Why are there no creative yet responsible privatized mortgages?

World War III

Last week we highlighted a proposal by Senate Democrats that introduced a 20-year FHA type loan aimed at building wealth by increasing home equity faster than a traditional 30-year mortgage. The idea is worthwhile and could boost homeownership amongst societal groups who are less likely to experience generational wealth through long-term homeownership.

As with everything these days, a proposal like the one mentioned above launches World War III in any enabled comments section of any and every blog or article mentioning it. Rather than thinking through the merits of such an idea or asking critical questions, most users simply look at whose idea it was, plant their feet, and prepare for battle.

The purpose of this post is not to take one side or the other. The democrats proposal has merit. It also deserves critical commentary. However, what strikes most is not the validity or lack thereof of such a proposal. It’s that the government had to come up with it in the first place. Where is the private sector?

Creative Mortgage Financing was a Fiasco

Man, was it ever.

The early to mid 2000s were insane. Mortgage companies decided the underwriting standards of traditional mortgage loans were hindering their ability to grow. Basically, they made the decision that a normal, stable housing market with appropriate, sustainable growth was getting in the way of everyone in the industry becoming rich.

Is this a little dramatic, sure, but it’s more or less what happened. To make more loans and in turn more money, new loans were created by the private side of the mortgage industry. This is how capitalism is supposed to work. Have an idea, execute it, get paid. It’s a system that has served our country well and generally works. Except when it doesn’t.

Private mortgage companies taking chances, creating new ways for people to buy homes, and being rewarded for doing so is how it’s supposed to work. That sentence precisely defines how American business and its economy lead the world. Innovate, create efficiencies, improve life - that’s business in the United States.

What the mortgage companies did pre-2008 was not this. These new loans and the lack of standards required to obtain one weren’t created for the greater good or to solve a housing crisis. A handful of lenders wanted profits to explode and virtually everyone in the industry followed suit.

We’ve all seen “The Big Short”. It doesn’t need to be rehashed. We can all agree that giving a mortgage loan for nearly any amount to nearly anyone who asked for one was a bad idea. No one is suggesting that’s what the currently exploding housing market needs. However, what would happen if mortgage lenders decided to create responsible products out of the goodness of their hearts that actually would benefit the industry, including themselves?

A Few Ideas to Get the Ball Rolling

As a mortgage lender in a previous life proficient in the government loan programs - FHA, VA, and USDA, questioning why there weren’t alternatives was a daily occurrence. Situations on borrower applications would arise that would prevent a potential homebuyer from qualifying. Many warranted a denied application. However, many would also spark a conversation into why there wasn’t a loan for this particular borrower?

Of all the scenarios that resulted in a denied borrower that possibly could have been rectified by a private sector alternative, “Why is there not a VA loan for everyone?” would be asked most often.

This is not to say there should be a government loan to which every U.S. citizen should be entitled. But more, why is there not a private sector mortgage loan modeled from a VA loan?

A “VA Loan” for the Rest of Us

There is no other mortgage loan quite like a VA loan. Eligible veterans and active service members get extremely competitive interest rates without being required to make a down payment and do not have to pay mortgage insurance. That is an incredible, deserving benefit afforded to individuals and families dedicated to our country.

The VA loan program works. Without getting too deep into the weeds, it works because it uses math differently than every other mortgage loan.

No doubt you’ve heard your DTI must be this or that to qualify for a mortgage. VA loans work differently. A VA loan looks at your actual take home pay, which is to say how much money you actually have to spend, and determines after deducting other debt payments and critical expenses if you can afford to pay your mortgage. What a concept.

Residual income is unique to VA loans. However, it seems like a logical way to determine if a homebuyer will repay their loan. In addition to residual income, VA loans include a funding fee that is used by VA to guarantee a portion of the mortgage loan should the veteran default. The VA funding fee is simply a form of mortgage insurance that protects the lender. This concept is not unique and exists on all types of high loan-to-value mortgages.

So, VA loans work like this:

The homebuyer is not required to make a down payment.
A funding fee is charged and financed into the loan that insures 25% of the purchase price for the lender should the homeowner default.
To qualify for 100% financing, the homebuyer must meet residual income requirements that have been determined to produce a high likelihood of repayment.

Why can’t this work for all homebuyers?

Mortgage lenders love to do VA loans. They get paid back and a quarter of the loan’s value is protected when they’re not. Yet they are only available to a small portion of homebuyers. It seems a private mortgage product modeled from an extremely successful existing loan program that mortgage lenders cannot get enough of would make sense.

Mortgage lenders blew it the last time they tried to change the game. Perhaps with hindsight and scruples, they could get it right. If only they’d try.