Throw the Baby Out with the Bath Water

Those of you in the mortgage business are surely familiar with the term "Yield Spread Premium" (or YSP). It has been a hot issue for several years, and if the Federal Reserve has its way it will soon be illegal. Yesterday, the Federal Reserve issued a proposed rule that would make YSP illegal. Why are these three little initials such a lightning rod? First I will provide a simple explanation of YSP for those that are not familiar with it.

Mortgage brokers are company's that originate mortgage loans, but rely on a bank (known as a wholesale lender) to fund the loans they originate for their customers. The mortgage broker may earn fees for their work, but they may also be paid by the wholesale lender for delivering the loan. This fee paid by the wholesale lender to the broker is the YSP.

Why does the wholesale lender pay the broker? Because the wholesale lender wants the loan. These wholesale lenders (aka the banks) earn money from the interest on the loans they service. Therefore it is worth it to the wholesale lender to get brokers to send them as many loans as possible. For most of my career I was one of these wholesale lenders. Working for Countrywide's wholesale lending division, we funded loans for mortgage brokers and often paid them yield spread premiums when they delivered the loans to us.

How is the amount of the YSP determined? The amount the broker is paid in YSP is typically determined by the interest rate. A higher interest rate will pay more YSP, a lower rate may pay zero YSP (also called par). An even lower rate would actually cost money in the form a discount points to the bank.

Below is an example of how a rate sheet might appear for a 30 year fixed mortgage. The rate sheet would come from the wholesale lender, and the broker would use it to price their loans. It is important to note that wholesale rates are lower than retail rates. Even if a bank has both a wholesale division and a retail division, the wholesale rates will look more attractive. This allows the broker to earn their fees and still offer competive rates and fees to their customers. Having a wholesale division also offers lenders a lower cost of doing business.

On the table below, the interest rate is on the left and the amount of YSP (negative numbers) or discount points (positive numbers) are on the right.

4.750 1.375
4.875 0.625
5.000 0.000
5.125 -0.250
5.250 -0.875

In the table above, 5% is par. The wholesale lender would not pay any YSP, and the borrower would not have to pay any discount points. At 5.25%, the broker receives .875% of the loan amount in the form of YSP from the wholesale lender. On a $100,000 loan that would be $875.

Yield spread premium is also a tool for brokers to offer flexible options for their customers. Like I said in the beginning, brokers can earn their income from the customer in the form of fees, as well as from the wholesale lender in the form of YSP. So in the table above, the broker may offer a customer the option of getting a loan at 5% with a .875% origination fee, or 5.25% with no origination fee. Either way the broker earns the same amount of income, but the borrower can choose whether they want to pay a fee for 5%, or pay no fee for 5.25%.

Now why does that sound like something that the Federal Reserve wants to make illegal?

Unfortunately YSP was abused by a lot of mortgage brokers, and wholesale lenders allowed the abuse to take place. For many years, mortgage brokers would rarely earn more than 1% in YSP. The only exception would be if the broker was paying other closing costs for the customer. But then some unscrupulous brokers were taking advantage of unsuspecting borrowers and getting 2% or more in YSP as well as charging up front fees like an origination fee.

The wholesale lenders capped what brokers could earn, but that cap was typically 5%. That seems high, unless the broker is trying to close a $40,000 loan. On a $200,000 loan that 5% is $10,000, an outrageous amount for closing a $200,000 loan. Why a borrower would choose to work with a mortgage company that charged those fees is puzzling, but they did.

The most egregious abuse of yield spread premium took place with a particular loan product called an option ARM. This was an adjustable rate mortgage that was appealing to borrowers because it offered a low minimum payment, sometimes at a rate as low as 1%. But the loan would accrue interest at a higher rate. How higher of a rate was determined by the margin that was added to the rate index. With this program it was the margin (the add on to the rate), not the rate itself that dictated the YSP the broker would earn. The higher the margin, the more YSP.

This product was not a bad loan product (I use past tense because you can't find a bank that will lend an option ARM loan any more). It had been around for decades. I even seriously considered getting an option ARM myself (although I chose not to). It was a unique product that was appropriate for a small population of sophisticated borrowers. Unfortunately, it was sold to main stream America. Actually it was mostly main stream California, Nevada, Arizona, and Florida.

Why did brokers as well as mortgage bankers want to sell so many option ARMs? The obvious answer is because they were profitable. And they were very profitable. A broker could earn at much as 3% YSP with the wholesale lender that I worked for. Add another 1% origination fee and they could easily earn $10,000 on a $250,000 loan. Some of our competitors offered as much as 4% YSP on option ARM loans.

Why did wholesale lenders offer so much YSP on option ARM loans? Because they were so profitable. They could sell them to Wall Street where the appetite for mortgage products was insatiable. Some banks like World Savings kept them in their portfolio where they were earning high rates of interest. Even if the borrower only paid the minimum 1% payment, the bank could show the higher interest as earned income on their financial statements. Wholesale lenders were in competition with each other to get option ARM loans originated by brokers, so they paid the brokers handsomely.

At one point while I was a sales manager at Countrywide, we received a memo that we were raising our maximum YSP from 3% to 3.5%. In the memo the senior manager implied that brokers shouldn't really be choosing that high of a margin which would result in a 3.5% YSP. In addition we (my sales team, and all of the company's account executives) should encourage our brokers to select a lower margin that earns them only 1% or so in YSP. I was so stunned by the duplicity of the memo that I called my boss and let him know my thoughts. Why were we talking out of both sides of our mouths? The senior manager was clearly acknowledging there was something wrong with paying too much YSP, but at the same time we were increasing the amount we were willing to pay the brokers in order to compete with other wholesale lenders that were offering as much as 4%.

This illustrates the blind race for market share in which banks were competing. The loans were profitable and otherwise obvious flaws were ignored.

But I digress...

So this is how YSP turned from a useful tool that offered options for borrowers into the lightning rod that it is today. Instead of banning YSP altogether, it should be regulated not to exceed a certain amount, say 1.5%. Why would the Federal Reserve want to throw the baby out with the bath water? Eliminating mortgage brokers makes the Fed's role as a regulator much easier. It also creates greater market share for the big banks that the Fed is closest to. That's my guess anyway.

In the end, if the Fed's proposed rule goes into effect, it will mean less competition and choice for borrowers. It will also shut down thousands of brokers and harm other small businesses that service brokers. Borrowers will still be able to get loans from mortgage bankers that fund their loans on lines of credit, then sell them to banks. Those mortgage bankers don't earn YSP. Instead they get something called SRP from the bank they sell the loan to. Yes, it's pretty much the same thing as YSP, except that it won't be illegal. Frankly neither one of them should be.

Upside Down Refinances

Head over heels, but not in a good way, is how to describe the mortgage debt with which many homeowners are strapped. The government's Home Affordable Refinance Program attempted to address this back in March when they began allowing some homeowners to refinance their current mortgages for up to 105% of the value of their homes. In other words, if the home is worth $100,000, then the homeowner can get a refinance up to $105,000.

This limit of 105% reflected the disconnect in Washington with the real world. Unfortunately, the homeowners that are truly at risk of foreclosure owe significantly more that 105% of the value of their home in mortgage debt. Five months later the government has tried to address the issue by raising the limit to 125%. While this will certainly help some folks, it will not help the great number of homeowners in Arizona, California, Nevada, and Florida that are considerably upside down with their mortgage debt (by more than 25%).

The best suggestion to resolve this came from John Courson at the Mortgage Bankers Association when the program was first announced back in March. He recommended that there be no limits on the loan to value. These refinances are only for loans that are currently owned by Fannie Mae and Freddie Mac. And Fannie and Freddie will own the new loans that are created by the refinances. Since the federal government owns Fannie and Freddie, we the tax payers own these mortgages.

These homeowners that are upside down are potential foreclosures which will cost the government (aka we the taxpayers) mucho dinero. Why not let these homeowners refinance to a lower payment and avoid the foreclosure and the cost that goes with it regardless of the loan to value ratio. There is already a precendent for this with FHA and VA refinances. Since the government already guarantees those loans they just want to put the homeowner in a better financial position. How is Fannie & Freddie any different today from FHA & VA? The answer is, they are not any different from an ownership and accountability standpoint.

Lift the loan to value restriction and more homeowners will be helped. If not, then more loan modifications will need to be done. For homeowners that need a loan modification and don't want to pay thousands of dollars to an attorney or loan modification company, visit www.eModifyMyLoan.com. The site helps struggling homeowners in need of a modification create a complete and well-organized package to deliver to their lender and will help expedite the modification process.

Deflated Expectations

A traveler wandering through the desert spots a watery oasis. He moves toward it in hopes of quenching his thirst and taking a dip in the cool clear water. It's only a mirage of course, but in the traveler's mind it clearly exists. His belief in the mirage is strengthened by the only thing he has to hang on to. Hope.

Financial markets have recently been influenced by hope. Hope that the recession will end soon. Hope that the worst is behind us.

After an apocalyptic fourth quarter, the first half of 2009 resulted in a rather beefy improvement in equities with speculation (aka hope) that the recession had bottomed out and that there is light at the end of the tunnel. Interest rates rose in May and June as government debt soared and a new fear took hold, inflation. But is that fear real yet? Isn't our immediate fear deflation?

In the long term, the massive government spending that is taking place no doubt will have negative effects, but in the near term, deflation is the enemy. Starting with real estate, the value of assets has declined the past couple of years. Bank lending continues to decline because it is foolish to lend on a declining asset. This is evident in the Fed's weekly H.8 report which shows that bank credit actually fell $59 billion last week, and fell $83 billion over the past two weeks. Without credit, markets for these assets are stifled. And the negative loop continues.

Until credit loosens, inflation cannot appear. So in the near-term, deflation and low interest rates abound. The benefactors in the second half of the year will continue to be first time home buyers who can now afford homes (which values have deflated) and qualify for loans at low interest rates. Also, the handful of homeowners who still have equity in their homes and can take advantage of refinancing.

So with every bit of bad news, there is a silver lining. Low interest rates are what we have to look forward to for the second half of the year.

Mortgage Lending and the Search for the Bottom

Housing statistics are like a good news - bad news thing now. The good news is that there are more sales taking place in markets that have been hammered like Phoenix. The bad news is that prices are falling and don't seem to want to stop. What does this mean for the housing market and real estate lending?

The obvious conclusion is that the number of sales is increasing because the prices are coming down to a reasonable level. We are actually seeing multiple bids taking place for homes at the lower end of the market. First time home buyers can finally afford to buy a home which is a wonderful silver lining that doesn't get much attention in the media. Real estate investors are also able to buy some of these low end homes, often at trustee sales or from banks. These investors make repairs and rent the homes for a profit.

These two players in the market (first time home buyers & real estate investors) are able to win because of the funding available to them. For first time home buyers, they are primarily utilizing FHA loans with a low down payment (3.5%) to secure their financing. Government guaranteed loans are about all that is left and first time home buyers are often the biggest users of these loans.

Real estate investors don't have many financing options available. With excellent credit, income they can document, and a significant down payment, they can secure a Fannie Mae or Freddie Mac loan. More often than not, they pay cash or get a private money loan with an even larger down payment (40% or more) and high interest rate. But because the sales prices are so low (I have seen many sales between $20,000 and $50,000) they have enough cash to purchase the property without financing or put down such a large down payment that their debt service is low enough to generate positive cash flow.

What about everyone else? The player that is absent from this market is the move-up buyer. There are a couple of factors keeping this player from participating. First, they already have a house that they are unable to sell. In the past, move-up buyers could sell their existing home for a profit and use that profit as the down payment for a newer, nicer home. That's not the case today. In fact, if they bought their home after 2003, it is likely that they owe more on their mortgage than what the home is worth today. Even if a move-up buyer can overcome their first challenge, their second challenge is the lack of jumbo mortgages available (loans over $417,000).

Outside of the activity in the lower end homes with first time home buyers and investors, the rest of the market continues to be sluggish. Where is the bottom? If you were looking for an answer to that question in this article, you will be disappointed. I don't know. However, homes are finally priced at affordable levels. So it is reasonable to infer that prices may stabilize soon. The wild card is employment and income. If unemployment continues to be an issue, and it likely will, and incomes continue to decline, and they likely will, then housing still has further to fall. Once it does stabilize it will be a very long time before they rise again.

Unfortunately this is what banks and lenders are thinking when they analyze their lending guidelines. They are afraid to give loans secured by a declining asset. So they don't lend, and people can't buy, and the negative loop continues.

I'll try and finish on something more positive next time.

Is it OK to Walk Away?

Is a home an investment or simply a dwelling where we reside? Should I give the lender the keys to the house the moment it is worth less than the balance of the mortgage? Is it okay to walk away?

Here's the dilemma. The Jones family lives in a beautiful home in a Phoenix suburb. They have children whose only memory of home is that house. They refinanced the home a few years ago when values were high and pulled some cash out. The cash was used for a variety of things. As home prices have fallen, and fallen, they find themselves with a loan balance that is two hundred thousand and fifty dollars more that what the home is actually worth today. Fortunately, both Mr. and Mrs. Jones fall into the 90% of people who are still employed and are capable of making the mortgage payment.

Mr. Jones looks at the situation and decides action must be taken. Men are problem solvers and this "upside down" issue needs to be addressed. It seems foolish to pay the lender a quarter of a million dollars more than what this home would fetch on the market today. If the lender won't write-down the principal balance, then let's mail them the keys and rent a house in the same neighborhood. A logical and practical solution.

Mrs. Jones views things differently. She doesn't want to move. This is her home. This is where she wants to continue to raise her children. This home is not an investment. The decision should not be based as if it is an investment. If the payment is affordable, then she wants her family to stay put.

This debate is likely taking place in thousands if not millions of households. I am aware of this particular debate, because I know the Jones's. That's not really their name. It has been changed to protect the delinquent. My own opinion is that people should keep their homes if they can still afford them. I will admit that I have not been placed in their situation, at least not yet. I don't envy their dilemma.

Stock Market Death Watch

As I write this, the Dow Jones Industrial average is at 6820 and falling. I have not witnessed a bear market like this in my lifetime. In fact, people twice my age haven't witnessed anything like this in their lifetimes either. I hear comparisons of this economy to 1982. I was only nine years old at the time, the same age as my oldest son is now. Back then I was more interested in Star Wars than the economy. I won't try to make comparisons with that recession, rather I tend to believe that this recession will represent a fundamental change in our economy.

As humans we tend to make assumptions and predictions based on our own experiences. Some people may look at the '82 recession and make predictions based on what happened then. Others may look at the Great Depression, and draw comparisons there. It appears the Obama administration is attempting to define their legacy as the New Deal Part 2. In the media I hear people cry to the government for help. Save UAW jobs in Detroit, save Citi, save me, save you. Instead of trying to preserve our economic fortunes of the past, perhaps we need to acknowledge the fundamental changes that are occuring. Like farmers moving from rural areas to cities to accept industrial jobs a century ago, this change will require a great number of people to get out of their comfort zones.

Changing jobs is difficult. Changing industries is more difficult, not because former mortgage loan officers are incapable for becoming nurses (just as an example, they certainly are), but because it requires one to try something that they don't know how to do yet. Individuals are not born to do a particular job. They can do any job as long as long as they have an open mind and the willingness to learn. A great example is Daniel Seddiqui. The 26 year old from Utah is 24 weeks into his journey to work 50 different jobs for one week each in all 50 states. In this journey, Daniel has worked as a corn farmer in Nebraska, a wedding coordinator in Las Vegas, a park ranger in Wyoming, and a cheesemaker in Wisconsin just to name a few. Every week he learns a new skill and is getting an education well beyond anything he could pay tuition for at a University. Perhaps government hand-outs need to instead be hand-ups to provide training and education for those individuals that are willing to adapt.

Adapting doesn't have to be as drastic changing industries. Perhaps it can be as easy as adjusting a product to fit the current environment. Hollandia International makes high-end beds. They made a custom bed for a client that contained a safe where he keeps a gun close by while he sleeps. Hollandia has adapted that concept to the recession and now markets a SAFE-T Bed so you can keep your cash in your mattress and feel secure about it. Brilliant! The Dow has dropped another 3 points since I started writing, so cash in the mattress sounds like a good investment in this deflationary environment.

Obama and Congress have a choice to make when they create bail-outs and programs to assist those that cry out for help. They can spend our money in an attempt to preserve the past, or they can accept the fundamental changes that are occuring and attack them head on with programs to help retrain individuals that are willing to adapt.

The Rescuers

I live in a nice house. It's not a mansion, but a nice house. I also live in a nice neighborhood. It's not millionaire row, but its nice. At the peak of the housing market, I was making good money, and I thought very seriously about moving to a larger, more expensive home in the subdivision adjacent to mine. As the market slowed I thought even more seriously about it, because I thought I could find a bargain. In the end, I decided that I was better off in my older, more modest home. What a great decision that was! Six months later I was laid off. Now I have started my own company. Those of you that are self employed understand what it is like to not get a regular paycheck even though you work. Any money I make goes back into my company, and it has been seven months since I have seen a paycheck. I should be the perfect candidate for a government bailout.

Alas, despite the lack of income I have paid all of my obligations on time. I had plenty of savings (and still have some) to get me through this. If I had only known that the federal government would be pushing loan modifications, I wouldn't have wasted my money on something as useless as savings. I would have bought that big beautiful house on millionaire row. I blame my parents for instilling me with financial sense and personal responsibility. Little did they know how useless those virtues would be in 2009.

Now that I have resigned myself to the fact that I won't benefit from any financial rescues, and will in fact be paying for the rescue of others for years to come, I can objectively review the President's announced Homeowner Affordability and Stability Plan. The plan covers three key areas: creating opportunities for homeowners to refinance; encouraging a larger number and more effective loan modifications; and strengthening of the governments commitment to Fannie Mae & Freddie Mac.

Refinancing
The first part of the plan is the affordability initiative. Loans that are currently owned by Fannie or Freddie or in mortgage back securities guaranteed by the government sponsored enterprises will be eligible for a refinance to current interest rates, which are very low by historical standards. A lack of equity is keeping many people from refinancing, so the President's proposal is to allow for loan amounts up to 105% of the current value. That will certainly open up the opportunity for some homeowners to refinance. It will leave out quite a few as well. For example, people who don't have a conforming loan (Fannie or Freddie) currently will not be eligible. Also, if they are so upside down (owe more than the house is worth) that 105% is not sufficient, they won't qualify either. There are a lot of homeowners here in Arizona that fall into that category. Jumbo loans are also not eligible (over $417,000). The Mortgage Bankers Association has argued that the 105% limit should be removed from the plan. Their argument is that Fannie Mae and Freddie Mac already have the liability for the existing loans no matter what the loan to value ratio is. Therefore it is in their best interest to refinance these loans to lower rates regardless of how much the value of the home has declined. That's a pretty valid argument, especially since there is already a precedent set in the form of FHA and their streamline refinance program.

Modifications
The second key to the plan is to increase the number of and the effectiveness of mortgage loan modifications. Many people have fallen behind on their mortgage payments and the only thing that will save them from foreclosure is a lender that is willing to change the terms of the loan and make the payment more affordable. Obama's plan calls for lenders to modify mortgage payments down to 38% of the borrower's gross income. In addition, the government will match dollar for dollar a reduction of the payment to 31% of the borrower's gross income. There are additional incentives that can be paid to the lender if the modification is successful (meaning the borrower makes the payments and stays in the house) as well as incentives for the borrower (beyond being able to keep their house) in the form of principal reductions for successfully paying their modified payment on time. It's a positive to get some guidelines on what has been a messy and confusing subindustry called "Loan Modifications." Lenders will continue to struggle with the problem of filtering true hardship cases versus those individuals that look to take unfair advantage of the lender and taxpayer. And the borrowers with the true hardship cases are not likely to comprehend how the plan works anyway. If they claim to have not understood their original mortgage that got them in trouble, how are they going to understand this?

Low Rates
The final part of the plan will likely be the most effective. That is because it is simple. The Treasury will continue to purchase Fannie & Freddie mortgage backed securities and increase their portfolios. The fact that the government is buying mortgage backed securities is keeping mortgage rates low. That is great for those that can refinance. It is really great for first time homebuyers that can now finally afford to by a home because of the devaluation that has occurred.

Meanwhile, I will continue to pay my mortgage on a timely basis. I even have one of those evil adjustable rate mortgages. My rate is lower than any fixed rate you can get now, and it is scheduled to go down again in a couple of months. An adjustable rate mortgage doesn't seem nearly as "evil" as the government taking my money to pay down someone else's mortgage.