I have been involved in the mortgage industry for nearly 15 years in the following capacities: fee appraiser, staff appraiser for savings and loan, underwriter for savings and loan, underwriting/processing manager for a local bank and, currently for the past 4 years, as a review appraiser analyst for a mortgage due diligence company. My particular job is reviewing collateral related issues, i.e. perform desk reviews of appraisal reports. During these past 15 years, I have accumulated a myriad of experience which lends creditability to my opinions.

The government is now left with the task of cleaning up problems and, in many cases, fraud that resulted from excesses in the loosely regulated and fee-driven mortgage brokerage and appraisal industries. I will make recommendations on how to reform the system and thus avoid the misleading of borrowers, inflated valuations of properties and other abuses that have led to hundreds of thousands of foreclosures and related problems around our country.

First I will examine the roles of the players.

There is really no one person to blame for the current mess exacerbated by the subprime market. All players are responsible and need to strive to make corrections to avoid the current situation from re-occurring.

Our Economy

We live in the greatest country with the best market system that affords success to those who want to work and apply themselves. This means capturing the American Dream, which consists of home ownership. During the past 4 years, interest rates sank to all time lows, which meant that the availability of funds made to banks to lend was plentiful. The advent of these lowered rates acted a fuel to offer home ownership to those who couldn’t afford a home in the past; offered capital to builders to develop vacant land and build new communities; and offered ability of existing home homeowners to renovate their current homes, buy a second/vacation home and buy homes for investment purposes-to rent or fix up and re-sale. For the first time, real estate became a commodity, like trading a stock or buying pork bellies.

Lenders

The big institutional lenders, such as Countywide (CFC), Citibank (C), Chase (JPM), Wells Fargo (WFC) and Washington Mutual (WM), to name a few, saw the economic picture 4 years ago as an opportunity to maximize profits by extending credit and entered into a niche called subprime lending. This afforded the lenders to offer loans to persons with less than stellar credit ratings and persons were happy to accept since the subprime program was the only way for some to attain home ownership. The lenders were happy to make these loans due to increased profits derived by the additional fees and higher interest rates incurred.

The problem here begins with the lenders' internal risk management and oversight/underwriting, combined with thee various loan programs offered. With a subprime product, why would a lender offer a no income no asset verification program, with a maximum 100% combined loan to value [CLTV] on an owner occupied property and a 95% CLTV on a non owner occupied property? Yes, the fees and rates associated with this program are higher, but so is the risk. A subprime borrower has credit issues for a reason, so documenting income is very important.

The goal here is to make a sound loan decision which is based upon minimizing risk to make sure the borrower will make the loan payment. Not verifying one's income when there are past credit issues is not a fundamentally sound decision. The no income verification programs were designed as a streamlined method for quick qualification of those persons established in businesses that cannot prove their income, but have demonstrated an ability to save and have good credit. Over time, the program was expanded at the request of loan origination officials to apply to salaried individuals who can easily prove their income, and finally it was opened to the subprime borrower.

Also, the debts to income ratios were expanded to as high as 50%. This means that 50% of the borrower’s income is for the mortgage payment and all other debt (car loans, student loans, credit cards etc). These guidelines were created by loan origination and underwriting staffers and approved by senior bank management.

On the lending side of banking, the loan origination team drives the bus. Origination staffs are partially compensated on commissions generated by the number of loans funded, the loan processors are commissioned on the number of loans they process which close and in some situations the underwriters are paid a bonus on the number of loans reviewed regardless if the loans were approved or denied. The loan officers, including senior origination management, are typically in direct odds with underwriting. Many times as an underwriter, I or my fellow underwriters made decisions either to deny a loan, ask for certain stipulations to be supplied by the borrower to help make a better decision, or reduce the loan amount loan officers complained and senior origination personnel intervened and approved the loan. After all, loan volume requirements superseded sound underwriting decision making. This scenario happened on a regular basis.

Secondary Markets

With low interest rates and increased lending activity, which lead to increased profits for banks, credit rating agencies such as Fitch, Moody’s and Standard & Poor gave high ratings to so-called mortgage backed securities, which means investors gobbled up these securities, which in turn afforded the larger bank/mortgage companies the additional capital to lend.

Mortgage Brokers [MB]

This group of individuals has established relationships with a myriad of lenders in order to utilize various products lenders offer in an effort to match a borrower’s particular needs to the best program. In some situations, the MB has passed certain criteria standards approved by the lender and establishes a line of credit with the lender. The broker can originate, underwrite, close and fund the loan and then send the loan package to the lender who reviews it and, if accepted, the broker's line of credit is replenished with the loan amount plus a fee from the lender. These loans were reviewed by an independent due diligence company hired by the lender to “protect their interests”.

In other situations, the MB originates the loan, sends the loan file to the lender who underwrites the loan and, if the loan is approved, the lender closes the transaction and the broker is paid a fee. As the MB compensation is essentially 100% commissioned there is great pressure exerted by the MB on the lender to approve the loans submitted. Otherwise, the broker threatens to take the business elsewhere. In many instances, loans identified as having issues which were re-underwritten by the due diligence companies were still approved by institutional lenders.

There is legitimate MB and then there are those who bend the rules. This rule bending takes the form of fraud, falsifying income documents, placing borrowers in no income verification programs in order to take advantage of the lender since the borrower could not qualify for the loan if income was documented. Placing a naïve borrower into a subprime product to take advantage of increased fees when the borrower could qualify for a better rate with a lower payment occurred with some regularity.

Loan Programs

Proliferation of adjustable rate mortgages. These types of loans have been around for many years. The format of this loan is the borrower agrees to accept a low initial start rate with a low initial payment with the knowledge that after a specified period of time the interest rate will change based upon a specified index or formula. Usually at adjustment time the interest rate increases and the payment also increases. These loans are popular for persons knowing they will not stay in the property for longer than the initial rate period (1-5 years). Also, ARM products were used as fixed rates were at higher levels compared to ARM start rates.

Mortgage brokers were qualifying the borrower at the initial start rate (low rate), not at the fully indexed rate. Few borrowers could qualify at the higher fully indexed rate, so MB ignored this fact and used the lower rate. This is incorrect underwriting technique. When it came time for lenders to buy these loans, many were purchased, despite the concerns raised by due diligence companies; lenders accepted many of these incorrectly qualified loans rather than risk losing their MB client base. Many naive borrowers were placed in these loans due to the “fudged” income doc or entry into a stated income program where the income was incorrectly stated combined with an ARM program is a recipe for disaster. Recently, the media has portrayed this same scenario where the naive borrower was not prepared to make the higher payment once the loan adjusts. Investors/speculators who tired to flip a property and couldn’t are now stuck with making higher loan payments. Many have walked away from their properties. Already there is an abundance of real estate owned properties for sale. Many who bought properties in 2005 and 2006 (market climax time) with ARM products with initial rate periods of 2-3 years will be in for a big surprise soon upon receiving notice of the first adjustments. This could result in more REO properties flooding the market.

Appraisers

There is a special place in my heart for real estate appraisers as I stared out as an appraiser before becoming an underwriter and now my responsibility is collateral review where I review appraisal reports. The general scope of work assignment for a qualified residential real estate appraiser is to provide the lender a supportable/defensible estimate of market value of specific identified real estate. Like with any other professions most appraisers are hard working persons who take seriously their role in the mortgage process. Unfortunately a few have tainted the profession and it is not entirely their fault.

A real estate appraiser is an independent contractor. In most cases the appraisal report is ordered by the mortgage broker. Again remember if the loan isn’t approved and does not fund the broker does not get paid. For example if the loan program calls for an 80% loan (loan amount of $80,000) and the purchase price is $100,000, or a $100,000 value is needed for refinance purposes and the appraisal report indicates a market value of $85,000, the broker becomes very upset. Hence in the majority of instances the appraiser is pressured to “hit the number”. What type of pressure is applied you may ask. The broker will threaten to not send the appraiser any more work-essentially black listing the appraiser. No wonder why property values are inflated. This type of coercion doesn’t stop at the MB level. Currently there is a pending law suit in California where an institutional lender is being sued by an appraiser. In a nutshell the appraiser contends she was placed on an exclusionary list by a lender because she indicated a particular market was experiencing declining values. The lender didn’t want that indicated on the appraisal report and asked the appraiser to change the report to reflect stable values. The appraiser refused to do so. Why did the lender want the change, so when the loan was packaged into a security to be sold off on Wall Street the purchaser/investor would not accept the loan as part of the total securitized package due to the loan being in an area of declining values. Many appraisers simply will not associate themselves with these more unscrupulous MB and lenders. However it takes a strong will person with a diversified client base to withstand this type of pressure.

There is a common thread that binds together all of the above players and that is greed and the manipulation forcing persons to make bad decisions and or defraud the system for the sake of profits. The system is flawed due to the way compensation is delivered to the parties involved combined with a lack of state level and national oversight. Although I am not a fan of big government, it seems the private sector is not capable of self regulation and the government may be forced to intervene as by not doing so could result in a continuing circumstance of the current situation.

Suggestions

Both the mortgage broker and appraisal professions are currently state regulated. The federal governments should crackdown and force the states to raise licensing and educational standards (currently in effect in some states) and federal money is needed to insure the states have the manpower needed to better regulate and enforce state government monitoring agencies overseeing these professions. States should raise licensing fees in order to help offset the costs.

Appraisers need to be separated from the process and have a more independent status in an effort to eliminate the pressures from lenders/MB currently in effect. Appraisal Management Companies with no ties to lenders may be a step in the right direction; however the AMC should not be involved with setting the fee schedules for the appraisers work.

Banks are now tightening their guidelines, but it is essential that a more common sense approach to underwriting is needed and that includes requiring down payments (showing commitment to the property being purchased) and a return to a more conservative approach to qualifying debt ratios and eliminating no income verification loans for the sub prime borrower. Also qualifying the borrower at the low start rate should be eliminated at using the fully indexed rate should be the industry standard. This may cause a decline in loan volume but will also reduce potential foreclosures. This is something that has to be imitated internally as part of the bank’s risk management program. Compensation of employees involved in the mortgage process should be reviewed in order to de-emphasize commission status with emphasis on compensation for positive loan performance/quality of the loan submitted.

The federal government should mandate stronger disclosure of the interest rate, loan program and fee structure associating with both sub-prime, alt-A and A quality loans. Additional federal regulation is needed with regulators having the ability to examine mortgage broker operations as well as any “player” involved in the loan process from start to finish-this includes purchasers of mortgage backed securities. The regulatory entity needs to have the power to evoke binding disciplinary actions when wrong doing is identified and proven. The use of taxpayer monies to help “fix” the problem should be used only as a last resort. I think lenders should burden most of the costs.