Mortgage Industry Trends

The Wall Street Journal came out with a hard hitting look at the role that rating agencies played in the creation of mortgage related debt instruments, coming full circle, with every involved party sharing some degree of blame: mortgage brokers, uninformed borrowers, mortgage bankers, and Wall Street investment banks.

Everyone talks about industry cycles, but this one has been different. I could be wrong, but we have never had such an unprecedented flow of capital into US real estate, and as the survivors move forward and begin to restore operations, and as regulators and politicians examine what went wrong and attempt to prevent future abuses, I think its useful to highlight some of the participants and their roles in the market, how things went wrong, and suggestions for implementing positive changes.

I’d like to recap an overview of the mortgage process, and rather than start as most others do with the consumer, I’d like to work back from the investor, following the money:

Investors buy mortgage back securities from Wall Street, and rely upon ratings that credit agencies assign. These MBS are assembled from pools of loans that Wall Street aggregates, buying them from lenders who fund them through retail and wholesale channels. Alternatively, the loans are not pooled and securitized, but are funded, again through either a retail or wholesale channel, and the funder is a commercial bank that then continues to hold the loan in its portfolio.

If we look at the money- it flows from end investor, be they a depository or institutional investor buying a MBS or CDO, to Wall Street, then to the mortgage bank, and finally through to the borrower, through either a retail loan officer or mortgage broker.

As the Wall Street Journal examined, and as others note, Wall Street and the rating agencies work hand in hand to structure deals.

But, how does this serve the institutional investor? The truth is, not well. If you are a pension fund manager and you are looking to possibly invest in an MBS, what kind of industry expertise and knowledge can you be expected to have in inner workings of mortgages? Not much, I think is a fair statement. And certainly, if you are considering investing in an MBS that is a slice of a larger pool of mortgage loans, you could hardly be expected to perform loan level diligence.

Yet the party you depend on for insight into that investment doesn’t really work for you. It's Wall Street that controls the purse strings tied to the rating agencies.

How did Wall Street buy all those mortgage loans that they pooled into that MBS? They bought them on the whole loan secondary market from mortgage originators, and originators here means those that fund in their own name as opposed to the mortgage originator who might be a loan officer or mortgage broker who works with a borrower, but does not have their own money to lend out.

Typically, these mortgage originators are wholesale lenders that fund through independent mortgage brokers. Regardless, Mortgage Banks, as they are sometimes referred to, have very little in common with your neighborhood bank. Bank here, refers to the ability to fund in their own name, usually using a line of credit from a warehouse bank, just long enough to fund the transaction and sell the mortgage loan. Mortgage Banks, or Originators, don’t have the capacity to hold loans for long, and unless they are impaired, they look to sell them to Wall Street (conduits and others also buy, some to resell on, others to hold in portfolio).

The trick here is that until Wall Street got picky with its loans, every mortgage originator was monetarily incented to produce loans. And because buy back requests really didn’t gain momentum until recently, bad loans, be they fraud or foreclosures, were, by some, viewed as part of doing business. Once these loans did go bad, and Wall Street invoked buy back covenants, mortgage originators were quickly overwhelmed.

How? You would think a firm like First Magnus that originated $6.59B in the first quarter this year would somehow have the resources to sustain buy backs. The poorly understood truth about mortgage banks is that they have only a small amount of capital; the rest of their money is borrowed. They get paid to do deals, but if they can’t sell the deal in the secondary market, there is no point to originate in the first place, and no point to keep their overhead in place.

Mortgage banks typically employ three channels for generating loan business: retail, where they control the loan officer and underwriting; wholesale, where they use external agents (mortgage brokers) to bring the customer; and correspondent, where they will usually buy funded loans from smaller players.

The market changed dramatically, and for the worse if you talk with Peter Cugno, with the most recent market correction in 1998. It was from that market that the practice that mortgage brokers and wholesale account executives are ‘sales’ agents paid on ‘commission’ came into its own.

With this structure in place, it is clear that given to its pure, logical conclusion with no regulation, mortgage brokers are monetarily rewarded to do loans, whether they benefit the borrower or not.  There are not two sides to this story. End of discussion. Brokers don’t get paid more to give borrowers ‘better’ loans. Often, the exact opposite is true.

A Blue Print Forward

The one theme throughout this market event is how better to align interests.

Rating agencies should work for investors. Not the issuers & architects of the mortgage instruments. I personally cannot see how this change can take place. It seems counter-intuitive to expect investors to pay to know what they are buying. Barring this kind of structural realignment, perhaps there is an opportunity for some out of work mortgage bankers to develop new research consultantancys that would work with these non-sophisticated, sophisticated investors to better decipher what the rating agencies and Wall Street are rating and selling.

But, the largest realignment of interests has to be with the borrower. If a loan doesn’t benefit the consumer, it shouldn’t be done by the broker, the mortgage bank shouldn’t buy it, Wall Street shouldn’t securitize it and rating agencies should object to it and institutional investors shouldn’t buy any MBS with this kind of loan in it.

Sounds great, but how do you do that? The same way you do this in the financial advisory world. Regulation, training and audits. Mortgage Brokers and loan officers would need to have their income reworked to perhaps include residual payments (trailing commissions) over the life of the loan like they do in Australia and New Zealand.

Then, you can bet there would be an incentive to brokers that the loans they help originate are best matched to their borrowers needs. There is no way any broker who desires to be in business long term would ever put a borrower into a 2/28 unless that particular borrower planned to sell within two years.

Another party to the mortgage transaction that I haven’t mentioned before are appraisers. Usually, the independent broker arranges for an appraiser to issue a report offering lenders an objective opinion of the actual value of the collateral. A common theme throughout the recent rise in properties has been the pressure appraisals feel to have their report reflect a certain number (i.e., the purchase price or the amount being refied). And it is the borrower who pays the appraiser.

Why? This is stupid. The lender is relying upon them to verify the value of the collateral, but allowing the homeowner to pay the appraiser clearly delineates the relationship. The appraiser works for the borrower. I’ve talked with one mortgage banker who is looking to change the way his company operates, and shift the appraisal into a similar category as flood certification or other service that the lender orders using selected vendors. This makes too much sense not to happen. And, I would hope that investors and Wall Street would pay some level of premium for loans that utilize appraisers in this fashion.  

Overall, there is an opportunity at every level, from the broker, banker, Wall Street executive, investor, politician and regulator to reshape the mortgage industry to be stronger and healthier. Failure to do so will result in a repeat in past performance, hardly something to strive for.