Friday, August 17, 2007

Houses to Hedge Funds--The Great Chain of Owing

Subprime mortgage lending sits at the center of current global financial upheaval and at the same time in our backyard. How did this happen and what is happening in Michigan to protect consumers or borrowers?

How did we get here?
Prior to 1981, most mortgages were made through banks, credit unions and savings and loans–depository institutions. There was a high degree of local accountability as institutions would actually take in deposits and make long-term loans that would remain on their books. Loan officers were required to make sure borrowers could actually pay back the loan, because a bad loan meant a loss for the lender. In addition, depository institutions were interested in creating relationships with clients and communities.

Recession, deregulation and global influence
High interest rates during the recession of the 1970s decimated the savings and loans. Deregulation of the financial and securities sector in the 1980s and 1990s changed things even more dramatically. Mortgages went from local transactions between borrowers and lenders within communities to something entirely new–local transactions financed at a global level.

According to Kirt Gundry, Director of the Mortgage Examination and Investigation Section of the Michigan Office of Financial and Insurance Services (OFIS) “Mortgage lending is local in terms of the loan officer and the borrower, but it is global in terms of financing and where the lenders are. Most lenders, including banks, package loans and sell them on the secondary market. The secondary market will securitize those into big mortgage-backed debt instruments and then investors will purchase those bonds.”

Gundry sees a positive outcome from the current market,“Home ownership increased in this country because of the global marketplace and the greater access to credit. A lot of loans would not have been available in the old model.”

When borrowers begin to default though, the local once again becomes global and bites everyone in the mortgage-to-hedge-fund food chain. Homeowners face foreclosure, mortgage companies weaken or fold (American Home Mortgage, Countrywide), hedge funds vaporize (Bear Stearns among others), investors freak out, and central banks pump currency into the system to maintain liquidity and stave off a credit crunch.

An ounce of prevention
Here in Michigan, the Office of Financial and Insurance Services is responsible for licensing and examining mortgage companies. OFIS licenses entities–companies or sole proprietors, usually LLCs or corporations, due to liability issues. Loan officers work for licensees; there are no standards for loan officers. In Michigan, you could be a janitor one day and a mortgage loan officer the next.

OFIS recently issued best practices for subprime mortgage lending in Michigan reflecting recommendations from CSBS (Conference of State Bank Supervisors), AARMR (American Association of Residential Mortgage Regulators) and NACCA (National Association of Consumer Credit Administrators). But these are best practices, not regulations carrying the force of law. These amount to suggestions for prudent lending practices–the sorts of things that were standard procedure before deregulation.

Legal and profitable
Offering adjustable rate mortgages to subprime borrowers is not illegal.

Industry practices make it profitable for brokers to steer borrowers into inappropriate products. Lenders reward brokers/loan officers for steering customers into higher rate products when customers qualify for lower rates. The broker is given a bonus called a "yield spread premium." In a U.S. Senate Banking subcommittee meeting June 26,
John Robbins, the chairman of the Mortgage Bankers Association, told senators,"Are yield-spread premiums abused? Absolutely. Do borrowers understand what they are paying in yield-spread premiums? The vast majority of time they do not."(source)

Unclear Jurisdiction
According to Tim Doyle, Vice President with the Conference of State Bank Supervisors, issues of jurisdiction are still being worked out between the states and the federal government in the courts.

Because of the diversity of corporate structures found among mortgage originators, states have had a tough time regulating them. This April, in Watters v. Wachovia the U.S. Supreme Court ruled that state-chartered subsidiaries of national banks are exempt from state regulation. OFIS Commissioner Watters had advocated for state regulation of state-chartered subsidiaries. Numerous organizations filed amicus briefs, as well as every state attorney general in the nation (including Washington D.C. and Puerto Rico).

Doyle says, "Consumers who are having difficulty with a financial institution do face confusion over where to turn for help, because in some states certain types of institutions are exempt from state regulation."

In spite of regulatory murkiness Doyle says that more and more responsibilities have been placed on states to supervise the mortgage industry, even as mortgage brokers have proliferated. "There are about 90,000 licensed mortgage brokers across the country and the state agency staffs in many states have not increased with the growing responsibilities."

How many examiners are enough?

OFIS has 13 examiners to oversee nearly 3200 mortgage companies.

Even though OFIS augments its in-house examiners with additional contract examiners, Gundry says, “there isn’t enough regulatory presence in the market place to really keep an eye on all these companies. It would take us over 10 years to examine every mortgage company in Michigan just once. If we had 36 examiners, we could get the examination cycle down to 2 years. It would then be similar to banks, trusts and credit unions that are on an 18 month cycle. In those depository institutions, an examiner is coming in the door every 18 months. We’re coming in the door only if we think there is a problem.”

Could a higher number of examiners in Michigan have mitigated the impact of subprime lending here? “If we had been on a 24-month cycle and kept up with new licensees I think we could have definitely prevented some of this,” he allows.

Why aren’t there more examiners?
Actually there are. Prior to last year, there were only 6 examiners for the entire state. Last year OFIS was able to add seven more. OFIS examiners are funded by licensing fees and activity fees, not the general fund, yet OFIS cannot hire more examiners without approval of house and senate appropriations committees. In the midst of the state budget crisis and hiring freeze, hiring additional examiners is highly unlikely.

Hope for the future
States are attempting to collaborate and share information with respect to licensing. In February OFIS announced its participation in developing a nationwide Residential Mortgage Licensing System. At that time, Commissioner Watters said, "the system will give us an increased ability to hold industry professionals accountable for their actions, and should help reduce fraud and other illegal or unethical behavior such as predatory lending.”(source) As of February, 29 states had agreed to participate in the system expected to launch in January of 2008.

Real protection
In spite of the vastness of the mortgage lending industry and the shortage of examiners, Gundry's office is carrying out a lot of enforcement. In some cases licenses are revoked; in the most extreme cases, loan officers are prohibited from working in Michigan. Prohibition results from some type of fraud such as: overstating income or assets, understating liabilities or forging documents, even falsifying entire applications. A list of prohibited loan officers is posted on the OFIS website.

Advice to borrowers
With an industry in chaos, what are borrowers to do? Gundry had some sound advice, "Potential borrowers can find HUD approved non-profit credit counselors to help evaluate their situation. If they are getting ready to close on a house, they might want to have an attorney review the documents before closing.”

And what if you are already in your home and unclear about the terms of your loan? “If you already have a mortgage, get your loan documents out, locate the note and find out if you have an adjustable rate loan. You might want to consider refinancing to a fixed rate loan before the ARM resets. If you can’t refinance in time, at least you will not be caught off guard when your payment increases.” The Detroit News reported last week that loan activity in Michigan increased in July due to borrowers seeking to refinance out of ARMs to fixed rate mortgages.

Helping consumers, education versus rescue
Debate on how best to help consumers rages in Michigan and every state. Some propose bailout funds for homeowners, others take a hard line saying borrowers should take responsibility for bad decisions. More consumer education is certainly needed. A bailout fund in Michigan seems completely out of the question given all the other budget pressures and disagreements facing the legislature.

For now, it is still buyer beware.