The Dark Side of Mortgage Lending

This HuffPost article about a Virginia couple who got roped into an unaffordable mortgage just makes my stomach churn. So much of what this article describes could have been avoided if people had just used their brains. If you want to read it as a cautionary tale against entering into financial deals you don't understand, it's compelling.

Lenders have, for years, made loans to borrowers who were not asked to verify the income that they stated on their applications. At one time, these loans made sense. There are numerous borrowers who have very complicated income stories that tax returns and W-2s do not adequately explain. I am working with someone who is like that today. He is an international investor and manages a hedge fund. His income is well sheltered and accounting practices allow him to report only a minimum amount of income as capital gains. Most lenders do not have the sophistication to analyze tax returns to the point where they understand capital gains, and many of them simply exclude such income. And yet, he regularly carries five figure debts on his American Express card, has a car loan and rented an expensive apartment near the beach. Someone with his lifestyle is either a crook living off of other people's money or really makes that money. Two plus years ago, he would have been a perfect candidate for a "Stated Income" loan. If he had very good credit, and was putting down enough on the purchase or had enough equity for the refinance, it would make sense to grant that loan.

The problem is that those who originated those loans figured out quickly that, if lenders aren't going to bother with verifying income, they could put whatever they wanted on the application so long as the amount resulted in an adequate ratio of debt to income. Therefore, you saw lots of teachers or police officers (or janitors, or ditchdiggers) applying for loans stating that they made double or triple what they actually made. Couple this with the fact that lenders made it OK to qualify applicants on the low-interest-rate "teaser" payments instead of the full payment after the teaser rate expires (or, worse still, on just the interest portion of the payment, ignoring the portion devoted to reducing principal).

Before stated-income loans were eliminated as a product line, a test was developed whereby lenders determined if the stated income was reasonable in light of the applicant's profession and length of time on the job. Trouble was that there wasn't much data available, and the test was flawed at best.

In the case described in this article, add the fact that the applicants were illiterate and had no idea what they were signing. If a couple like this is working with a broker or lender who does not take seriously the notion that they are acting as "financial advisers" to this couple, the result is a disaster. In my business, I regularly advise customers who are interested in an adjustable rate mortgage that their payment at the end of their fixed rate period may be more than they can afford -- we simply have no way of knowing where interest rates will go. It is for this reason that I advise customers to opt for a more expensive fixed-rate loan if they can afford it, or to count on a double payment once the rate adjusts.

Further, the article states that the creditworthiness of the couple was suspect. This was another thing that lenders ended up doing. When I worked at Indymac Bank, I regularly saw stated income loans fund that represented up to 95% of the value of a home that hadn't even been built, with borrowers who had what I would call marginal credit (it would be credit that would exclude an applicant today). And, in August 2007, when the shit hit the fan in the mortgage industry, it was these loans -- high loan to value, low credit, stated income -- that blew up and went into default most often.

The broker described in this article, and the lender who approved and funded the loan, simply held their noses (and, in the broker's case, broke the law) and funded the loan to add to their funding volume and their incomes. But the couple bear some responsibility as well. Simply telling someone "I'm illiterate, and you have to tell me what it is I'm signing" doesn't mean that's going to happen. A consumer like that needs someone he trusts in his corner, who understands the lending process and can adequately explain what the documents say. It can be as simple as reading the heading on the Promissory Note, which will usually read "Adjustable Rate Note" if the loan is an adjustable rate mortgage. This Virginia couple were too trusting of the people around them, did not understand the transaction, and should have simply refused to sign anything until someone they knew and trusted could explain it to them. Putting their signature on an inaccurate or misleading application is a commission of fraud, and even if they were duped into signing the document, at least they exposed themselves to prosecution for fraud.

Today's lending environment is the most cautious one in which I've ever worked. We require so much documentation that it's almost impossible to commit fraud. In fact, those who do the income/credit analysis put their jobs on the line if they make even as few as two mistakes in a month. When one is reviewing 5-10 files a day that contain up to hundreds of pages of documentation, the odds are good that one will make a mistake. But, as they say, the lock on the door will only keep out the honest man, so a way will be found to get around the rules.

I feel for the couple in this article. I also sympathize with the broker and the employees who worked on the loan. It's tempting to look the other way when thousands of dollars in income are on the line. I've left a lot of money on the table because I won't go there.

One day, these types of loans will return, and there will be enough controls to make them a lot safer. Only self-employed people will be allowed to apply, and the loan will not exceed 60-70% of the home's value, and the applicant will need a minimum of a year's payments in the bank. Either that, or self-employed people will have to report their incomes differently (and pay the taxes they so eagerly try to avoid paying) if they wish to qualify for mortgages that exceed what their tax returns currently will allow. Either way, it kinda sucks.