Earn My Business

At this point, your eyes have rolled back in your head, or you are ready to negotiate with your lender. I’ll be an optimist and assume the latter. If not, read back though the last five or six postings. Email me if you are still lost.

Here are a couple of simple facts. It should cost about $3,500 to originate a mortgage. That includes the cost of everyone who may be in the food chain – the mortgage broker, the mortgage lender, the loan officer, etc. Most lenders would like to net about $2,000 after expenses.

You know how to calculate the gross profit the lender is quoting on your loan – by starting at the securities rate and working your way up. Subtract $3,500 from that. If the remainder is $2K or less, you’ve made a good deal. If it’s more, negotiate.

You can negotiate by asking for lower lender fees or a lower rate. Then recalculate the profit.

You are now empowered to negotiate for low mortgage rates and fees. Let the loan officer beware!

Circle the Wagons

Image by Matthew Stewart | Photographer via Flickr

Let’s add all of this up. How much is your lender making from the origination of your mortgage? In previous postings, we identified the following sources of revenue that the lender is earning, as follows:

• The Trading profit or loss from sale of the security and/or mortgage
• The value created from the interest rate mark up – the MSR gain
• The lender fees collected at closing

Here is an example. Lender A makes you a $200K FHA mortgage at a rate of 5%. The lender places your mortgage in a 4.5% GNMA mortgage backed security. Investinginbonds.com says that a 4.5% GNMA security is presently selling at 100.24 (100 24/32 or 100.75%). The lender charges a 1% origination fee, an underwriting fee of $350 and a processing fee of $250. The lender’s profit, before expenses, is

• $1,500 trading profit (.75% times $200K) plus
• $5,500 MSR gain (2.75% times $200K)
• $2,000 origination fee (1% of $200K)
• $600 underwriting and processing fees
• The lender’s gross revenue is $9,600.

Before we go to the final tally, I must add one more ingredient. You may have noticed that the rate on your mortgage is not always exactly .5% above the security rate for an FHA/VA loan or .45% above the rate for conventional loans. In order to fit a loan into a security, the lender may have to discount the amount of the mark up above the security rate. That reduces their profit. As a rule of thumb, reduce the amount of the MSR gain .625% for each 1/8% that your mortgage rate is below the sum of the security pass through rate and the standard service fee mark up.

For instance, a 4.875% mortgage best fits into a 5% security. But the mark up spread is only .375%, not the normal .5%. Reduce the MSR gain of 2.75% by .625% in this example. If the mortgage rate is 4.75% in the same example, reduce the MSR gain by 1.25%.

You should now be able to calculate the gross revenue that a lender is making from the origination of your loan, before their expenses. Look back through the last six postings and play around with some real life examples. Email me if you get lost.

In the next posting, I will talk about how much a lender should be making on your transaction.

Lender Fees

Most lenders charge fees. There are lender fees and there are third party fees.

Examples of third party fees are credit report fees, appraisal fees and loan documentation preparation fees. The lender is not allowed to mark up and make money on these fees.

Examples of lender fees are:

• Underwriting fees
• Processing fees
• Admin fees
• Origination fees
• Discount fees (see the last posting regarding trading losses precipitated by an unusually low mortgage rate)

These fees are paid direct to the lender and represent part of their profitability model. You will find them in the 800 section of your Good Faith Estimate or HUD1 Settlement statement. Identification of these fees is perhaps the easiest part of this process.

Let the Fees Begin

We have already determined that the yield investor buys a mortgage backed security with a guaranteed pass through interest rate. In the last posting, I told you where to find that pricing. Here is the next step.

If your mortgage is pooled with and backs one of these mortgage backed securities, you will have to pay more than the security pass through rate that the investor receives. That is because of two reasons:

Someone has to service your mortgage and handle all of the accounting related to the servicing of the security pass throughs to the investor
The lender who makes your mortgage wants to recoup the cost of that servicing, and make a profit

As a rule of thumb, the rate that you will pay on your mortgage will be higher than the corresponding security pass through rate by

• .50% on an FHA or VA loan – a GNMA security
• .45% on a conventional mortgage – a FNMA security

If the investinginbonds.com daily price sheet shows that a 4.5% security pass through rate is paying 100.875%, that means the mortgages that back that security – maybe yours - will average about:

• 5% for FHA and VA mortgages
• 4.95% for conventional mortgage

Also, as a rule of thumb, the value of that markup above the security pass through rate is equal to about 2.75% for an FHA or VA mortgage and 1.5% for a conventional mortgage. Those are simply the net present value of the anticipated collection of those mark ups collected over the life of the mortgage.

Let’s recap how your lender is doing so far. I will use an FHA loan for this example.

• Your lender makes you a loan at 5%
• Your lender puts your loan in a GNMA mortgage backed security with a 4.5% pass through rate
• The 4.5% GNMA security with a 4.5% pass through is selling for 100.875% according to investinginbonds.com
• Your lender sells the security at 100.875% and makes a profit of .875%. We will call this trading profit

Your lender realizes a 2.75% gain from the markup above the security pass through rate – the difference between your 5% mortgage and the 4.5% security pass through rate. I will call this the MSR profit – the mortgage servicing rights profit.

So far, your lender has made 3.625% (of your mortgage balance) through the origination of your mortgage. The math on that is .875% plus 2.75%. If it had been a conventional loan, the profit would be 2.375% - .875% plus 1.5% for the rate markup. On a $200K mortgage, that’s $7,300 for the FHA loan and $4,750 for the conventional loan.

Before I close this posting, it is important to note that a lender could originate a mortgage that is placed in a security that is trading at less than 100. Look back at the previous posting. The GNMA 3.5% security pass through is trading at 94 2/8/32 or 98.875. If the lender makes you a 4% FHA mortgage - .5% above the security coupon – and creates a 3.% security, they will realize a trading loss of 1.125% (100% - 98.875%) and rather than being at a profit of 3.625%, they will be at a profit of 1.625% ( minus 1.125% plus 2.75%). They make up the difference by charging discount fees, which I will discuss in the next posting.

We’re not done yet. So keep your eye out for my next post – there’s more!

The Yield Investor

If you had $100,000 to invest, would you loan it to your nephew on a 30 year fixed rate mortgage? Probably not. You would not want to lock your money up for thirty years at a fixed rate of return, hassle with the possibility that he might not pay, collect the monthly payments, etc.

In previous postings, I talked about mortgage backed securities. Most investors who want to invest in a 30 year fixed rate mortgage prefer to simply buy a 30 year mortgage backed security. The security is guaranteed by one of the quasi-governmental agencies (Fannie Mae and Freddie Mac) and collateralized by 30 year fixed rate mortgages. This allows the investor to buy an interest in a pool of mortgages rather than an individual mortgage. By doing so, they gain the following advantages:

• The security is easily saleable for cash – with a phone call.
• There is an active market for these securities, the pricing is very efficient and the pricing is publicly available – just like a stock price.
• The investor does not have to worry about payments being made – they are guaranteed by Fannie Mae or Freddie Mac and the investor is paid even if the borrower does not make payments

Agency guaranteed mortgage backed security prices are available on the Internet.

Today, here’s what the pricing shows. “Cpn” is abbreviated for Coupon. Coupon is the pass through interest rate that is paid to the investor who buys the mortgage backed security. The 15 and 30 years column is the price – the percentage of par – at which the investor can buy a security that pays the corresponding pass through Coupon. 15 ear is for a 15 year mortgage and 30 year is for a 30 year mortgage. GNMA securities are for FHA and VA loans. FNMA securities are for conventional loans with a balance less than $417K. For example, an investor can buy a mortgage backed security backed by 30 year fixed rate FHA and VA mortgages, paying them a rate of 4.5% for a price between 101.02 and 101.04, or between 103.08 and 103.10 if the loans are backed by 15 year mortgages. The corresponding FNMA price, for the same security pass through rate, is 100.28 and 103.00 respectively. The prices are quoted in 32nds. 101.02 actually means 100 2/32 or 100.0625. To buy a $100,000 security that is selling at 100 2/32 (or 100.02 from the chart), the investor will have to pay $100,062.50.

GNMA (as of 14:34 SEP 11, 2009)
Cpn	15 Years	30 Years
3.5	98.18/20	94.28/30
4.0	101.27/29	98.22/24
4.5	103.08/10	101.02/04
5.0	104.18/20	103.00/02
5.5	105.17/19	104.17/19

FNMA (as of 14:34 SEP 11, 2009)
Cpn	15 Years	30 Years
3.5	98.09/11	95.04/06
4.0	101.07/09	98.24/26
4.5	103.00/02	100.28/30
5.0	104.11/13	102.26/28
5.5	105.10/12	104.07/09

In the next posting, I will dig deeper into this.

The Pot of Gold

Image by beluga 7 via Flickr

There are two reasons why a bank or mortgage company might make a residential mortgage loan:

• To earn the interest that is paid over the life of the mortgage
• To earn fee income from the origination and sale of the mortgage

At current interest rate levels, most mortgage borrowers want a 30 year fixed rate mortgage. Most banks do not want to lend their money at fixed rates for 30 years. That is because the money that the banks have to invest in that mortgage is from their depositors who, on average, have deposited the money for only about 3 years. The bank makes money on the spread – the difference between the rate on the 30 year mortgage and the rate that they pay the depositors. If the bank lends the money out for thirty years, and the depositor wants their money back after three years, the bank has a problem. In order to give the depositor their money back, the bank either has to sell the mortgage or take in new deposits at whatever deposit rates then exist.

If deposit rates have gone up, the rate on the 30 year mortgage stays fixed and the difference – the bank’s profit spread – goes down. If the bank tries to sell the mortgage, the value of the mortgage has gone down because current interest rates are higher than the rate at which the mortgage was made.

For that reason, most banks are willing to make 30 year mortgages, but they immediately sell those mortgages. They are willing to make the mortgages because they can earn fee income from the origination of the mortgage.

Who buys the mortgages? I will cover that in the next posting.