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Friday, July 24, 2009

Throw the Baby Out with the Bath Water

Those of you in the mortgage business are surely familiar with the term "Yield Spread Premium" (or YSP). It has been a hot issue for several years, and if the Federal Reserve has its way it will soon be illegal. Yesterday, the Federal Reserve issued a proposed rule that would make YSP illegal. Why are these three little initials such a lightning rod? First I will provide a simple explanation of YSP for those that are not familiar with it.

Mortgage brokers are company's that originate mortgage loans, but rely on a bank (known as a wholesale lender) to fund the loans they originate for their customers. The mortgage broker may earn fees for their work, but they may also be paid by the wholesale lender for delivering the loan. This fee paid by the wholesale lender to the broker is the YSP.

Why does the wholesale lender pay the broker? Because the wholesale lender wants the loan. These wholesale lenders (aka the banks) earn money from the interest on the loans they service. Therefore it is worth it to the wholesale lender to get brokers to send them as many loans as possible. For most of my career I was one of these wholesale lenders. Working for Countrywide's wholesale lending division, we funded loans for mortgage brokers and often paid them yield spread premiums when they delivered the loans to us.

How is the amount of the YSP determined? The amount the broker is paid in YSP is typically determined by the interest rate. A higher interest rate will pay more YSP, a lower rate may pay zero YSP (also called par). An even lower rate would actually cost money in the form a discount points to the bank.

Below is an example of how a rate sheet might appear for a 30 year fixed mortgage. The rate sheet would come from the wholesale lender, and the broker would use it to price their loans. It is important to note that wholesale rates are lower than retail rates. Even if a bank has both a wholesale division and a retail division, the wholesale rates will look more attractive. This allows the broker to earn their fees and still offer competive rates and fees to their customers. Having a wholesale division also offers lenders a lower cost of doing business.

On the table below, the interest rate is on the left and the amount of YSP (negative numbers) or discount points (positive numbers) are on the right.

4.750 1.375
4.875 0.625
5.000 0.000
5.125 -0.250
5.250 -0.875

In the table above, 5% is par. The wholesale lender would not pay any YSP, and the borrower would not have to pay any discount points. At 5.25%, the broker receives .875% of the loan amount in the form of YSP from the wholesale lender. On a $100,000 loan that would be $875.

Yield spread premium is also a tool for brokers to offer flexible options for their customers. Like I said in the beginning, brokers can earn their income from the customer in the form of fees, as well as from the wholesale lender in the form of YSP. So in the table above, the broker may offer a customer the option of getting a loan at 5% with a .875% origination fee, or 5.25% with no origination fee. Either way the broker earns the same amount of income, but the borrower can choose whether they want to pay a fee for 5%, or pay no fee for 5.25%.

Now why does that sound like something that the Federal Reserve wants to make illegal?

Unfortunately YSP was abused by a lot of mortgage brokers, and wholesale lenders allowed the abuse to take place. For many years, mortgage brokers would rarely earn more than 1% in YSP. The only exception would be if the broker was paying other closing costs for the customer. But then some unscrupulous brokers were taking advantage of unsuspecting borrowers and getting 2% or more in YSP as well as charging up front fees like an origination fee.

The wholesale lenders capped what brokers could earn, but that cap was typically 5%. That seems high, unless the broker is trying to close a $40,000 loan. On a $200,000 loan that 5% is $10,000, an outrageous amount for closing a $200,000 loan. Why a borrower would choose to work with a mortgage company that charged those fees is puzzling, but they did.

The most egregious abuse of yield spread premium took place with a particular loan product called an option ARM. This was an adjustable rate mortgage that was appealing to borrowers because it offered a low minimum payment, sometimes at a rate as low as 1%. But the loan would accrue interest at a higher rate. How higher of a rate was determined by the margin that was added to the rate index. With this program it was the margin (the add on to the rate), not the rate itself that dictated the YSP the broker would earn. The higher the margin, the more YSP.

This product was not a bad loan product (I use past tense because you can't find a bank that will lend an option ARM loan any more). It had been around for decades. I even seriously considered getting an option ARM myself (although I chose not to). It was a unique product that was appropriate for a small population of sophisticated borrowers. Unfortunately, it was sold to main stream America. Actually it was mostly main stream California, Nevada, Arizona, and Florida.

Why did brokers as well as mortgage bankers want to sell so many option ARMs? The obvious answer is because they were profitable. And they were very profitable. A broker could earn at much as 3% YSP with the wholesale lender that I worked for. Add another 1% origination fee and they could easily earn $10,000 on a $250,000 loan. Some of our competitors offered as much as 4% YSP on option ARM loans.

Why did wholesale lenders offer so much YSP on option ARM loans? Because they were so profitable. They could sell them to Wall Street where the appetite for mortgage products was insatiable. Some banks like World Savings kept them in their portfolio where they were earning high rates of interest. Even if the borrower only paid the minimum 1% payment, the bank could show the higher interest as earned income on their financial statements. Wholesale lenders were in competition with each other to get option ARM loans originated by brokers, so they paid the brokers handsomely.

At one point while I was a sales manager at Countrywide, we received a memo that we were raising our maximum YSP from 3% to 3.5%. In the memo the senior manager implied that brokers shouldn't really be choosing that high of a margin which would result in a 3.5% YSP. In addition we (my sales team, and all of the company's account executives) should encourage our brokers to select a lower margin that earns them only 1% or so in YSP. I was so stunned by the duplicity of the memo that I called my boss and let him know my thoughts. Why were we talking out of both sides of our mouths? The senior manager was clearly acknowledging there was something wrong with paying too much YSP, but at the same time we were increasing the amount we were willing to pay the brokers in order to compete with other wholesale lenders that were offering as much as 4%.

This illustrates the blind race for market share in which banks were competing. The loans were profitable and otherwise obvious flaws were ignored.

But I digress...

So this is how YSP turned from a useful tool that offered options for borrowers into the lightning rod that it is today. Instead of banning YSP altogether, it should be regulated not to exceed a certain amount, say 1.5%. Why would the Federal Reserve want to throw the baby out with the bath water? Eliminating mortgage brokers makes the Fed's role as a regulator much easier. It also creates greater market share for the big banks that the Fed is closest to. That's my guess anyway.

In the end, if the Fed's proposed rule goes into effect, it will mean less competition and choice for borrowers. It will also shut down thousands of brokers and harm other small businesses that service brokers. Borrowers will still be able to get loans from mortgage bankers that fund their loans on lines of credit, then sell them to banks. Those mortgage bankers don't earn YSP. Instead they get something called SRP from the bank they sell the loan to. Yes, it's pretty much the same thing as YSP, except that it won't be illegal. Frankly neither one of them should be.

Thursday, July 9, 2009

Upside Down Refinances

Head over heels, but not in a good way, is how to describe the mortgage debt with which many homeowners are strapped. The government's Home Affordable Refinance Program attempted to address this back in March when they began allowing some homeowners to refinance their current mortgages for up to 105% of the value of their homes. In other words, if the home is worth $100,000, then the homeowner can get a refinance up to $105,000.

This limit of 105% reflected the disconnect in Washington with the real world. Unfortunately, the homeowners that are truly at risk of foreclosure owe significantly more that 105% of the value of their home in mortgage debt. Five months later the government has tried to address the issue by raising the limit to 125%. While this will certainly help some folks, it will not help the great number of homeowners in Arizona, California, Nevada, and Florida that are considerably upside down with their mortgage debt (by more than 25%).

The best suggestion to resolve this came from John Courson at the Mortgage Bankers Association when the program was first announced back in March. He recommended that there be no limits on the loan to value. These refinances are only for loans that are currently owned by Fannie Mae and Freddie Mac. And Fannie and Freddie will own the new loans that are created by the refinances. Since the federal government owns Fannie and Freddie, we the tax payers own these mortgages.

These homeowners that are upside down are potential foreclosures which will cost the government (aka we the taxpayers) mucho dinero. Why not let these homeowners refinance to a lower payment and avoid the foreclosure and the cost that goes with it regardless of the loan to value ratio. There is already a precendent for this with FHA and VA refinances. Since the government already guarantees those loans they just want to put the homeowner in a better financial position. How is Fannie & Freddie any different today from FHA & VA? The answer is, they are not any different from an ownership and accountability standpoint.

Lift the loan to value restriction and more homeowners will be helped. If not, then more loan modifications will need to be done. For homeowners that need a loan modification and don't want to pay thousands of dollars to an attorney or loan modification company, visit www.eModifyMyLoan.com. The site helps struggling homeowners in need of a modification create a complete and well-organized package to deliver to their lender and will help expedite the modification process.