No Income Verification Mortgages and their place in Society

There are many reasons for the housing recession. People borrowed too much, developers built too many new properties and lenders lowered their underwriting standards because Wall Street firms would purchase any mortgage and securitize it.

One type of loan that became widely used is called a no income verification mortgage (aka liar loans). In a no income verification mortgage, the borrower will either state his or her income on the loan application or leave income information blank. Pay stubs and income tax returns are not submitted with the loan. Home equity loans were also done as no income verification mortgages. Someone could finance 90% of the purchase price of a property without submitting paystubs or tax returns.

Starting in 2004 or 2005 Fannie Mae and Freddie Mac decided that they would purchase no income verification mortgages that met certain standards. The standard was simple, all a borrower had to have was a credit score of at least 720. Fannie Mae and Freddie Mac did not require borrowers to submit asset information either. Historically people with excellent credit did not default on their mortgages, so the theory was, why ask for the paperwork from these people. In addition, there was no way that a bank underwriter could deny one of these loans. It streamlined the underwriting process and lowered the cost of approving a loan.

In the disaster that followed Fannie Mae, Freddie Mac, banks and investors learned that there is no substitute for properly underwriting a loan (having proper documentation on credit, income and assets). The question that needs to be asked is the following: Is there a place for no income verification loans today? The answer is yes. Based on current tax law, self employed people need these loans. While W2 employees strive to make more money each year, self employed people (and their accountants) use a different strategy. The strategy is to write off as many expenses as possible in order to keep taxable income to a minimum. Many self employed people effectively write off between 30% and 50% of their gross income on either Schedule C or form 1120S.

In the current mortgage market no income verification loans usually require a larger down payment (at least 30%) and have interest rates that are anywhere between .375% and .75% higher than a full documentation loan for the same amount of money. In addition, the minimum acceptable credit score may be higher than it is on a full documentation loan.

No income verification loans have their place in the mortgage market. Without this type of loan, most self employed people would be shut out of the mortgage market effectively reducing the number of people that can purchase properties. Lenders have to be sure that these loans are used only for self employed people and not W2 employees.

Please feel free to comment on this and send me any feedback that you want to pkoppelman@yahoo.com.

The future of GSEs

By now everyone is aware that the government may do away with Fannie Mae and Freddie Mac. Bailing them out has cost the US taxpayers over $135 billion. Doing away with the organizations and not replacing them with something that plays a similar role in the housing market could destroy any equity that most people have in their homes. Bill Gross, who runs the largest bond fund in the world at PIMCO has stated that he would expect to see a 3% premium to purchase mortgage backed securities if there are no GSEs (Government sponsored Agency, which is what Fannie Mae and Freddie Mac are). Lets see how this can effect the housing market. A married, college educated couple earns $120,000 annually and has no other debt. Based on current bank standards, they can afford to spend 38% of their gross monthly earnings to housing. This would be $3,800 per month. If we assume that the property that they want to purchase has $6,000 in annual real estate taxes ($500 per month) then they can spend $3,300 per month on mortgage payments. Using a 30 year fixed rate mortgage at 5%, they can afford a mortgage of $614,729. Assuming a 20% down payment means they can look to purchase a house that costs up to $768,411. Now lets assume that there are no Government Sponsored Agencies and interest rates are 8% instead of 5% (the 3% premium that Bill Gross mentioned) our couple can now only afford a mortgage of $449,735 (with a 20% down payment on top of that their maximum purchase on the property could be $562,168). Their purchasing power has declined by approximately 27%. From another viewpoint, this would mean that the equity that everyone has in their property would decrease. One of the reasons would be that the pool of potential purchasers has decreased. Our couple mentioned above would have to earn about $158,000 to afford the $768,411 house if interest rates were 8%. The $38,000 difference ($158,000 - $120,000) would eliminate a large percentage of the population from the purchase of the property.

How many more people would be underwater and what percentage of those people might just give the banks the keys to the house and walk away from their homes? It’s possible that the great recession that we are just getting out of would get a whole lot worse. It could easily take 5 – 10 years for housing prices to recover (assuming that after they are devalued due to the rise in interest rates that they start to increase in value at an annual rate of 2% - 4%).

So how did Fannie Mae and Freddie Mac get into the problems that caused the United States Government to spend over $100 billion bailing them out? At least one reason is their ownership structure. These were publicly owned companies. They have (or had) stock that could be purchased or sold by anyone. This put pressure on management to have outstanding earnings every quarter. It also made them subject to pressure from stockholders that were looking for better returns in the form of higher stock prices. One of the ways that Fannie and Freddie tried to do this was to lower standards so that almost everyone could get a loan. At one point they created a product that was called SISA. This stood for stated income, stated assets. As long as someone had a 720 credit score they would not have to submit pay stubs, tax returns or bank statements to get a loan. It invited people to lie through their teeth.

What should the new government sponsored agency look like and what should it demand from people asking for mortgages?

1)      It can not be a publicly traded company. Being public invites pressure from the large shareholders to push management for better returns, possible at the expense of the quality of the loan.

2)      Standards must be kept high and consistent. Down payments must be a minimum of 20%. This is to insure that home owners have enough equity in their properties that they don’t walk away.

3)      Credit scores must be high (over 680 or 700).

4)      The maximum debt to income ratio allowable must be lowered. Based on the down payment and credit scores it is now possible to get a mortgage approved through Fannie Mae automated underwriting system with a debt to income ratio up to 49%.

In addition, it must be determined whether this new agency should purchase mortgages for investment properties and, if so, how many mortgages someone should be allowed to have.

The concept of a Government Sponsored Agency subsidizing mortgages (mostly for the middle class) has become part of public policy. It needs to be continued in some form.

So what do you think? Feel free to tell me. I can take it, I’m a big boy.