender a deal for a customer who needs 100% financing and the lender issues a prequalification based on the broker’s credit report. When the loan comes in, the lender would reorder the borrower’s credit report. I’d estimate that 1 out of 8 subprime loans were denied because the credit score dropped and the borrower no longer qualified. When lenders began to develop automated underwriting programs, the broker could use their credit report with the lenders program to get the borrower approved. Suddenly the same borrower who would’ve been denied a few years earlier was given an approval. Question: You devote a lot of time to discussing appraisals and the problems that arose with them. What did you see as the biggest challenge? Answer: One of the biggest issues comes from the fact that appraisers can be easily influenced. Keep in mind that appraisers rely on lenders and brokers who order the work. Whoever is ordering the appraisal will give the appraiser a target value. If that value is high, this presents a problem for an ethical appraiser. If they tell a broker, hey I can’t reach this figure because it’s too excessive, they run the risk of losing business. The broker doesn’t have to exert any direct influence. They can easily go to another appraiser until they get someone who says, “I can get you that value”. Question: From your perspective, how bad was the appraisal problem? Answer: It was probably the single biggest obstacle that we had to deal with. Again, remember that most of the loans have issues. At the very least, the one thing we needed to be certain of was that we had the value nailed down, because that’s what we’re loaning money against. Unfortunately, the vast majority of appraisals that came into our office were overvalued. Question: So give us a sense of what you saw in the way of inflated values during your five years in business? Answer: I think this may surprise some people. I estimate that half of all loans that were underwritten by my company had appraisals that were overvalued by as much as 10%. Another quarter were overvalued between 11-20% and the rest, another quarter of all loans we underwrote, were overvalued by more than 20%. Now, let’s translate this into understanding how the business works. The investors we sold loans too would typically allow for an appraisal deviation of 10%. This isn’t written anywhere. This just comes from five years of selling loans to these companies and understanding what they were willing to accept. So a 10% variance means that if I’m looking at a property and my research is telling me that the house is worth $200,000, the end investor would accept a appraisal as high as $220,000. The other half of the appraisals we received, the ones that were overvalued by more than 10%, were usually declined, or we reduced the value of the property to an acceptable level. Think about the implications of these numbers. More than half of every deal we’re looking at has an appraisal with a value inflated by more than 10%. Question: How did you handle these over-inflated property values? Answer: We’d order a review appraisal, which is an independent third party appraisal on about 70% of our loans. In essence, it’s one appraiser reviewing another appraiser’s work. Unfortunately, we found a lot of holes in this process as well. Question: But I thought these people were independent? Answer: Yes and no. We used Landsafe Appraisal Services for our reviews, a company owned by Countrywide Financial Services. As part of our business relationship, they committed to standing behind whatever value Landsafe assigned to a property. This was huge for us because it helped us gain a comfort level with the property value. The ugly side of this process didn’t rear its head until the loan started to go bad. When that happened, Countrywide would look for a reason why we should repurchase the loan. In every single instance, they would no longer view the value from Landsafe as an accurate property value, even though we closed the loan based on the work of their appraisal company. They would order another appraisal and wouldn’t you know it, every single one came in with a value much less than what Landsafe originally supported. Question: You believe that the mortgage industry was a major contributor to the rate that property values increased around the country. How did you come to that conclusion? Isn’t demand what drives value? Answer: You’re correct. Demand is the primary driver, no question. But the key is to connect all the dots. First, keep in mind that we’ve seen greater levels of property appreciation nationwide over the last 10 years than at any other point in our history. As we go through this period, the percentage of borrowers who are financing with no money down is steadily increasing. Second, you’ve got an industry that is willing to accept overvalued appraisals, which helps fuel the appreciation rate. If the process worked correctly, a lot of borrowers wouldn’t have closed because they didn’t have the cash to make up the difference between what the house was really worth and the purchase price. Remember, if you want to buy a house that worth’s more than it’s actual value, the lending industry is going to require that you bring in the difference. Question: Let’s change directions for a moment and talk about a different part of the food chain. Even with all the issues you’ve identified with the lending and brokerage world, you remain adamant that the greatest culprit in all of this is the rating agencies. Why do you single them out? Answer: I’m a big believer that the only way to really understand a problem is to get to the root cause. For all the mess that we’ve made between brokers, lenders and Wall Street investment firms, none of this happens if the rating agencies actually did their job. Question: Explain that to us. Answer: In a nutshell, the agencies rated the securities as being investment grade, in essence fooling the investors who buy them into believing they were safer then they were. This in turn, only fueled the appetite for more of the same product. The promise of solid returns for what was believed to be a safe investment lured money from all over the world. We’ve even got stories of municipalities who pooled funds and invested in these securities. Question: What caused this to happen? Answer: The relationship between the Wall Street investment firms and the agencies was flawed. The agencies are supposed to be neutral but they are paid directly by the investment firm who create these securities. It’s not unlike the broker-appraiser relationship. If the investment firms don’t get the answer they are looking for, they can march across the street, until another rating agency gives them what they are looking for. Question: You mentioned at the beginning that you were motivated by the fact that you wanted to see the industry get fixed. What are your feelings about how things are progressing? Answer: The key, in my opinion, is that unless all of these areas are addressed, from the broker to the rating agency, these problems don’t get fixed. What concerns me most is that the biggest issue, the rating agencies, is being completely ignored by Congress. Question: What do you propose should be done with the agencies? Answer: This is perhaps the greatest challenge, because the only way to fix it is to change their motivation. The point is that most of us get paid for doing a job. If we do it well, we hopefully retain our jobs. If we don’t, then we typically get fired. For the agencies, it doesn’t matter. In fact, they actually get rewarded more for doing a poor job. If they are too aggressive in how they rate a security, the only thing that happens is they make their customers, the investment banks, really happy. In fact, the worse they do, the more money their customers make, which increases the likelihood of getting more business in the future. It’s nothing short of asinine. If Congress is going to do one thing, and one thing only, it would be to completely revamp the way the agencies are compensated. Again, this goes back to getting paid for the quality of the work that you do. I propose a radical shift from the current structure to one in which a portion of the agencies compensation is tied to the performance of a security. Admittedly, this is not an easy task but it would fix the system in a heartbeat. Question: What other types of action do you believe Congress should take? Answer: The final chapter of my book outlines 19 different suggestions, which I realize is a lot, but again, there’s a lot to be discussed. I’ve posted many of them on my website, www.lendingsanity.com, so people read about them in greater detail. But here are a couple of highlights. First, Congress needs to create a simple one-page disclosure that borrowers can understand about their loan. Borrowers were duped because it’s often easy to miss the fine print. Second, very controversial but I believe in retaining prepayment penalties as long as borrowers are given a choice. The key is that there should be a trade-off. Accepting a prepayment penalty for a loan should come with a lower rate, compared to not having one. Question: What do you see if the future of the real estate market? Answer: Given everything I’ve seen, it’s difficult to be a cheerleader. Some markets, like DFW, will fare better than others. Markets that rose the most will feel the greatest amount of pain. There are a couple of unknowns in all of this. Right now it’s harder to get a mortgage. The days of easy credit are gone. While that’s not a bad thing, it also means that a lot of borrowers who really should be able to qualify under normal circumstances, aren’t able to qualify. The real key in all of this will be to see how long it takes for investors to return buying the mortgage-backed securities. Until that happens, the housing market will continue to suffer. That’s one of the reasons I’m so big on fixing the rating agencies. Until investors are comfortable with what they are buying, they will stay away. |
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