When Creative Real Estate Financing became Alarmingly too Creative

This article is relating to real estate financing options which made financing available to home buyers for the better part of seven decades and although they have undergone a number of changes over the years, the FHA and Conventional real estate financing programs continue to be the overwhelming choices for home buyers despite a number of economic downturns over that period.

The FHA (Federal Housing Administration), Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation) and PMI (Private Mortgage Insurance) provided the mortgage insurance necessary to protect mortgage lenders against mortgage foreclosure - VA provided a mortgage guarantee - pursuant to which lenders were required to process loans which the VA approved.

These programs combined to create a robust real estate financing industry that led to real estate investment and home-ownership as one of the most profitable and safest ways to create equity. Creative real estate financing meant providing mortgage financing alternatives to home buyers who did not meet all the requirements set forth by the conventional bank.

Those financing alternatives came in the forms of FHA and PMI mortgages, or VA if the home buyer was a veteran. Creative real estate financing became too risky when mortgage insurance was either ignored or compromised and therefore created risk for all parties involved making that type of mortgage financing unsafe for everybody.

How and When Creative Became Destructive

Is conventional real estate financing considered creative? A Conventional mortgage loan is considered the traditional type of mortgage loan and is the most straightforward type of residential mortgage available; It is the mortgage against which most other mortgages are measured, meaning that conventional mortgage guidelines are adhered to by a majority of banking institution and licensed lenders that approve loans for real estate financing pursuant to Fannie Mae and Freddie Mac guidelines.

These guidelines required that a borrower seeking approval for a conventional mortgage loan must document the ability to manage a 20% down payment (20% of the purchase price or appraised value, whichever is less); Enough monthly income, 28% of which must support payments of Principal & Interest plus Taxes & Insurance (PITI) and 36% must support a total monthly payment when all other revolving & installment debt payments are added to PITI (e.g. credit cards, student & auto loans, etc.) - excluding utilities - and Creditworthiness (evidenced by a minimum credit score of 720). You could say that mortgage loans with guidelines other than the conventional (Fannie Mae & Freddie Mac) standard are creative real estate financing programs, but conventional financing would not be thought of as creative.

Even before the modern-day conventional loan existed in its present form, steps taken by potential homeowners requiring real estate financing to complete their purchases were long and hard. The process was fraught with sacrifice and many would-be homeowners sustained great loss due to the lack of reasonable mortgage financing terms.

Based on information published on the History News Network (HNN), Fannie Mae was created in 1938 as part of Franklin Delano Roosevelt's New Deal. The collapse of the national housing market in the wake of the Great Depression discouraged private lenders from investing in home loans. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.

Pre-Fannie Mae Mortgage terms called for a borrower to make a down payment equaling 50% of the home's purchase price in order to qualify for a five year "Interest Only Balloon" mortgage loan. These terms were made available through private lenders, many of whom discontinued lending due to the collapse of the national housing market.

Fannie Mae, the only GSE (Government Sponsored Enterprises) in existence at the time, owned conventional mortgages until the creation of Freddie Mac in 1970, after which the two agencies "...controlled about 90% of the nation's secondary mortgage market..." and are currently the primary purchasers of conventional mortgage paper despite having been placed under the control of the federal government through a conservatorship procedure in September of 2007.

Other than conventional real estate financing programs, there was one other popular loan program that had insured mortgage loans since being created by congress in 1934. This program is known as the FHA (Federal Housing Administration), which instituted an altogether different set of mortgage lending guidelines. Where conventional banks required 25% down payment (currently 20%), FHA required 2.25% (currently 3.5%); Enough monthly income (31% required to support PITI payments & 41% to support PITI+R&I debt payments), assets (down payment + closing costs) as well as creditworthiness (reasonable underwriting prior to credit scores, but currently 640 per the underwriting policies many lenders adhere to) must also be documented in a similar fashion to the kind of documentation required under conventional guidelines; And because of this difference in income & assets and the kind of credit background that was required, it could be said that the FHA-insured mortgage loan program fit the description of creative real estate financing, except that full documentation and verification of a borrower's qualifications for this type of mortgage loan were all required.

After the enactment of FHA and then Fannie Mae, mortgage lending had begun its rise but, as mentioned above, many who wished to purchase a home could hardly afford one until these two agencies were created and later the VA (Veteran's Administration) Loan Guarantee program, intended specifically for military veterans and their wives.

There was more competition in the real estate financing market and home loans were now referred to in terms of the type of mortgage a home buyer qualified for instead of the type of borrower mortgage banks were willing to lend to (when many borrowers did not get mortgage loan approvals despite their qualifications) based solely on the bank's discretion and/or prejudices.

With more competition in the mortgage industry came more risk-taking, not recklessness in the early days, but risk-taking which meant that the huge increase in mortgage applications taken by lenders approved to lend FHA-insured and VA guaranteed mortgage loans (VA loans had to be approved and stamped by the Veterans Administration) was mortgage business that perhaps included a number of applications which may have otherwise gone to the savings & loans were it not for the restrictive lending policies and guidelines they adhered to at the time.

Despite this noticeable spike in mortgage business being done all around him, the conventional (traditional) mortgage lender was in no hurry to change his lending policies and guidelines, so changes to the conventional mortgage loan did not occur as quickly as many in the real estate industry had expected, but remained the lending standard.

FHA, VA, and PMI (Private Mortgage Insurance) were the other widely recognized mortgage loan programs on the market where the conventional mortgage loan was established as the traditional mortgage type; The mortgage prototype, if you will. Each of these programs deviated from the qualifying requirements and guidelines set forth by the conventional mortgage lender, except that PMI was based almost entirely on the conventional mortgage loan guidelines but differed in the LTV (Loan-to-Value) ratio which exceeded conventional ratio requirements by up to 15%, thereby requiring a home buyer to make a down payment as low as 5% of the purchase price or appraise value (whichever is less) of the home s/he would be purchasing.

Although FHA was a creative mortgage program, designed by the federal government to increase home ownership among low-to-moderate income working people desirous of home ownership, the program worked well because it was, and still is a federally insured loan and as such protected mortgage loan lenders from loss due to delinquency and subsequent mortgage foreclosure.

The VA mortgage loan worked because the Veteran's Administration (a different arm of the federal government) guaranteed mortgage loan lenders against loss due to mortgage foreclosure, so this type of mortgage provide and even stronger protective blanket for the lender because the federal government, through the Veteran's Administration, Guaranteed repayment!

The only mortgage type which deviated from conventional mortgage loan guidelines and was not insured or guaranteed by the federal government was the PMI mortgage program, and although PMI mortgages met a need in the mortgage financing marketplace, there were those who viewed this mortgage type as a model of even more creativity in real estate financing.

Soon there were mortgage programs introduced requiring 5% down but only 3% of the buyer's own money; 10% down but no PMI; 5% down but no PMI as long as the buyer/borrower agreed to a small second mortgage (piggy-back second); And a number of different variations and creative versions without the provision for mortgage insurance.

Then there was a new term introduced to describe these newly created non-conventional, non-FHA, non-VA, non-PMI ty mortgages types. The term was Sub-prime mortgage or Sub-prime mortgage loan! As it turned out the Sub-prime mortgage loan was the most reckless kind of creative mortgage financing program to have been introduced to the contemporary mortgage marketplace, and - we now know - was responsible for an almost collapse of our financial system (a recession lasting from late 2007 to late 2010 resulted) and near depression.

Creative mortgage financing did not cause the mortgage crises and, contrary to several reports during the sub-prime melt down, the FHA-insured mortgage loan program was not responsible for the 2008 mortgage crises and market melt down; Neither was the VA-guaranteed loan program the culprit. PMI provided insurance to protect conventional mortgage lenders for loan amounts over 80% and up to 95% of the lesser of a home's purchase price or its appraised value, a clear indication that when lenders' interests were protected (insured) the exposure to loss was greatly reduced.

When there was little or no insurance, lenders were opened to substantial losses, and when those losses were incurred and compounded, many lenders sought help from the US government and received it via the many $Billions in bail-outs towards the end of 2008 and early 2009.

So what purpose did such creative real estate financing, technically fraudulent-inducing sub prime mortgage programs serve? What was the end game? The truthful answer to this question has yet to be determined, and may not be for years to come. A recent Huffington Post article detailing Neil Barofsky's quarterly report to congress provides additional insight that may be helpful in determining the "truthful" answer to this question. Mr. Barofsky is special inspector general for the trouble asset relief program, or TARP.

Works Cited:

Alford, Rob. "What Are the Origins of Freddie Mac and Fannie Mae?." HNN - History News Network. George Mason University, 8 Dec. 2003. Web. 13 Oct. 2010.

Wagner, Daniel and Zibel, Alan. "Tarp Watchdog Neil Barofsky: Government Bailout Increased Risk Of Economic Crises". Huffingto Post, Jan. 30, 2010. Web. 25 Oct. 2010.

Copyright © 2010, Tony Phillips