Yesterday we discovered that, in being to thine own financial interests true, mortgage brokers claim they work neither for consumers nor for lenders.

“Neither a borrower nor a lender work for.

And it shall follow as the night the day.

Thou canst not be sued by any man.”

Imposing a fiduciary duty would increase the risk of litigation over whether brokers are to blame for loans that go bad, says Joseph Falk, legislative chairman of the association. He adds that the group favors clear disclosures to consumers and no hiding of important details.

Mr. Falk is right — litigation risk would rise.  Yet litigation is also the means of pursuing a legitimate grievance, so its possible rise is not ipso facto proof that adding fiduciary duty would be unwise.

For now, most states lack any legal provision spelling out whether brokers have a fiduciary duty. Many brokers sell a relatively small range of products without being obliged to make sure the consumer gets the best terms known to the broker on a suitable loan.

Yet that’s true of every salesman!  There’s a reason we all know the Latin for caveat emptor.

They receive fees — often totaling between about 1% and 3% of the loan, but occasionally even more — for finding customers and guiding them through the loan process.  

Even though the fees are expressed as percentages, it’s helpful to think of them in total dollars for the unit service.  Place a $150,000 loan, and the broker may make $1,500 to $4,500.  By itself that’s not a huge amount — provided the borrower (who’s paying it in economic reality) is aware of the charge.  Sometimes, unfortunately, the buyer is unaware:

These fees come either from borrowers or through payments from lenders known as yield-spread premiums, or YSP, or through a combination of the two.

Fee?  What fee?

For the moment this sounds simply like a commission embedded in the calculation of loan total proceeds, but it’s subtler than that:

… when the borrower is paying a higher interest rate than the best he or she could qualify for, which makes the loan more profitable for the lender.  

If the broker persuades the customer to take a loan whose rate, for one reason or another, is higher than that same lender would offer, one might think that either the lender or the broker would let the borrower know, and adjust the rate downward. 

Your broker told us your interest rate should be lower, so here’s a check

Not so:

Lenders pay YSP to the broker …

Got that?  The overcharge, if I may so call it, is pocketed by the intermediary.

The higher the rate, the higher the payment to the broker.  (Some lenders put a ceiling on YSP.)  Lenders may also pay brokers a bonus for loans with prepayment penalties, which make it expensive for borrowers to refinance within the first few years.

This sounds very much like a commission for overcharging borrowers.

YSP amounts to “a payment for giving the homeowner a worse deal,” says Prentiss Cox, an associate professor of law at the University of Minnesota who previously investigated lenders as an official in the state attorney general’s office.

It certainly is!

In some cases, paying a slightly higher rate and allowing the broker to receive YSP can make sense for cash-strapped borrowers who don’t want to pay an immediate fee to the broker. With YSP, the cost of the broker’s service is spread over the life of the loan in the form of higher interest.

If they know they’re being charged it!

Yield spread premium?  I can’t see any yield spread premium!

But Howell Jackson, a professor at Harvard Law School who has analyzed thousands of home loans, says YSP is confusing for consumers and can allow brokers to “extract excessive payments” from unwary borrowers.

For what it’s worth, I’ve never heard of YSP in a residential loan context, and I’m mortified that it’s considered standard practice.  There should be a duty to disclose and adjust before closing.

In Washington, legislation was introduced this month by Sens. Charles Schumer (D., N.Y.), Sherrod Brown (D., Ohio) and Bob Casey (D., Pa.) that would impose on brokers a fiduciary duty to put their customers’ interests first. The proposed legislation is considered a long shot for this year.

In Minnesota, legislation enacted last month specifies that brokers have “an agency relationship” with borrowers, meaning they must act in a borrower’s best interest and can’t put the broker’s interests first.

An ‘agency relationship’ is within putting distance of ‘fiduciary duty’, and gives the consumer the same reasonable expectation.

Colorado legislators recently shied away from imposing such a standard. Instead, the state House and Senate passed bills stating that brokers have only “a duty of good faith and fair dealing.”

California is an exception. A 1979 ruling by the state Supreme Court established that mortgage brokers there do have fiduciary duties. Pete Ogilvie, president-elect of the California Association of Mortgage Brokers says that hasn’t caused him any problems and clarifies his role.

How many mortgage brokers have a code to live by?

In AHI’s listing of the right policy questions, I asked:

Some systemic weaknesses we’ve seen suggested already are:

1.       Should consumers have more disclosure?  Many borrowers claim, very plausibly, that they were duped or at the very least under-informed.

As Polonius said it, four hundred years ago:

For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

In view of the undisclosed and substantial yield-spread premium, and California’s painless adaptation to a fiduciary-duty standard, there’s no question: where California went 28 years ago, the other states should go tomorrow. 

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“I’m innocent and you’re guilty!“

the search for blame among the lending community’s dramatis personae is increasingly zeroing in not so much on the subprime lenders as companies but rather on the individual originators –

I think I see a mortgage broker in the trees

mortgage brokers — who placed customers into the loans:

Originator. An individual who works for a mortgage broker or direct lender, and who interviews the applicant in hopes of turning him into a borrower.

Now then, Mr. Apricot, do you qualify for this loan?

As Bob Hagerty of the Wall Street Journal provocatively asks:

The political debate over how to deal with a surge in defaults on home loans is raising a question that consumers ought to consider: Is my mortgage broker really working for me?

To which the answer is, “Of course not.”

“He’s not?!?”

“Why would you think so?”

Borrowers often see mortgage brokers as their allies, searching far and wide for just the right home loan at an attractively low price. But many brokers are making it clear they don’t see things that way. They are fighting efforts by federal and state politicians to impose a fiduciary duty on them to put their customers’ interests first, as lawyers, real-estate agents and financial planners generally are required to do with their clients.

“The mortgage broker does not represent the borrower,” says Chris Holbert, president of the Colorado Mortgage Lenders Association. “We sell access to money.”

“Selling access”? Spoken like an independent actor!

“Don’t look at me, I just sell access to money.”

Such a view is seemingly at odds with the CMLA’s noble statement of “Who We Are“:

Who We Are

The Colorado Mortgage Lenders Association is an organization committed to a world of homeownership achieved through the practice of integrity-based lending. We serve our community through effective education, principled representation, and gracious networking to advance free enterprise and the highest ethical standards in the mortgage lending industry.

Apparently “highest ethical standards” can be loosely translated as “selling access to money.”

The industry group recently opposed language in Colorado legislation that would have required mortgage brokers to act “primarily for the benefit of the borrower.”

We’re against having to work primarily for benefit of the borrower

That provision was later deleted.

There goes that nasty fiduciary duty

I’m sure they had their reasons, although what those might be is, shall we say, not readily apparent, since lawyers, accounts, securities brokers and others have been generally found to have fiduciary duty, and have learned to live with it.

Brokers, most of whom are lightly regulated by state agencies, are involved in originating around 60% of all home loans, according to Wholesale Access, a research firm in Columbia, Md. The industry is under scrutiny in Washington and state capitols because rogue brokers have been accused of contributing to the spike in mortgage defaults and foreclosures by encouraging borrowers to take risky loans and by charging excessive fees.

You’ve contributed to a spike in defaults!

That doesn’t mean consumers should shun all brokers.

No need to avert your eyes, folks

Many provide good service and can help people sort through the complexities of choosing a loan.

I’ll go further than Mr. Hagerty — most mortgage brokers add value for their customers.

Why then the resistance to a fiduciary standard?

Consumers don’t necessarily get a better deal by going directly to lenders, which also can charge excessive rates and fees.

Like their cousins the real estate attorneys, mortgage brokers perform services, assembling and analyzing customer information, helping customers determine how big a loan they can prudently afford, and in general providing the front-end loan application assembly that lenders value. But as classic middlemen, they are paid contingent, if and only if the loan actually closes, which means they are pro-transaction.

We get paid only if you buy!

None of this is to say that mortgage brokers are any more venal than the rest of us. It’s simply a feature of their economic incentives.

Commission? Commission?

When you are paid a commission wholly contingent on closing a transaction, you have an economic incentive to be pro-transaction. When you further space each customer’s transactions apart by many years, past the memory and grudge horizon, you invite short-term behavior to the customer’s detriment.

Camilo Ramos, a house painter and remodeler in Minneapolis, wishes he had asked a few more questions of his broker before refinancing a home loan last year. Mr. Ramos says he wasn’t warned how much his monthly payment on the $300,000 adjustable-rate mortgage could jump after an initial low-payment period. The brokerage firm, Source Lending Corp., Brooklyn Park, Minn., received total compensation of $13,517 from the transaction, says Jeff Skrenes, a member of the Minnesota branch of the Association of Community Organizations for Reform Now, a nonprofit advocacy group [that is not universally beloved -- Ed.], which is trying to help Mr. Ramos refinance into a more suitable loan.

There’s no question fees of 4.3% of loan proceeds are way higher than they should be.

Chris Hacker, owner of Source Lending, says his firm did nothing wrong in this transaction and adds, “We have thousands of satisfied clients.” [Google finds at least one dissatisfied one -- Ed.]

Favorable behavior occurs only when there is a time series record, so the prisoner’s dilemma effect of reputation can come into play — hence Mr. Hacker’s invocation of his thousands.

Every one of us a satisfied customer

When the professional-client relationship is brand new, it’s risky. As I previously expressed it:

Welcome to the realm of agency risk. The financial interests of the individual originator are misaligned with those of the borrower family, and with her own company. It goes like this:

1. Applicant lacks enough income to repay loan, so unscrupulous originator commits fraud by inflating borrower’s income.

2. Borrower now qualifies for a loan.

3. When loan closes, originator is paid a closing fee (often, one percent of the loan), and has no further responsibilities.

Got it? Lying about a borrower’s income is worth money for the originator unless somebody catches on.

Flight is always part of the business model

Meanwhile, the poor borrower is stuck with payments he cannot afford:

How then to pick a good mortgage broker?

Ask tough questions first. Among them: In searching for loans, do you feel obliged to put my interests ahead of yours?

Is that a trick question?

Exactly how much will you earn on this loan? And how many lenders do you check regularly for rates and terms?

Some brokers offer to fix their fees in advance so they won’t have any incentive to recommend a loan that would be more lucrative for them.

Fixing the commission amount changes one incentive — which loan to take — but leaves the more fundamental one untouched — just do a loan, any loan, no matter how it is.

Trade group Upfront Mortgage Brokers Association maintains a list of brokers who set their fees in advance.

We set our fees in advance

The National Association of Mortgage Brokers, the main nationwide trade group for brokers, argues that brokers work neither for consumers nor for lenders.

If you work neither for buyer nor for seller, are you working for anyone but yourself?

Shouldn’t your customers know this?

Did you know that my glasses have no lenses in them?

[Continued tomorrow in Part 2.]

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They never found it, but in the process they discovered the Pacific Ocean, tobacco, and the New World.

Every government or policymaker I’ve ever encountered thinks of affordable housing as a temporary challenge, something that arises out of unusual current circumstances, but will cure itself if just we can get through this interval.  As I wrote a few years back:

Today’s affordable housing production and preservation programs set a goal of ‘permanent affordability.’  But though this objective is laudable — indeed, it is the right programmatic design parameter — it is unattainable.  Because the future is infinitely complex, with more things in heaven and earth than are dreamt of in our policymaking, programmatic cohorts experience steady attrition on the upside (conversion) and downside (default) — and those rates of attrition tend to increase over the years, as fickle reality diverges ever more from the original program-design environment.  

Indeed, government thinks that if there is an affordable housing problem, we can just create new homes, and they will provide for our population:

Fortunately, from time to time government does inaugurate a successful program that gives birth to a property cohort: hundreds or thousands of properties with a very high degree of similarity because they were all developed more or less contemporaneously under a standard production program.  Creation of that successful cohort is the triumph of production. 

Every one of us is identical, and perfect

When a program turns into production, with ribbon-cuttings and smiling happy families —

Always let the elected official wield the big scissors

— policymakers understandably tend to declare victory, slap dust from their palms, pat each other on the back, and move on to the next crisis.  Meanwhile, the Aristotelian perfection of their creation immediately starts to dissipate:

Almost immediately after its creation, the cohort of properties starts to diversify.  How and why it does creates profound challenges for enduring sustainable affordability. 

Though properties start out similar, they rapidly diverge:

Imagine a race of a thousand identical rubber ducks, utterly alike except in their numbering, all dumped into a slow-moving river at the same point and the same time. 

That’s what happens when you create a big new funding program

At first they move in a jostling mass, but inevitably a few are in front, catching the narrows and shooting ahead.  Those to the sides may be caught in small eddies. 

Some may become entangled in shorebank branches.  Bit by bit they separate from one another, until they are stretched the length and breadth of the river, some clustered in independent flotillas, others completely isolated. 

Consider a portfolio’s performance over time as being represented by a two-dimensional graph:

·         The vertical axis ranks the properties from best (at the top) to worst (bottom). 

·         The horizontal axis measures time from original production. 

Then we can draw two lines indicating property viability:

·         Conversion viable: A top line heading down indicating that some properties become more valuable as conventional real estate than they are as affordable housing. 

·         Affordable non-viable: A bottom line heading up, indicating that some properties no longer work.  They are headed for default and foreclosure. 

Above the top slanting line, the properties can go market.

Below the bottom slanting line, they are non-viable without help.

At inception, everybody is alike:

Little boxes, little boxes …

Yet differences of location, construction, rentup, operations, ownership, management, and random local events, all mean that each property becomes distinct.

But sooner or later, the original cohort will have divided into three basic groups:

·         Conversion.  Properties economically viable for market conversion. 

·         Equilibrium.  Properties that are neither conversion nor non-viable. 

·         Non-viable.  Properties that are no longer viable as affordable housing. 

Naturally enough, policy makers view both changes are losses of affordability, so they both try to intervene to prevent loss and design contingent rights into the original documents:

Policymakers, recognizing this, have in most programs sought to cap the exit of conversion-viable properties.  Typically, the financing instrument requires the owner to waive the legal ability to convert for some (long) time.  In the short run, this is fine, because it suppresses conversion …  but the instant the lock disappears, there is a burst of pent-up demand that sometimes turns what would otherwise be acceptable conversion triage into a stampede, as shown conceptually in Figure 2:

Once the bell rings, out they go!

Meanwhile, even as policymakers are trying to prevent loss from market conversion, they also create rescue programs for properties that are failing:

“Help!  I need some money!

Help!  Not just any money!

Help!  You know I need some one to he-elp!

When a cohort hits a systemic problem (such as 1974’s utility-cost spike), legislators often design a programmatic intervention.  Most such interventions do mitigate the loss of viability, as shown in Figure 3:

In the last 35 years, we can count at least seven significant program interventions:

1970: Birth of modern era in US affordable housing.

1976: Loan Management Set Aside workouts.
1981: The Economic Recovery Tax Act and resyndication.
1986: Tax reform and real estate pricing collapse (also led to the S&L bailout and FIRREA).
1989: Preservation (ELIHPA or LIHPRHA).
1995: Mark to Market (demonstration; permanent legislation in 1997).
1996: Preservation repealed; prepayment and opt-outs.
1999: Mark Up to Market and renewed affordability.  See Mark to Market, a Fundamental Shift in Affordable Housing Policy. 

Seven interventions in thirty years.  And each intervention further subdivided the portfolio. 

What does it all mean?

[Other than that we're overdue for major program reform in the United States, as I've posted on many occasions.]

There is no such thing as the perfect program.  Every so often, program rules have to be redesigned.  Experience shows this can be as frequently as every five years, but if we assume they alternate between bad (workout) and good (conversion) interventions, the half-life of a typical stimulus is about ten years. 

Since perfection is impossible, does that make all striving pointless?

Godel couldn’t decide

Paraphrasing Robert Louis Stevenson, we should travel hopefully, but expect never to arrive, instead periodically making changes.

Policymakers should recognize and accept that no matter how robust, any program will need periodic adjustments as its property cohort ages and diversifies.  This represents a huge challenge for government, because (a) government may be slow to recognize that what seem to be isolated failures are instead harbingers of the need for systemic change, (b) when the time comes to make changes, chances are it will be different individuals from those who created the original program, and they may lack historical context, and (c) often the key elements needing change are embedded in statute, and thus very hard to change. 

Statutes should specify less, not more: outcomes and boundaries, not processes or breakpoints.  Statutes should allow regulations and administrative guidance room to make periodic tweaks in program parameters, consistent with the broader objectives.  In effect, this principle reduces the cost of program modification, and thus increases a program’s practical flexibility. 

Related to the idea of administrative flexibility is participant flexibility:

Since environments change, programs may actually be more robust if they embed one or more options for either the public or private sector.  This is counterintuitive — how can creating a sunset make something more long-lasting? —

— but opening options raises public consciousness and creates the useful anticipatable turbulence that enables managed change. 

I’ve previously posted that affordable housing always costs money.  Related to this is the idea that to preserve existing affordable housing, government must from time to time provide financial incentives using three complementary strategies:

·         A property-level goal of durable sustainable affordability (that is, not permanent but decade-plus in half-life) to create a high degree of near-term stability in a fairly homogenous cohort of properties. 

·         Periodic property-specific interventions because, no matter how homogenous properties may begin their lives, they are affected by individual circumstances that need individual solutions. 

·         Periodic program redesign to adjust program parameters (based on What Works and What Doesn’t) to accommodate unexpected major events. 

As T. S. Eliot wrote, in Little Giddings:

We shall not cease from exploration
And the end of all our exploring
Will be to arrive where we started
And know the place for the first time.

A similar spirit must animate the quest for the perfect affordable housing program.  It may be El Dorado, fabulous but mythical, yet our search for it is endless, and endlessly rewarding.

Just keep looking

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Not only (as we saw two days ago) have the state housing finance agencies been able to lend in the subprime marketplace without experiencing high rates of default, we can also trace their lower defaults to specific structural elements in their business approach. Yesterday I listed the originate-and-hold business model, less aggressive underwriting, a prudent copycatting of market innovations. Today I’ve got three more things the HFAs doing right that the private subprime lenders didn’t.

Three things I know about her subprime lending

4. Pre-lending consumer education programs

As I’ve previously posted, a home is a complex financial instrument, mixing long-term planning, a large capital outlay (the down payment), behavioral changes, and substantial ongoing capital obligations. Owning a home requires a degree of financial sophistication considerably greater than being a renter — one of the many reasons people often start their independent adult living as renters and move up to homeownership. Logically, moving to homeownership means graduating to a new level of learning, and S&P says the HFAs make that consumer education integral to their loan origination:

HFAs see their primary motive as increasing housing affordability, so that their activities before and after the loan improve a borrower’s chances to repay it. HFAs offer homebuyer education classes that vary in rigor and length, but give an uninitiated customer background that helps prepare them to purchase a home.

Saving precedes borrowing, and first-time homebuyer applicants, who are by definition inexperienced in housing finance, need someone to trust as they learn about their new obligations and risks. A state-chartered, publicly accountable lender is and is perceived to be a bit more dispassionate and even altruistic, encouraging applicants to make decisions — including, sometimes, the decision not to buy a home.

Homebuyer education also provided the benefit of causing potential homeowners to pause, and even decide not to make purchases.

It’s not only lenders who win by losing; sometimes it’s aspirant homeowners who are better served by remaining renters.

5. Generous internal reserves

Though they operate as a business, because they are government-funded entities, HFAs have a cushion against failure — direct or indirect legislative appropriations — that means they need not run their engine in the red all the time.

I think the subprime margins are running too hot

The HFA single-family and multifamily indentures contain reserves that are sufficient to maintain adequate equity for foreclosure rates much higher than HFAs are experiencing.

They have the political and economic option to be more cautious in their deployment of capital, and to maintain larger reserves against adversity.

For example, an ‘AA’ rated indenture in a large state should be able to withstand foreclosure of 42% of the loans. Over-collateralization of assets versus bonds tends to be in the 5% to 15% range, which when combined with mortgage insurance and guarantees would enable an indenture to pay bonds should the foreclosure rate reach at least 42%, as described in the above example.

There’s a downside to all this accumulated money. Capital, like any other muscle, should be worked and toned.

I have twice the reserves I used to have

Leaving it on deposit in the HFA bank means that some number of houses that could be built, rehabbed, financed, sold, or made more affordable, in fact aren’t because the HFAs are being too cautious with their money. There are many contexts in which I believe HFAs could do much more than they do — but here, unquestionably, their high levels of reserves have protected them, and helped keep their bond costs low.

6. Active asset management with customized tools

The more financial tools you have, the healthier your portfolio

Because they hold on to their loans (even if packaged into bond issues), HFAs have their reputation behind their portfolio’s long-term performance. That, coupled with their public mission, makes them particularly attentive to asset management across several phases, starting with loan servicing and monitoring:

Following the closing on the loan, HFAs monitor loan repayment, sometimes even servicing their own loans.

That extends further to loss mitigation and restructuring:

HFAs also institute loss mitigation to help delinquent borrowers become current on their loans and avoid foreclosure. Of course, not all of these safeguards will be effective in every case, but they differ dramatically from more common lending practices.

As public bodies, HFAs also can tap quasi-social capital, including their own reserves or other grant funds bestowed upon them by Congress or their state legislatures:

Several HFAs are even offering to assist borrowers in danger of defaulting on subprime loans. Colorado Housing and Finance Authority recently initiated a program called HomeStretch, which is a $50 million pilot program with about $4 million in reservations, although no loans have closed yet. The loans will be 40-year, fixed-rate loans that CHFA intends to sell to Fannie Mae, but the HFA will retain the servicing to generate fee income without assuming any risk. The loans will be underwritten to Fannie Mae guidelines and will be conventionally insured.

Access to public capital allows them to add additional protective features and absorb the costs thereof into a blended rate:

The PMI insurance will also include six months of unemployment insurance for borrowers in the event they lose their jobs. Borrowers are not eligible if they have previously refinanced and taken cash out as part of the refinancing. The program requires a $500 deposit by borrowers [A smidgen of hard equity -- Ed.], who must also take a homebuyer education class.

That’s a very nice package: consumer education in the front, favorable loan terms throughout, and risk and loss mitigation features built in.

Viable subprime lending kit inside

Conclusion: the HFAs are managing their risks

The HFAs substantially better performance in the subprime sector owes little to luck and a great deal to differences in their business model relative to the specialized value chain in the pure-private markets:

Hands across the keyboard

1. An originate-and-hold business model
2. Less aggressive underwriting
3. Adding innovative features pioneered in the private market
4. Consumer education before lending
5. Generous reserves, and
6. Active asset management with customized tools.

A loan is a bargain struck across the years if not decades. A commission is a payment made at an instant in time. They are temporally at odds. Businesses built around one-off commissions are eternally vulnerable to principal-agent risks, to risk blindness (it falls between the radar screens), and to short-term thinking.

Hey, nothing to worry about until the end

The HFAs have a political accountability and an enduring immobile political visibility. That makes them cautious even as it bestows upon them extra social capital and resources. In good times HFAs can be much too conservative, too settled in their ways — but that’s a post for another time.

Both conservatism and risk have their features

In wobbly times, those same characteristics keep them active in the arena and out of trouble, while others are either idle on the sidelines or foolhardily flinging capital into the ocean.

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All my blog posts seemed so far away

— we saw, in an era when national multi-billion dollar subprime lenders could collapse seemingly overnight, one category of lender — the state housing finance agencies — has been working in the same space, with the same target customers, in the same period of time, and yet these lenders have neither melted down nor sunk their clients. What are the HFAs doing right that the private subprime lenders did wrong?

I’m from the government and I’m here to help you

1. Originate-and-hold business model

Like the old-time savings bank, HFAs use a simpler business model. Instead of securitizing or selling off their portfolios, they simply hold on to the loans (or bundle them into HFA-backed bond issues):

An overriding factor is a difference in motivation. The interaction between borrowers and HFAs is more relationship-based, whereas for subprime lenders, the relationship is focused more on producing loans, which are then sold in the secondary mortgage market. HFAs hold on to their loans through maturity.

The specifics here deserve a bit of elucidation. HFA’s raise capital from the public markets by selling (usually tax-exempt) bonds.

Side note: The bonds’ exemption of their interest from Federal income tax enables HFAs to offer lower rates — in a perfectly efficient market, a discount equal to the marginal ordinary income tax bracket (today, 35% before considering state taxes). For instance, on 25 May, the ten-year taxable AAA stood at 5.58%, while the ten-year tax-exempt earned 4.05% — 27% lower. (The difference between 35% theoretical savings and 27% actual market represents a bit of inefficiency that is generally present in tax-exempts, for a host of reasons.)

They secure these bonds by assigning a particular pool of mortgages, plus other bond collateral (escrows raised in the bond issue), and an implicit brand-and-reputation commitment to keep the bonds from going into default.

Think of each of us as a happy individual mortgage!

(The rating agencies severely punish issuers who default, or even get close to default.) Though the HFA’s have thus raised money from the public, they have held on to those mortgages as a servicing agent, and the mortgages represent the main form of bond collateral.

As I’ve previously posted, bad lenders make bad loans, in part because they have agency risk between the lender’s agents and the lender, and between the originator and the eventual investing lender. Even a few horror stories of subprime origination certainly illustrate the power of the loan origination fee or brokerage fee in making the individual pro-transaction — at any level of implied or assumed future risk.

2. Less-aggressive underwriting

Lending less aggressively means that the HFAs got a smaller share of the market:

The subprime cats were after us

HFAs lost ground in terms of volume to the conventional mortgage market by not offering numerous loan options to less creditworthy borrowers. But in doing so, HFAs maintained a low to moderate risk profile that should limit any fallout from subprime lending.

Lending is a long-term business. Sometimes you win by losing.

During the refinancing boom of the early part of the decade, mortgage brokers and lenders experienced a large increase in volume. HFAs were often unable to compete and lost loans through prepayment. From 2002 to 2004, the 25 HFAs with Issuer Credit Ratings lost $5.3 billion in loans, more than 10% of their portfolio.

It’s also more than plausible that the HFAs were charging higher interest rates — or at least, higher starter payments — than their market competition. So not all of their runoff can be traced to conservatism … but a fair portion can.

Meanwhile, loan volume increased in the broader market, and these entities hired additional staff and offered an array of products to generate revenue.

3. Innovating program design to learn from market experiments

Even if not losing future money represents ‘real’ winning in the present, it feels like losing.

Consolation prizes in the mortgage business

HFAs continued to offer 30-year fixed-rate mortgages, using conventional insurance and guarantors like FHA and VA, or PMI (private mortgage insurance) loans using underwriting guidelines from Fannie Mae and Freddie Mac.

Further, the private sector innovates, which it usually does faster than the public sector. What’s a public body to do? Shamelessly copy — or partially copy!

Some HFAs expanded their product lines, but the new offerings did not involve the risk of many subprime loans. California Housing Finance Agency has a loan that pays interest only during the first five years, but the rate is fixed at closing for the entire term, which is extended to 35 years to permit an amortization period of 30 years.

Note that this product mixes some of the subprime innovations — longer-term, interest only — with a double safety valve: the rate is fixed now, and the uptick in payment happens five years out, and is probably manageable. (For instance, if the base rate is 6.0%, the increase is from 6.00% to 7.19%, a 12% increase five years out.)

Wyoming Community Development Authority has long offered loans to so-called subprime borrowers, but these borrowers must still provide full documentation verifying employment and income.

Finding the same customers, with different products

Some parts of the subprime sector were using ’self-documented’ underwriting, jocularly named ‘liar’s loans,’ a practice so fundamentally unsound that some of us are glad they went under.

The proper fate of self-documented originators

On this point, avoiding idiocy has served the HFAs well.

The only difference is that these borrowers can have a slightly lower FICO score.

That is, the HFAs used precisely the same due diligence and verification protocols, they just adopted a slightly more liberal/ Pelagian view of their applicant borrower’s credit history. That’s a conscious policy choice — one compatible with their mission and their capital structure (see below) — and a far cry from willful blindness to risk.

Delinquency on these loans in June 2006 was 4.8%, not much higher than the 3.8% for the indenture that holds the loans.

A delinquency rate of one in twenty is nothing to crow about, but it’s within the range of manageable.

We’re managing the delinquency rate

[Concluded tomorrow in Part 3.]

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