What a Difference a Crisis Makes

Roger Schlesinger
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Posted: Mar 17, 2009 12:01 AM
What a Difference a Crisis Makes

For those old enough to remember, there once was a song "What a Difference a Day Makes" whose next line was "24 little hours". Oh how I wish we could have created a parody to that song and this financial nightmare would have been over before it started. We didn't accomplish that, and now I am sure that other than attempting to destroy a once vibrant industry, we haven't accomplished much of anything else. I believe that the media in this country, innocently or not, have created an atmosphere, or at least added to one, that keeps confidence low and worry high. If you have just awakened from a 3 year sleep, you might think everyone (or almost everyone) in the entire nation is in the process of losing their house to foreclosure or simply walking away. Nothing makes headlines as often as "Foreclosures Up 60%" because saying foreclosures in a given area have increased from 5% to 8% doesn't have that emotional punch. As best as I can tell without contacting all of the almost 100,000,000 homeowners, about 90% of the American population is doing just fine with their house, thank you!

If we (the government) keep developing more ways to spend money… I mean, “help the downtrodden homeowner,” the 90% could easily have another 5% impact: we could drop to 85% of the homeowners doing fine. To counter a popular theme, the mortgage industry didn't just give a mortgage to anyone and everyone who could sign their name. As hard as it is to believe, people actually got turned down for mortgages over the last 2 to 3 years, as they had for decades before. Everyone who is an investment advisor on Wall Street isn't a Bernie Madoff; every governor isn't a Blogo; and every baseball player doesn't take steroids. (I am not as confident on that last one.) The mortgage industry didn't just have 6 or 7 good years before finding itself in this crisis. It has had a lifetime of good years, at least my adult lifetime (my first mortgage was in 1968).

From my perspective, the crisis hasn't done anything to really improve the mortgage market and in fact has hurt it in several ways. I have watched and listened to the politicians talk about the problems in the industry, generally reaching the wrong conclusion from the data, and then move in the wrong direction, in my opinion, with their quick fixes. Therefore, I am going to break down the basis of how a loan is originated and why those who are the most verbose have the least knowledge and generally the worst solutions.

There are four factors to consider when determining the viability of a borrower and the worthiness of the property that will be the security for the loan. The four are earnings, reserves, loan to value and credit, in no particular order. The biggest complaint by the pundits in the way we did business was giving 100% mortgages and not checking the earnings of the borrower, especially those who were NOT self employed. The least important of the four, according to the industry, are the reserves of the borrowers. Loan to value doesn't seem to catch much of the critics' attention, except it can't be 100% and "it seems a lot of the homes are underwater". The type of programs that were offered haven't seemed to do much to gain notoriety, even the "Option Arm", which did and is still doing maximum harm to many (not a sub-prime loan). So let's look at the fixes!

If you are going to buy a home today in the popular price range which is covered generally by conforming loans, Fannie Mae and Freddie Mac, as well as the FHA, you are required to put down a whopping 3.5%. If you are or have been in the military and have your VA available, forget the 3.5%, it is back to zero percent, up to $417,000. What about the 20% down we all felt was necessary? Fannie and Freddie have a surprise for you. If your credit score is 699 or less, and you put 20% down, your credit score adjustment fee is 1.5% of the loan (new fee). On a $250,000 loan, that would be $3,750 (as an aside, that was my down payment when I bought my first house, and I actually borrowed that from a friend.) As your credit score decreases from the 699, you can easily pay double for the credit score adjustment, 3%, or $7,500 per our example. This fee does not buy down the interest rate, it is just a fee that goes to Fannie and Freddie.

Let's examine what has happened. Fannie and Freddie, who need more earnings, found a way to accomplish this by all types of fees for "credit adjustments" and other reasons, including cash out of your property. If you took out a second trust deed or HELOC after buying your place, and now you would like to roll that payment into a new first mortgage, that is now considered cash out, and yes, you guessed it, there is a fee from Fannie and Freddie. Obviously, the borrowers are being pressed into service to get Fannie and Freddie healthy again. I may be wrong, but that doesn't seem to be a boost to real estate. Banks and brokerage houses have also been hurt in this downturn, and I don't see large fees to use their products.

I moved off the point for a moment, which was no longer getting into a house without a good down payment. Forgetaboutit! So let's move on to checking people's income. What does a tax return show you: how well the borrower did in the PAST. It doesn't do a thing for the future, when the borrower will be making the payments on the house. Just ask the employees of Circuit City, Lehman Brothers, Mervyns, IndyMac Bank and several hundreds of other businesses. The stubbornness of my industry to insist that this is the premier way to ascertain the borrower's ability to repay the loan has been one of the large contributing reasons for the problems we are having.

I believe we should concentrate on the present if we can't use the future. If a borrower has good credit (say, 700 or above) a low loan to value (like 60% or below) and has liquid assets equal to a minimum of a year's gross income, or 50% of the balance of the loan or some combination thereof, this borrower should be acceptable for a lower rate on a refinance.

We would have enough information from the credit report, the value of the house and the fact that the borrower has sufficient liquid assets to care for the loan under any circumstance. Unfortunately, this method of loan approval has been ruled out since December 15, 2008. You obviously can figure out what my opinion is about this ruling?

Liquid reserves, to me, are the answer to most financial problems. If you are still nervous about my idea set up a scale that has the most reserves needed, and seasoned for the longest time, when the loan to value is between 60% and 70% and the credit score is between 680 and 700. At this level, I would want 1 year's gross income in liquid assets that have been seasoned for 1 year (in the borrowers possession). Decrease the reserve requirement as the loan to value drops and the credit score rises, to a maximum of 740 credit score and 50% loan to value. At that value, I myself would be satisfied with 6 months of gross income in liquid reserves that have been seasoned for 6 months.

What we need is common sense and reasonable rules. We need to strengthen the mortgage industry, not destroy it.