The Diamond Blog

If you wondered why mortgages are so difficult to get through underwriting these days, a lot has to do with the financial markets.

In the past, a lender could always get rid of mortgages where something was missed in underwriting, or fraud was found, and the loan ended up different than previously anticipated.

For instance, a loan may have been funded as owner occupied and subsequent investigation revealed the property was a second home or investment property. More likely, the appraisal was accepted and the loan funded as written, but further investigation determined that the comparable properties were improper and the real comparables indicate that the property is worth less than the initial appraised value.

For whatever reason, when the loan quality becomes less that what was funded, the loan is considered Scratch and Dent. Just like products in the store that have blemishes and the price/value is reduced, the same applies to mortgage loans.

The problem is, these days there is no market to sell Scratch and Dent loans. Previously, when a wholesale investor had Scratch and Dent loans they could either sell them for 90 cents on the dollar on a flow basis (one at a time), or put them in a whole portfolio (bulk) of say $20 Million good loans and tell the buyer that 95% of the loans are excellent but 5% are blemished. Normally the seller would put the blemished loans on the top of the stack and tell the buyer to look at those first, since if they are not willing to take the blemished loans they can’t have the perfect loans. A take it or leave it package deal.

It was a seller’s market and the buyers were mostly corporate or private funds. Today, the buyers or insurers are mostly Government Agencies (Fannie, FHA, etc) and they don’t negotiate. It either fits the loan guidelines or it doesn’t. This is one reason that FHA loans were the minority in the boom years because there were for profit funds willing to purchase all sorts of loans with less red tape than the government agencies. Nobody struggled with an FHA self-employed loan when there were a hundred private sources willing to fund the loan No Income Verification.

Today, if you have a Scratch and Dent loan you have to keep it. There is no place to sell or insure them.

Just think of a reverse mortgage where the borrower falsifies their age, and after funding is found they are not old enough to qualify for a reverse mortgage. It is still a valid mortgage, except nobody will buy it. So, whoever originally funded the loan has a large cash investment and are probably paying interest on the warehouse line expecting to sell the reverse mortgage to get back their money to pay down the line. But now, they are stuck paying interest on the line and holding a mortgage that may not make any payments for 30 years. Too many of these and your warehouse line of credit is all used up with non-performing loans. With no remaining line available, you can’t fund new loans so you are out of business.

The moral of the story is, all remaining wholesale investors today are still in the business to make a profit by buying and selling mortgages, but they can’t afford to get stuck with mortgages they cannot sell. Therefore, they are overly cautions and double and triple check everything. That is why underwriting is slow and tedious.

Delivering especially good mortgage files is one way to eliminate the underwriting stress. Putting a nice little cover letter in your loan file to explain the loan quality helps. Developing a reputation in underwriting that your loans are never any problem invites less scrutiny.

As real estate values stabilize, which they will, the private funds will come back into the market. In the financial world, there is always someone willing to take a little extra risk for a little extra return.

Pension funds, insurance companies, etc. have billions of dollars that they have to invest. Not investing is not an option. If the stock market is too volatile for a pension fund, and the mortgage backed security bonds are too risky, where would you invest 50 billion dollars? As soon as the real estate values stabilize, mortgages will become a safer investment, that pays a better return, and the pendulum will start swinging the other way.

Then, mortgages will become a good secure investment and will be in demand. Supply and demand kicks in and drives the price up. We head back toward a seller’s market and the guidelines start to loosen. Someone on wall street will obtain a commitment to deliver big block of safe No Income Verification loans at 80 LTV or less, that pays and extra 1% and the new cycle begins …