May 25, 2010

The Quality of Loans is not Strained

Posted in Financial Markets, Social Commentary tagged , , at 3:26 pm by Doug Brockway

I did something fairly “wonkish” today. I read a newly published document from Fannie Mae titled “Lender Letter LL-2010-03, An Introduction to Fannie Mae’s Loan Quality Initiative” (LQI). As stated in the document’s introduction:

“Historically, many issues related to compliance with Fannie Mae selling policies are not detected until after loans are delinquent or through the foreclosure process. Loan repurchase requests to lenders have increased in the past three years, highlighting the need for an improved approach for working with lenders to deliver loans that meet Fannie Mae’s underwriting and eligibility guidelines. Fannie Mae conducted an extensive analysis to determine the primary drivers of repurchase requests and is launching the Loan Quality Initiative (LQI) to identify and implement policy, process, and technology enhancements to improve the compliance with underwriting and eligibility guidelines and mitigate repurchase risk.”

For loan investors (Fannie in this case) and their counterparties (mostly mortgage bankers, conduits and securitizers) the big issue is so-called “repurchase risk.” If the information submitted to Fannie Mae for their approval of a loan is incorrect or inaccurate than in many cases the banker must buy back that loan from Fannie Mae.

Some important things to know:

  1. Most mortgage bankers take out loans from large institutions and use those borrowed dollars to fund loans at your closing. They then turn around and sell the loan, often to Fannie Mae, and generate the cash to do it again,
  2. The loans they must repurchase are by definition, by “reputation” tainted whether there is actual fraud or error. The inaccuracy in the loan application may be immaterial to actual risk but the repurchase must happen in any case
  3. Since the loans are tainted the mortgage bank won’t be able to sell them to a third party.
  4. Mortgage banks don’t have the cash lying around to buy whole loans so the repurchase cash comes out of profits.

Many mortgage bankers were caught in this squeeze when investors stopped buying sub-prime mortgages at all. According to Implode-o-meter, “since late 2006 383 major U.S. lending operations have “imploded.””

Now, many face the prospect of going out of business because the loans they wrote in recent years have problems. Sometimes the issue is outright fraud, sometimes a mis-calculation of a formula, sometimes a missing document. The reason for the LQI is to reduce this activity in the future and create a more stable system, and that’s a good thing. That will work itself out for investors and bankers, for Fannie Mae, Freddie Mac and the rest.

What I find “curious” is the nature of the holes that the Loan Quality Initiative is aiming to fix. Here’s some of the issues they’re tackling:

  • Confirmation of Borrower Identity and Occupancy
  • Validation of Qualified Parties, and Borrower Credit Profile
  • Confirmation of Borrower Occupancy
  • Identification of Property Unit Number
  • Loan Delivery Enhancements
  • Validation of Loan Eligibility at Delivery

Reading down the list, with these, and other updates Fannie will only fund loans to people who actually exist, they’ll only do it with brokers and banks who aren’t on lists of crooks and incompetents, if you say you’re going to live in a house they’ll really be sure,… really, if it’s a condo they’ll make the loan on the right condo in the building or complex, and the loan that they fund will actually be a qualifying loan.

All systems and procedures have error rates. After all of the LQI initiatives are in place we’ll probably still be concerned about borrower identity and the rest. Still and all, it’s a sobering list. In my interactions with the mortgage industry as a customer the rules and the controls were paramount. At your closing you sign and sign and sign, document after document.

We were told that the mortgage process was solid. It wasn’t. We were told that BP understood deep sea drilling. They don’t. Many people are evoking the name of George Bailey from “It’s a Beautiful Life” lately. I often feel a bit more like another Jimmy Stewart character, Elwood P. Dowd….

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1 Comment »

  1. John Pumpelly said,

    Seems they missed a couple underwriting standards in their list; such as income verification. This list may address investment property issues but not financial capacity of the primary residence borrower. The same tune gets played over and over again which is what typically happens when politics enters finance. Oh, and there are still institutional investors purchasing no-doc refi’s by the truckload.


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