Basic Characteristics and Life of Residential Mortgage Loans
In today’s real estate mortgage market, it is essential that the expert understand, be fully aware of, and cognizant of the entities involved and their roles in initiating, processing, underwriting and funding all types of prime and subprime residential mortgage loans including ones. In addition, the stages that a prime and subprime residential mortgage loans processes through during its “life” are also crucial. The following is a summary of these two areas.
The Entities and their Roles
To understand the steps that a residential mortgage loan goes through, each of the persons/entities involved in the various residential mortgage loan stages must be defined. These six persons/entities involved in this process are the borrower, mortgage broker, mortgage banker, private mortgage insurance provider, secondary market investor and loan administrator/servicer.
A borrower is a person purchasing or refinancing a residential property who through a mortgage broker obtains a mortgage loan for the purchase or refinance.
A mortgage broker is a firm or individual who for a commission matches borrowers and lenders. A mortgage broker takes the borrower’s application and processes the loan with the mortgage banker, but generally does not use his own funds for closing.
The National Association of Mortgage Brokers has a Code of Ethics. For example:
➢ Honesty & Integrity
NAMB members shall conduct business in a manner reflecting honesty, honor, and integrity.
➢ Professional Conduct
NAMB members shall conduct their business activities in a professional manner.
➢ Compliance with Law
NAMB members shall conduct their business in compliance with all applicable laws and regulations.
A mortgage banker underwrites the risk involved in making a mortgage loan to determine whether the borrower satisfies the loan underwriting guidelines for the loan program and to ensure the associated risks are acceptable. After underwriting approval, the mortgage banker funds and closes the mortgage loan. Then the mortgage banker either sells/ships the mortgage loan to the investor or retains it in its own portfolio. In addition, the mortgage banker performs a quality control audit on a statistical sampling of the closed mortgage loans to detect fraud and to insure compliance with policies and procedures.
The Mortgage Bankers Association of America and the various states Mortgage Bankers Association have a Canon of Ethics and Standards of Practice. For example:
➢ Canon One ─ Professionalism: Members conduct their business in a professional manner, insuring that their personnel are knowledgeable in the areas of real estate finance in which they participate and are acting in compliance with sound industry practices.
➢ Canon Four ─ Public Trust: Members do not commit fraud or misrepresentation against the public and will endeavor to protect the public against fraud, misrepresentation and unethical practices of the real estate finance business.
➢ Canon Five ─ Disclosure of Information: Members provide accurate, timely and meaningful information to those with whom they do business.
➢ Canon Ten ─ Sanctity of Agreements: Members do not breach or avoid an agreement or commitment, whether written or oral.
Private mortgage insurance (PMI) provider provides insurance protecting the mortgage investors against financial loss occasioned by a borrower defaulting on the mortgage loan. PMI insurance is required for any loan with a loan-to-value of higher than 80%. The PMI provider can either underwrite each loan itself or delegate this responsibility to the mortgage banker/underwriter. The PMI provider has no direct relationship with the borrower or the mortgage broker. The PMI provider relies on the mortgage banker who in turn relies on the mortgage broker for information for underwrite. In this instance, the underwriting of the PMI insurance underwriting was delegated to the mortgage banker, which further enhances the need for the PMI provider to be able to rely on the mortgage banker to ensure that the loan is properly underwritten.
Secondary market investors are Government-Sponsored Enterprises (GSEs), private conduits, or investors who purchase mortgage-backed, long-term investment instruments made up of pooled individual residential mortgage loans.
Loan administrator/servicer is an institution servicing and acting for the benefit of ultimate investors regarding the mortgage loans. Functions include collection of payments for borrowers, customer service, advancing funds for delinquent loans, and taking defaulting properties through the foreclosure process.
For example, a borrower would go to a mortgage broker who would take an application and process the loan request by collecting all the other necessary information from the borrower. Then the mortgage broker would send the application along with the information he collected from the borrower to the mortgage banker, which would then underwrite the loan utilizing the three “C”s ─ collateral, capacity, character. After a complete underwriting and approval including PMI insurance, if the LTV is greater than 80 percent, the funder (in most cases the same as the underwriter) would then fund and close the mortgage loan. At this point the mortgage banker would either retain the loan for its own portfolio or sell the loan to secondary market investors, such as Fannie Mae or Freddie Mac.
If the mortgage loan goes into default, the loan administrator/servicer would liquidate the property and seek any deficit to be reimbursed by the PMI insurer, if the loan had it. However, if the original mortgage loan is not underwritten properly, for example, known information is not used by the mortgage banker and/or the mortgage broker or fraud has occurred by the mortgage banker and/or the mortgage broker, then the PMI insurance is negated and the mortgage banker must repurchase the loan from the secondary market investor.
Residential Mortgage Loan Stages
There are up to seven different stages for every residential mortgage loan. These seven stages are:
I. Loan production
II. Loan processing
III. Loan underwriting
IV. Loan closing
V. Shipping and delivery
VI. Quality Control
VII. Loan Administration
I. Loan production is the origination of residential mortgage loans. The originators can be either wholesale (external) or retail (internal) for a specific mortgage banker. The mortgage banker can have direct employees acting as residential mortgage loan originators who solicit the residential mortgage loans directly from the public.
At the same time, the mortgage banker can have arrangements with mortgage brokers to wholesale residential mortgage loans for possible consummation by the mortgage banker. The mortgage brokers directly solicit borrowers seeking residential mortgage loans so that the mortgage brokers can find a mortgage banker willing to make the residential mortgage loans being sought by the borrowers. In other words, mortgage brokers act as the marketing arm for the mortgage bankers.
II. Loan processing is performed by the mortgage brokers as part of their duties and responsibilities to the borrower and the mortgage banker. Loan processing is succinctly described in the Handbook of Mortgage Lending published by The Mortgage Bankers Association of America:
Loan processing consists of two very important functions. First, loan processing includes the gathering of verified documents that confirm credit, income, and collateral information about the applicant, loan, and the real estate. This verified information allows the underwriter to access the applicant’s ability-to-repay the mortgage and the adequacy of the collateral securing the mortgage loan. Second, loan processing involves a collection of various data required for closing of the loan.
III. Loan underwriting is performed by the mortgage banker’s underwriter who decides whether the loan will be consistent with governing loan program underwriting standards and, therefore, should or should not made by the mortgage banker. Also, the mortgage banker’s underwriter, where the PMI underwriting is delegated to the mortgage banker, decides whether the loan qualifies or does not qualify for PMI insurance. Based on at all the information gathered during the wholesale loan processing by the mortgage broker, the loan underwriter analyzes and considers these three areas of risks ─ collateral risk (loan-to-value), capacity risk (ability-to-repay/income) and character risk (credit, reputation).
Collateral risk is analyzed by reviewing the appraisal to ensure that all the criteria required by the appraisal standards are met. Second, the underwriter must address the liquidation value of the property if it should go into foreclosure. Third, the underwriter must address the marketability timeframe if the mortgage banker had to sell the property after foreclosure. After determining that the answers to these areas are satisfactory, the underwriter determines the appropriate loan-to-value (LTV) ratio for the collateral.
For capacity risk, the underwriter must analyze and evaluate how much income the applicant has to devote to the mortgage payments. Traditionally, the applicant’s income from salaries, overtime, part-time and second job income, commissions, interest and dividends, annuities, investments, trust income, etc. is substantiated by the applicant providing tax returns, W-2’s, pay stubs, etc.
Over the last 20 years or so, mortgage bankers have accepted more and more “reduced documentation loans”, which, for a higher interest rate paid to the mortgage bankers, allow loans to borrowers without requiring them to fully document their income, assets and/or employment. Reduced documentation loans include “No Income/No Asset” (or “NINA”) loans. “No Income/No Asset” is a bit of a misnomer in that a borrower cannot qualify for a loan if he or she has “no income” or “no assets”. Rather, a NINA program is a program that does not require the borrower to document his or her income or assets in the painstaking detail required by traditional, full-documentation loan programs. Originally, NINA loan programs were geared towards busy professionals who did not have the time or inclination to provide full documentation in support of their applications. NINA loan programs have also been geared towards borrowers who have greater difficulty providing traditional, full documentation in support of their applications, such as self-employed borrowers or borrowers employed by foreign employers. In all instances, however, the underwriter must assure himself that the borrower has the ability to repay the loan. In my 40 years of experience, I have never encountered a program that permits loans to be made to borrowers who have no income, no assets and thus no ability to repay their loans.
Under the traditional income analysis, the underwriter calculates two qualifying ratios. The first is the Primary Housing-Expense/Income Ratio, which is also called the front-end ratio. The second is the Total-Obligations/Income Ratio that is also called the back-end ratio.
The underwriter determines the Primary Housing-Expense/Income Ratio by adding up all the monthly housing expenses (generally, mortgage payment, association dues, special assessments, house insurance, mortgage insurance and property taxes) that the applicant will have upon receiving the loan and occupying the property and dividing this by the monthly income that the underwriter determined from his income analysis.
The underwriter determines the Total-Obligations/Income Ratio by adding up all the total monthly debt payments, which includes the monthly housing expenses plus any other debts or obligations (credit cards, child support, alimony, lease payments, car loans, home-equity lines, unsecured lines of credit, term loans, etc.) with the remaining terms exceeding a specified period, and dividing this by the total monthly income that the underwriter determined from his income analysis.
Some mortgage banker’s loan programs – usually NINA loan programs – do not require ratios to be calculated. However, even if ratios are not required to be calculated, where information is provided by a borrower suggesting ratios that exceed those that are generally accepted in the industry, a prudent underwriter would not make that loan or, at the very least, would request further information from the borrower to verify his or her ability to repay the loan.
Agency guidelines (including Fannie Mae, Freddie Mac and FHA) state generally that for adjustable-rate mortgages (ARMS) the Primary Housing-Expense/Income Ratio should be 28% and the Total-Obligations/Income Ratio should be 36%. For fixed rate mortgages, the ratio percentages are 33/38. Slightly higher ratios are sometimes allowed, but are generally capped at five points above the benchmark, i.e., 28/36 for ARMS and 33/38 for fixed rate mortgages.
The underwriter must also evaluate the character risk of the borrower. Statistics have shown that past satisfactory payment credit history indicates with high probability that the prospective borrower will make future payments including this new loan. The underwriter analyzes the prospective borrower’s credit history by obtaining a Residential Mortgage Credit Report (“Credit Report”). This Credit Report includes the prospective borrower’s credit histories for the last seven years. This includes credit histories for credit cards, automobile loans, student loans, other home loans, etc., as well as negative credit information including bankruptcies, notices of default, foreclosures and public records. As a requirement of the Credit Report, it must contain at least two of the three borrower’s FICO scores ─ Fair Isaac Score, Beacon Score and Empirica.
A FICO score is a numerical value that ranges between 300 and 850, with the low end of the scale representing a poorer credit risk. Loan entities then use the borrower’s FICO score to chart whether or not a prospective borrower is eligible to receive a mortgage.
During the underwriting process, the underwriter must continually be aware of the “red flags” that indicate that the borrower may have problems repaying the loan, that the borrower may not qualify for the type of mortgage loan being sought or that there may be fraud. Freddie Mac has put out a guide called Fraud Prevention Best Practices that outlines these red flags for the various documentation provided by the borrower, the appraiser and the credit reporting agencies.
For example, among the 15 red flags for a mortgage loan application are significant or contradictory changes in debt from the initial to final application and a non-purchasing spouse. For credit reports, among the 17 red flags are employment cannot be verified by a credit bureau, recent inquiries from other mortgage lenders and indebtedness discussed on the mortgage application varies from that reflected on the credit report.
IV. Loan closing is the stage where the mortgage banker’s loan closer reviews the file for completeness and orders the loan documentation prepared. The loan documentation is then sent to the closing agent, i.e., escrow company, Title Company, attorney, for legal execution of the loan documents. After receiving back the executed documents from the closing agent, the loan closer verifies the signed documents and authorizes funding of loan proceeds that are then wired transferred to the appropriate bank account of the closing agent.
V. Shipping and Delivery. Once the loan is closed, the mortgage banker has to decide to either retain the loan in its portfolio or ship the loan to fulfill its sales commitments to GSEs or other secondary market investors.
VI. Quality Control. Mortgage bankers must perform ongoing quality control audits of a statistical sampling of the mortgage loans that they make. This quality control is to detect not only fraud, but also to detect minor/major deviations from their own internal policy and procedures. The auditor accomplishes this by physically reunderwriting the mortgage loan and reverifying some or all of the borrower information. In some cases, actual telephone or possibly in-person interviews of the borrower may be part of the audit.
VII. Loan Administration/Servicing. This is the administrative and financial duties associated with the management of closed mortgage loans for investors/owners. For example, some of these duties include the collection of mortgage payments, escrow administration, foreclosures and customer service.
Understanding these basic characteristics and “life” is paramount to evaluating, reviewing and opining on residential mortgage loans.
1. Hutto, Gary W. and Jess Lederman, Handbook of Mortgage Lending (Washington, DC: Mortgage Bankers Association of America, 2003).
2. Black’s Law Dictionary, Abridged Seventh Edition (St. Paul, Minnesota: West Group, 2000).
3. First American CREDCO, Fair, Isaac Credit Bureau Risk Scores Information Packet, April 2001.
5. Everything Real Estate, FICO Scores (www.everythingre.com/FICO_Scores).
6. Mortgage Bankers Association of America, Closing, Shipping and Warehousing (Washington, D.C.: Mortgage Bankers Association of America, 1991, 1999).
7. Mortgage Bankers Association of America, Mortgage Banking Terms 9th Edition (Washington, D.C.: Mortgage Bankers Association of America, 2002).
8. Mortgage Bankers Association of America, Residential Mortgage Banking Basics (Washington, D. C.: Mortgage Bankers Association of America, 1998).
9. Mortgage Bankers Association of America, Canon of Ethics and Standards of Practice (Washington, D. C.: www.mortgagebankers.org/membership/mission, 2002).
10. Mortgage Bankers Association of Georgia, Canon of Ethics (Macon, GA: www.mbag.org/ethics.html, 2003).
11. National Association of Mortgage Brokers, NAMB Code of Ethics (McLean, VA: www.namb.org/membership/code_of_ethics.htm, 2004).
12. Department of Real Estate, State of California Using the Services of a Mortgage Broker (www.dre.ca.gov/mlbrkr.htm, February 3, 2003).
13. Division of Consumer Affairs, State of Washington Chapter 19.146 RCW Mortgage Broker Practices Act (www.dfi.wa.gov/cs/rcw19146.htm, June 1, 1994).
By B & F ExpertsABOUT THE AUTHOR: J F.
Financial Institutions, Mortgage, Banking & Real Estate Expert Witness
Financial Institutions, Mortgage, Banking & Real Estate Expert Witness
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.