Tactical Execution

Mortgage money. Where does it actually come from? When you get a $500K mortgage, who actually writes the checks? Most people have no idea. Does it come from a bank? Does it come from the government or some large quasi-governmental agency like Fannie Mae or Freddie Mac? It all seems so confusing and the numbers are so big that they become abstract. But an understanding of where the cash actually comes from is the first step to understanding how the mortgage industry operates.

You can effectively break down the source of money into two broad categories. On the one hand, you have banks that recycle money that’s been deposited into personal and corporate accounts. We all have bank accounts; checking accounts, savings accounts. Corporations also have bank accounts and some of them have huge sums of money on deposit. Microsoft is a good example with billions in cash reserves. That money belongs to all those account holders and the bank pays interest on it. But they, in turn, lend that same money out to people who want to borrow it.

These banks charge borrowers a higher interest rate than they offer to their savers. That’s how they make their money. They charge what’s called “a spread” between their borrowing interest rates and their deposit interest rates. In fact, banks can even lend out more money than they physically have on deposit, based on ratios federally regulated by certain governmental agencies. But the details of that mechanism are beyond the objectives of this recording. The point is that banks get money from our deposits and that’s what they lend out to their borrowing clients.

The interest rates charged by these banks are heavily influenced by the decisions of the Federal Reserve. Most of us are familiar with Alan Greenspan who was the chairman of the Fed from 1992 to 2006. His replacement is Ben Bernanke. Anyway, after dropping rates to record lows during the recession of 2001, the Fed then went on to raise interest rates a total of 17 consecutive times as the economy strengthened, primarily to ward off inflation. Then, in 2007, they started dropping them again. At the time of this recording, the Overnight Federal Funds Rate stands at 4.50% after being as low as 1.00% back in 2001.

The Fed manipulates interest rates by buying and selling bonds in the bond markets. During challenging economic times, the Fed buys bonds on the open market, and they pay for these bonds with cash. As the Fed continues buying bonds, it floods the market with cash. All of this excess cash makes money more available for people who want to borrow and interest rates naturally come down as different lenders compete for a limited number of borrowers. Think about it. If there’s excess cash out there, the interest rates to borrow that money gets bid down as different lenders compete for the business. Borrowers naturally seek out the lowest rate.

When the economy starts growing again, consumer confidence starts rising and people start spending money again. They buy cars. They buy stainless steel refrigerators. They buy computers and flat screen TVs. And with rising sales, companies start making bigger profits and soon, workers start asking for raises and better benefits. That increases the underlying cost structure and companies have to raise prices as a result … and a vicious cycle of inflation begins.

Inflation is a complicated phenomenon but suffice it to say, it can send the economy into a tailspin. So, to slow down that cycle, the Fed can start selling bonds on the market. Buyers pay for these bonds with cash and the Fed immediately puts that money away, taking the cash OUT of the economy. With less cash available on the open market, borrowers start bidding up interest rates which dampens the feeding frenzy and keeps the economic growth at a sustainable level.

The interest rate directly affected by the Fed is what’s called “the Overnight Rate.” This rate is what the banks charge each other. You may or may not be familiar with the Overnight Fed Funds Rate but most of us are familiar with the Prime Rate. Well, the Prime Rate is simply the Overnight Rate plus 3. Right now, for example, the Overnight Rate is 4.50% so the Prime Rate is 7.50%. Every time the Fed makes a change, the Prime Rate changes at the exact same time.

There are also a number of indexes that are affected by these policy changes made by the Fed. Some of you have heard of the LIBOR index. If you’re curious, the acronym LIBOR stands for the London Inter-Bank Offered Rate. You may have also heard about the MTA index. It stands for the Monthly Treasury Average and there are others like the Cost of Funds Index and so on. All of these indexes are all heavily influenced by the actions of the Fed. So as you can imagine, they have all gone up significantly during the past four years. In 2003, the Prime Rate was at 4.00% – that’s 1.0% Overnight Federal Funds Rate plus 3. Today, it’s at 7.50% and it got as high as 8.25% during all of 2006 and the first half of 2007. Since 2003, the LIBOR and MTA indexes have shown similar movements.

The Prime Rate and all these various indices govern the interest rates of all VARIABLE rate loan products. For example, a home equity line of credit is a variable rate product and is generally tied to the Prime Rate. There are also a lot of loan products these days that are fixed for the first few years, but that become variable afterwards. Once the fixed period expires, they are tied to one of the indexes like the LIBOR or the MTA. Anyone who has a variable rate product has seen their monthly payments go up significantly over the past four years.

We started this discussion by saying there are two primary sources of mortgage money. And the first is from bank deposits. Well, the second comes from a wide variety of “investors” who provide money through Wall Street. But don’t think these are just a bunch of super wealthy individuals. They’re actually Money Managers that are managing our own money through different channels. Most of us have various long-term accounts like Insurance Plans, Pension Funds and Retirement Accounts. Many of these accounts end up housing huge amounts of cash. You can imagine the Pension Fund for General Motors or some other Fortune 500 companies. Think about Insurance Companies like New York Life or State Farm. These companies manage immense sums of money; insurance premiums they’ve accumulated from all their clients over years and years – people like you and me.

These huge funds are managed by professional Money Managers – people paid to manage and invest the money. Naturally, they’re always trying to maximize the return they get so they look for good places to invest. For the most part, they end up putting the cash into three main areas. They buy equities; stocks of various companies that trade on the stock exchanges – shares of General Electric or Google or Starbucks Coffee. They also buy corporate and government bonds. That’s the second choice. And finally, they buy what’s called “mortgage-backed securities”. That’s the third choice. Well, those are mortgages! They’re bundled mortgage loans that are bought and sold on Wall Street every day.

Although I’m over-simplifying, these various Money Managers essentially approach the mortgage business and say, “all right, you can lend out our money as long as you follow these guidelines”. The guidelines they’re referring to are the underwriting guidelines Loan Officers have to follow when helping someone apply for a loan. When you apply for a mortgage, you have to qualify first. Well, what you’re qualifying for are the guidelines provided by these funds. And the interest you pay becomes the return on investment for these Money Managers. So that’s where much of the money comes from. Now, within certain limits, many of these loans are insured by Fannie Mae or Freddie Mac as long as they meet THEIR standard underwriting guidelines. As you can imagine, in order to benefit from that insurance, most investors have guidelines that closely resemble the Fannie Mae or Freddie Mac standard underwriting guidelines. The Fannie Mae and Freddie Mac guidelines are the benchmark for the entire industry.

Today, there’s so much money out there, money that has accumulated from Baby Boomers putting money aside for their retirement during the past 25 years, that a lot of investors have widened their guidelines beyond the standard Fannie Mae or Freddie Mac requirements. This is happening through the competitive process. There’s a lot of money out there. An economist might say, “there’s excess capital” out there. And what happens when there’s excess capital? Well, you can bet on two major results. First, you can bet that interest rates will get bid down as various investors compete for the business. Second, you’ll start seeing more and more innovative loan programs out there.

You have all seen this in your own lives. You’ve seen interest rates get bid down lower and lower with the bottom just behind us, back in 2003. Interest rates are now slowly on the rise again and you can bet they’ll start rising faster when all the Baby Boomers start retiring in a few years and start drawing money out of those huge pools of investment capital.

You’ve also seen a flood of innovative loan programs. First came all the different Adjustable Rate Mortgages, or ARMs. Then came the Interest Only options. Now, they have these Negative Amortization loans. You know the ones: the loans that start with an interest rate of just 1%. Interest rates were never that low and they never will be. These loans allow borrowers to make payments that are not even enough to pay the interest. So the loan balance actually gets bigger each and every month. We’ve all seen these phenomena play out right in front of our eyes.

We’ve also seen a dramatic widening of qualification requirements. Again, it’s the competitive process that has brought this about. People with ever lower credit scores have been able to get mortgages. These new programs are generally referred to as Subprime loans. In other words, you have the traditional A-paper borrowers who are referred to as “prime” borrowers and you have the lower quality borrowers who are referred to as “Subprime” borrowers.

Anyway, with interest rates slowly back on the rise, many of these Subprime borrowers have been stuck with increasing monthly payments, forcing them into foreclosure. We’ll talk about this in more detail in another chapter but I’m sure you heard all the news stories about the “Subprime meltdown” during the summer of 2007 which happened primarily because of this rising foreclosure rate.

Anyway, on the surface, it looks like all these mortgages come from a few large well known banks like Countrywide Mortgage, Wells Fargo, Chase, Citibank or Bank of America. Yes, these guys are huge players in the mortgage business. But that doesn’t mean the money is all theirs. Of course, Wells Fargo and Bank of America have all kinds of regular banking business but their mortgage divisions are generally in the business of packaging and servicing loans. They package the loans and sell them on Wall Street. In many cases, you may not even know because they continue to “service” the loans themselves. That means they do the customer service, they collect your payments and they pass them on to the investor that holds the actual loan, less an administration fee of course.

So again, this is all a direct result of excess capital. There’s a lot of money out there and they’re all competing for your business; your mortgage. So they’re all offering different perks to try and get you to pick them. A lower rate. Looser guidelines. Flexible new loan programs. It’s all marketing, trying to get you to borrow their money rather than somebody else’s. Now, that excess capital reached a peak in 2003 and is now slowly shrinking. That’s why rates are slowly going up. And that’s why underwriting guidelines have been tightened as well. It’s a natural consequence of the market becoming slightly LESS competitive ever since 2003.

Okay. Reviewing, there are two sources of mortgage money and both sources come indirectly from you and me. And far beyond the United States, by the way. We’re talking about people all over the world. Today’s financial markets are truly global and the excess capital we have here is mirrored across the developed world – and there’s China in the background as well with their own motivations for investing money in America. In fact, more than 50% of American mortgages are financed with international money today.

So, bank deposits all over the world get recycled and lent back out to people wanting to borrow. At the same time, investment, insurance and retirement funds also get recycled and lent back out. It’s all a big circle from savings to debts. Obviously, there are some very wealthy people out there who have huge savings and few debts. Others have huge debts and very little savings. But in the aggregate, across the globe lending money to itself and it’s the total amount of savings around the world that determines the interest rates borrowers have to pay.

If there’s lots of money available, interest rates are low. If there’s a shortage of money, interest rates rise. So the fact that we’ve enjoyed steadily dropping interest rates in recent years is a sign that the world economy is healthy and that there’s lots of money available. And the fact that rates are now slowly rising is a sign that the pool of investment capital is slowly shrinking. The soon-to-be retiring Baby Boom generation – not just here but across Europe as well – will definitely accelerate that trend and we can expect interest rates to continue rising as a result. In the meantime, for those who still qualify for today’s underwriting guidelines, it’s still a great time to borrow money and we should all take advantage of it while it lasts.