Dedication

This book is dedicated to all those mortgage professionals who have lived with and suffered through the good times and the crises the industry has put before us. It has taken grit, determination, creative thinking, and hard work to face the challenges in an industry that supports universal homeownership through the good times and the difficult times.

Table of Contents

Introduction        Conforming and Non Conforming Loans       

The Loan Application Process       

Loan Amortization             

Adjustable Rate Mortgages           

The Role of the GSEs            

Custom Mortgage Financing          

Home Equity Lending         

Reverse Mortgages         

The Role of the Commercial Bank         

Credit Reports and Credit Scoring       

Residential Real Estate Appraisals        

Private Mortgage Insurance         

Title Insurance       

The Closing Process       

Mortgage Loan Servicing        

Fraud in Mortgage Lending     

Technology in Mortgage Banking       Regulations and the Regulators      

Quality Control In Loan Originations     

The Mortgage Bankers Association    

Ethics in Mortgage Lending   Glossary    

Acknowledgements    

Introduction

The original book that proceeded this one was called Mortgage Banking and Residential Real Estate Finance by the Masters of the Industry . It was a collection of chapters contributed by professionals in the mortgage banking field and others associated with it. That work was published in 2003, and I would almost say it was a time of innocence in mortgage lending. While the market for loan production was heating up, and the real estate and homebuilding industry were buzzing along, we had no way of knowing what we were facing just a few years later. As I look back on what the mortgage industry looked like in that time, I can hardly believe what I see. It was a market dominated by huge spikes in residential values nearly universally across the country. In order to compete for loan production lenders introduced no-doc and low doc loans, a clear invitation for originators of all types to commit mortgage fraud. Many originators were of the mindset that if a loan was to be approved and funded based upon stated income with no need for income verification, then what difference did it make what the applicant, loan officer, processor, underwriter, or closer used to qualify the loan? And if just anybody could get a loan regardless of his ability to manage the payments, why not speculate on two or three or more properties and finance them to the max.

The original Mortgage Banking book referred to that kind of thinking in several of its chapters. But then, just a couple of years later in 2007 and 2008, the industry was faced with the consequences of so many of these ill-advised lending programs. There was a sub-prime crisis that took the rest of the housing and lending industry with it. At the same time it made our original Mortgage Banking book irrelevant in many ways.

But my goal remains the same, to unlock some of the mysteries of what goes on in a real estate finance transaction, the steps the lender must take to protect the money he puts into the deal, and the roles of some of the other players in the real estate finance area.

Often homebuyers and homeowners are agitated at the cost and hassle of such a transaction when all they want to do is put up their money and move into their house. Why is the mortgage company putting me through all this extra effort and expense? The fact is that there are logical explanations of what lenders do and why they do it. It is a multi trillion dollar industry, so the consequences for uninformed practices are monumental. Regulations and systems must govern the process if it is to be safe and enduring. The level of expertise at every working level, from the taker of initial loan applications to the CEO of the bank, must know exactly what is expected in that position to ensure continuity of the organization.

Many aspects of the Mortgage Banking business are highly technical. IT is used in every part of the business, and that technology is constantly evolving so that lending institution can stay up to date and employ these systems throughout. Underwriting guidelines change, reporting requirements are subject to the higher authority of the GSEs and bank regulators, and years of expertise in secondary marketing, investor relations, loan servicing, portfolio analysis, and many other disciplines are needed to do the job effectively.

Is over-regulation a good thing or a bad thing? To the loan originator who struggles with each loan applicant for an approval, perhaps it is seen as a bad thing that nit picks his loans apart and makes life difficult. To the stockholder of the institution making, selling, and servicing mortgages, it can be seen as a good thing that keeps his money safe. To those industry professionals who lived through the sub-prime crisis of the 2007-2008 era, there can be no doubt that under-regulation can lead to serious consequences.

This book is intended as a primer for students, novices, and professionals alike. The Mortgage Banker who has worked in the industry for twenty years as a loan underwriter, may know very little about the importance of commercial banks to the lending industry. The person in the loan servicing area whose responsibility it is to analyze escrow accounts might know very little about how home equity loans play a role in supporting the overall housing market. The title examiner may only know the Fannie Mae that makes candy. But there are specialists up and down the line in the mortgage banking industry. And a professional Mortgage Banker would welcome the opportunity to learn more about how the system works and how the pieces fit together.

For all these reasons I have decided to take my original Mortgage Banking book and bring it up to date. This is a fascinating industry that has many moving parts. There are many jobs to be done in order to successfully run a Mortgage Banking organization, and there are diverse skills needed to do it well. It is an industry full of analysts, communicators, managers, financial minds, disciplinarians, and free thinkers. It takes all kinds to make the effort come together, and I hope this work enlightens my readers as to just how special it is to be a part of it. 

Patrick Mansell, CMB

Conforming and Non-Conforming Loans

Conforming Loans

Conforming loans are defined as those loans that meet the purchase criteria of Fannie Mae and Freddie Mac as set forth in their Seller Servicer Guides. A broader definition includes the underwriting guidelines as established by the FHA (Federal Housing Administration) and VA (Veterans Administration). These two agencies of the U.S. Government insure and guarantee mortgages that meet their own criteria, but they account for less than 5% of all new originations. For purposes of this discussion only the guidelines of Fannie Mae and Freddie Mac will be considered.

Conforming loans are recognized by many characteristics including size, term, borrower profile, and property type. The guidelines for conforming loans are dynamic, meaning they change from time to time as conditions warrant. For example, in the 1980's the loan limits, meaning the largest dollar value of individual mortgages that Fannie Mae and Freddie Mac would purchase, more than doubled from the low $30,000's to the high $60,000's. In the later part of the twentieth century that limit broke through $300,000. Loan limits are established based upon the cost profile of housing in a specific area. There are high-cost areas within the following states: California, Colorado, Connecticut, District of Columbia, Florida, Georgia, Idaho, Maryland, Massachusetts, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Tennessee, Utah, Virginia, Washington, West Virginia, and Wyoming. Special statutory provisions establish different loan limit calculations for Alaska, Hawaii, Guam, and the U.S. Virgin Islands.  In these areas, the baseline loan limit was established at $726,525 for one-unit properties. Lenders can find the applicable loan limit for counties and Metropolitan Statistical Areas (MSAs) on the web site of the Federal Housing Finance Agency.

The world of conforming underwriting changed considerably with the introduction of AUS (Automated Underwriting Systems) that were introduced by Fannie Mae and Freddie Mac. Until the advent of AU lenders employed underwriters whose job was to examine loan files to see if they met the agencies’ guidelines. Now computers do that job and the guidelines for loan approval have expanded considerably. There was a time when the guidelines specified that a borrower who made a down payment of 10% would qualify if he had reasonably good credit, adequate reserves, two years of continuous employment, his housing payment to income ratio did not exceed 25%, and his total monthly payments, including housing and revolving credit, as a percentage of monthly income did not exceed 33%. This guideline was not cast in stone and there were areas where an underwriter could use a certain amount of discretion. For example, if this same borrower had many years of continuous employment and an exemplary credit record and vast reserves, the underwriter might be willing to approve higher payment ratios. Likewise if a borrower made a down payment of 20% and had good credit and reserves, the guidelines called for the underwriter to approve payment ratios of 28% and 36%. At the same time the underwriter had the flexibility to approve higher ratios under conditions where the borrower was exceptionally strong in the area of employment, credit, or reserves. In this scenario the human aspect of underwriting could not be ignored. In spite of guidelines that were meant to offer flexibility in the determination of whether a loan was considered investment quality, many loan applications that met the conforming guidelines were not approved by underwriters, and many loans that did not meet the guidelines were approved. All too often the entire concept of whether or not a loan was a qualified loan was subject to human error or whim. 

Many of the guidelines that underwriters in the past were supposed to follow have changed since the advent of the AUS. Years of research and many millions of dollars of software development have resulted in more flexible underwriting criteria and a more scientific approach to loan approvals. Today an underwriter, loan processor, or loan officer can enter a loan application into Fannie Mae’s underwriting engine called Desktop Underwriter (DU) or Desktop Originator (DO), or into Freddie Mac’s Loan Prospector (LP) and receive an underwriting determination within a few minutes. Vast data banks with credit profiles and property values are accessed through AUS.

Through the years of research done by Fannie Mae and Freddie Mac in developing Automated Underwriting Systems many of the past notions of what constitutes risk in a loan have been dispelled. For example, in the past the guidelines called for two years of verified employment, preferably in the same job, but at least in the same line of work. Since that time it has been discovered that job tenure is a weak indicator of risk in a loan, so under LP or DU an underwriter might expect a result that calls for income verification in the form of a previous year’s W-2 or 1099, or a recent pay stub from an employer. Far less frequent is the requirement for two year’s of full income tax returns, and rarely does a DU or LP determination require business tax returns, as was the case prior to the introduction of AUS. 

Emerging as the two most important elements of loan quality are credit scores and home equity. A borrower who is meticulous about his credit obligations resulting in high FICO or BEACON scores, in concert with the ability to make a sizeable down payment, is considered the strongest kind of borrower and approval for conforming financing can be assured. 

Guidelines for property have changed very little on account of AUS, however, the requirements for appraisals has been dramatically affected. In purchase transactions the requirement for full appraisals with interior inspections remains the norm and is often handled differently than with refinance transactions. The underwriting engines use data banks of property values to set a range within which it is reasonable to expect a property value to fall. In fact, Fannie Mae and Freddie Mac’s influence is so pervasive within the residential real estate community that a property submitted to AUS has a strong likelihood of having been financed through one of those agencies sometime in the past. Houseboats, condo hotels, and time-share properties remain ineligible.

The four most important considerations in loan underwriting simply stated are income, assets, credit, and property. When all of these elements fall into their proper place the loan will qualify as a conforming loan and receive the designation ‘investment quality’. Fannie Mae and Freddie Mac pool investment quality mortgages into securities called Mortgage Backed Securities (MBS) that are bought and sold by investors of every kind. These high quality securities end up in pension plans, mutual funds, international portfolios, and just about anywhere investments are made.

Securities backed by Fannie Mae and Freddie Mac are attractive for several reasons. The behavioral characteristics of conforming loans have proven over the years to have very low default rates, which translate into a high level of performance. Additionally, Fannie Mae and Freddie Mac are two of the largest financial institutions in the world and their guarantee leaves little fear of loss of capital when investing in these securities. In fact, the quality of agency guaranteed Mortgage Backed Securities ranks second only to Treasury Securities which are backed by the full faith and credit of the United States Government. Even when the two agencies were deemed insolvent during the crisis of 2008, the U.S. government took them into conservatorship and backed their guarantees. The lesson to remember here is that securities with strong backing will be more liquid and receive more favorable pricing in the investment market.

Non-Conforming Loans

Loans can be non-conforming for many reasons and, as such, securities backed by this type of loan may be priced less favorably than Fannie Mae or Freddie Mac conforming Mortgage Backed Securities. Since the securities backed by non-conforming loans receive less favorable pricing, this inferior pricing is passed on in the form of premiums charged to the borrower. Premiums in the form of higher interest rates and fees vary according to the degree by which a loan skews away from the conforming standard. Further, some non-conforming loans cannot be securitized which will often result in still higher premium pricing.

None of this is meant to say that non-conforming loans are not good loans or that they are risky. Take the example of a very wealthy individual who has excellent income and credit and borrows $650,000 toward the purchase of a $2,000,000 home. The investor in this loan takes virtually no risk with respect to the possibility of default. With a very strong borrower and $1,350,000 in equity ahead of the loan, it would be very difficult for the lender to lose money on account of the borrower’s failure to pay. On the other hand, this loan cannot be sold to Fannie Mae or Freddie Mac because the $650,000 loan balance exceeds their maximum loan limit. In this specific example there is still a market for the loan. Many institutional investors form their own securities and market them as alternatives to agency Mortgage Backed Securities. Since the loans in these securities are non-conforming, and since they do not have the backing of one of the agencies, the securities will be less liquid and command a higher price. Some of the institutions backing these securities are very substantial and their backing of a security is considered to be quite strong. The higher price of the institutional backing verses Fannie Mae backing will be passed on to the borrower. Because the borrower in this example was well qualified and the loan was of exceptional quality, the premium charged will not be so great. In the same market where a thirty year fixed rate mortgage eligible for sale to Fannie Mae might be priced at 4%, this high quality non-conforming loan might carry a rate of 4.5% to 5%, or a premium of .50% to 1%.

The greater degree by which a loan deviates from the conforming standards, usually the higher the premium paid. In the