In years past a borrower would visit their local Savings & Loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage was paid off. What the bank needed was a way to sell the loans it made, freeing up the capital to lend to new borrowers. This way they could lend the same money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.

 

To address this issue, FNMA and GNMA were established. The goal was to provide cheap mortgage money to prospective homeowners and a high-quality bond for the investment community. The bond or Mortgage-Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBSs know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is both capable (VOE), willing to repay (credit report) the debt, has the cash to close (VOD), and the value is in the property (appraisal), the loans and thus the bond will perform as expected.

 During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% N/O/O with credit scores below 600. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006. Keep Reading...