The Big Short by Michael Lewis

I just finished reading The Big Short, Inside the
Doomsday Machine, by Michael Lewis. It's an
intriguing story about how the whole subprime
mortgage crisis developed, and who some of the
players were who actually could see ahead to
the ugly crash.

Michael Lewis is also the author of The Blind Side,
on which the movie that earned Sandra Bullock
an Academy Award is based. He does a great job
of involving you with the major players and telling
the story through them.

The Big Short refers to a position in the stock
market where investors bet against the success
of a company, or a segment of the market and
in this case the investors bet against the success
of subprime mortgage bonds.

While the mortgage industry was behaving as
if property values would always go up, and that
borrowers could always refinance their loans
when they became intolerable, Lewis shows us
some of the people who were on the other side
of that bet.

Lewis is able to take some technical and arcane
information and explain it in terms that anyone
with an interest can decipher.

He takes the reader through some of the basics
of the subprime lending world, where loan orig-
inators marketed the loans to the consumers.
These loans in turn were taken by the lender
and put into subprime mortgage bonds and sold
to investors through Wall Street.

The bond traders on Wall Street then "sliced and
diced" these mortgage bonds into layers called
tranches, and rating agencies like Moody's and
Standard and Poors were supposed to use their
analytical prowess to properly assess the risk and
grade them accordingly.

The Wall Street firms then created new investment
instruments called Collateralized Debt Obligations
(CDO's), which gave them further opportunities to
sell positions in the same underlying bonds and
actual mortages. Some of these Wall Street firms
included Lehman Bros., Bear Stearns, Merrill
Lynch, Goldman Sachs, Deutsche Bank and
Morgan Stanley.

The investors who were betting against the success
of the subprime bonds, who wanted to be short in
the market, needed a way to make this work. They
needed a way to insure their position and were able
to buy Credit Default Swaps (CDS's) to do so. AIG
was the major player who provided this insurance.

I'm sure that I do not have a comprehensive under-
standing of how all of these pieces fit together. But
it finally became clear to me how it all started to
unfold.

The Greenspan era with the Federal Reserve was
notorious for providing a lot of liquidity at very
attractive terms. It provided the fuel and the
insatiable appetite for the subprime binge.

This incredible supply of liquidity meant that the
Wall Street firms needed to find a market that
could put that money to work. Mortgage-backed
securities (MBS's) traditionally filled some of that
market, because they were usually filled by first
trust deeds that conformed to well-understood
and conservative underwriting standards.

But these types of loans could not longer satisfy
the investment beast. It wanted to be fed, and
instead of holding firm to MBS product that
were filled with conservative first trust deeds,
it was willing to accept, at first, wilder versions
of first trust deeds. These became known in
the market as Alt-A loans, and they usually
commanded a slightly higher rate to compensate
for the risk.

Once the standards started slipping, it wasn't
incredibly long before investors were willing
to accept MBS product that were filled with
interest-only first loans, or stated-income and
no-doc loans, or negative amortization loans,
or stated-income and no-doc negative amort-
ization loans. Investors also rationalized that
the loans with teaser rates for the first two
years and then adjust to a higher rate would
be a good thing too.

And since these still didn't satisfy the demand,
investors were willing to buy MBS product
that included second loans. These second loans
could be fixed-rate or HELOCs (home equity
line of credit loans). A prudent investor may
want to limit their exposure to 80% of value,
but since property values were always going to
go up (right?), they thought: let's create second
loans that go all the way to 100% of the value,
let's do them on a no-doc basis, and to make
things easier, let the interest accumulate on
these without requiring payments.

The rating agencies did not do a good job at all
of assessing the risk in these MBS pools. Investors
were duped into thinking that they were buying
AAA rated bonds when in fact they were buying
into something of substantially higher risk of BBB
quality.

Inside the Wall Street firms, there may have been
only a handful of people that truly understood
what was being created, marketed and sold. Also,
there was a very limited understanding of how
highly leveraged this business had become. There
was one trader at Morgan Stanley that had
accumulated $16 billion of subprime positions
that were poised to go to zero when the eventual
crash came. As Lewis tells it, management at
Morgan Stanley had no clue as to the financial
risk that the company was in because of this one
trader.

We all know that the crash came. And with it
came the demise of Bear Stearns, Lehman Brothers,
and Merrill Lynch's absorption by Bank of America.
AIG received a massive bailout from the Federal
Reserve to stay solvent. Morgan Stanley and Gold-
man Sachs were tanking also, and the government
stepped in to prevent a total collapse.

Amazingly, almost everyone who was integral in
this house of cards was paid handsomely through
the process. People were richly rewarded for doing
the wrong things. And no one really cared who
was going to end up the big loser as long as they
got their piece of the action along the way.

If you want to see the process from the inside,
and maybe answer some questions for yourself
as to how we got into this mess, I highly recommend
reading The Big Short.

The Power of the Prequal

You've found a house that you want to buy.

You've checked other homes, you are confident
in the purchase price.

You are ready to write the offer with your real
estate agent.

The last time you needed a home loan, you
had little difficulty getting qualified and things
went smoothly.

All systems GO!

Hit the brakes, turbo! Things have changed
and the financing may not be as easy as it was
the last time.

All professional real estate agents want you
to go through the process of applying for a loan
and getting prequalified for the likely financing
you will need.

It makes every part of the process smoother.

You have an excellent idea of the proper price
range to be looking.

You have an idea of any obstacles that you may
be facing in this new lending environment.

The agent doesn't waste time and resources
showing you properties that are out of your
price range.

You don't fall in love with a home that you can't
afford.

The escrow period is significantly shortened if
we work together to get your paperwork in
order as you are looking at homes, rather than
starting from scratch from day one of the
escrow period.

When your offer is presented, it is strengthened
by an accompany letter from a reputable lending
source (me!) that you have done your homework and
that you are prequalified for the financing.

Admittedly, there are many borrowers who find
out that they are not quite prepared to buy at
the time they want.

But finding that out before they spend hours
looking at homes and getting emotionally attached
is a good thing.

Sure, it can be disappointing. But if you are
committed to buying at a future point, you can
develop a game plan to solidify your career, boost
your earnings, clean up some credit flaws, save
more money, etc.

So if you want to put yourself in the best possible
position in your next home purchase, it would be
wise to follow these steps:

1. Contact your preferred lender (me!) to get
your paperwork started. This will include a
written loan application, supporting paperwork
to verify income, assets, employment, debts.
It will also allow me to run your credit report
to make sure that all is well, or to see if we have
a project on our hands.

2. Narrow your choices for the type of financing
vehicle you prefer. In today's world, the choices
have been simplified. Low-doc, no-doc, interest-
only, exotic adjustable rate loans, and deferred-
interest loans have essentially disappeared.
The dominant choices are conventional fixed-
rate, FHA, VA, and some milder forms of adjust-
able rate loans.

3. In addition to me using my 33 years of exper-
ience to ascertain your qualifications, we can
also obtain a decision from an automated under-
writing system (AUS) that conforms to FNMA,
FHLMC, FHA and VA guidelines. This system
is based on data input, so the key is to know
what we can verify so that we get a decision that
is supportable.

4. At this point we can issue a letter that makes
note that we have received and reviewed your
loan application, we have run your credit report
and found it acceptable, and that we have verified
your income, assets and debts. We can also
indicate that we have a written loan approval
from the AUS that supports a specific sales price
and loan amount.

5. As you find the home that fits within the
qualifying criteria, we just need to make sure that
the property will also be acceptable. Special care
should be taken if you are looking at condominiums,
or if you are looking at home that may require
some repair or remedy of deferred maintenance.

The agent representing the property and the agent
representing you as a buyer will be pleased that
one of the major hurdles - obtaining the financing
to purchase the home - has been diligently assessed
and that the surprises can be kept to a minimum.

Some borrowers dread the process of the loan
application, but the reality is that it most probably
will need to be done sooner or later. 'Sooner' makes
the most sense to minimize transactional trauma,
while 'later' backloads all the pressure when emotions
are running high and deadlines are looming.

Let's work together, plan ahead and make the process
as smooth as possible.

Which Condos Earn The Gold Medal?

Have you been watching the Winter Olympics?

The results of some of the sports are clear cut -
the fastest time wins the medal like in bobsled,
alpine skiing, speed skating.

Other sports, however, are judged and the
results may be more subjective - ice skating,
ski jumping, and the wild snowboarding trick
events.

Condo approvals by lenders tend to be more
subjective with room for some interpretation
for conventional loans.

When lenders are asked to lend on a condo-
minium unit, part of their decision is based on
the creditworthiness of the borrower.

Beyond that, however, they are also concerned
about the health of the condominium project.

There are guidelines that are published by
FNMA and FHLMC that stipulate what they
require for a lender to sell loans to them. Most
lenders will adhere to those guidelines (or even
be more strict) so that they have the ability to
get the loan off of their books and have FNMA
and FHLMC take the interest rate risk in the
future.

A couple of the basic guidelines deal with the
occupancy of the units and how well the unit
owners are paying their homeowner's association
dues.

Guidelines typically call for at least 51% of the
units in the condominium project to be occupied
by owners as their primary or secondary homes.
If a borrower is seeking a loan with less than 20%
cash down payment, those loans require private
mortgage insurance. The mortgage insurance
companies may require owner occupancy closer
to 70% of the project.

There are some good reasons for these rules.
If a project is predominantly a rental complex,
the pride of ownership tends to be diminished.
Instead of the majority of occupants taking
responsibility for the care, maintenance and
appearance of the buildings, off-site landlords
tend to be less hands-on and the project
becomes less desirable.

Another guideline that is getting a lot of
scrutiny is the percentage of units where the
homeowner's association dues are delinquent.
Lenders are looking more favorably on projects
where there percentage of delinquent units is
less than 15%.

A homeowner that does not have the ability to
stay current on their HOA fees is an early
warning that they may be facing serious
delinquency on their mortgage. This may lead
to defaults and foreclosures which does not help
property values in the condo project.

Also, delinquent HOA fees means that the
homeowner's association has less money to run
the day-to-day operations of the project and
less money to out into the reserve fund for
big-ticket expenditures in the future (re-roofing,
re-paving, extensive pool repairs, etc.). This
may lead to special assessments to the unit
owners which puts a strain on their financial
capacity.

Lender are sometims vilified about being too
strict with their lending criteria. But as we
have seen over the past five years, when
lenders are very lenient they are enabling
homeowners to get into troublesome situations.

When the lenders exert more scrutiny, they
are also helping borrowers avoid condo projects
that may not be as healthy as everyone would
like. Borrowers implicitly are looking for "experts"
to help them make judicious decisions. The lender's
condo criteria can be considered as helpful in this
case.

If borrowers really thought things through, would
they want to be investing their money to live in a
predominantly rental project where a fair number
of their neighbors were struggling to meet their
financial commitment to the community of unit
owners?

I think many would seek ownership in a different
project, even if the lender did not impose their
requirements on the loan approval.

Knowing the guidelines before falling in love with
a condo can keep the disappointment to a minimum.

And The Winner Is . . .

1977 was a big year for me. Not only did I get
married to the to the lovely woman with whom
I'm still married, but I also started my mortgage
origination career.

So, going on 33 years now, I've been able to
thrive and survive through low interest rates,
high interest rates, ebbing business cycles and
expanding business cycles.

I can credit my sustained career as a mortgage
originator to a few basic principles that have
carried me through:

1. I've learned to listen to my clients and to
my referring sources about what they are
trying to accomplish.

2. I educate them as to how to get from Point
A to Point B to accomplish their goals, and

3. And, I learned the hard way, especially
early in my career, not to lie to my clients.
There were times in the beginning that I
fudged the truth and it always backfired on
me.

Now I do my best to be patient, answer all
questions to the best of my ability, and to be
as transparent as possible about what is going
on.

With all of this in mind, I am please to announce
that I have been selected as one of the 2010
Five Star Best-in-Client-Satisfaction Mortgage
Professionals.

This award is a result of a survey by San Diego
Magazine in which researchers asked 21,000
San Diego County area residents and 780 real
estate agents to identify exceptional mortgage
professionals in the County.

The respondents were asked to evaluate only
those mortgage professionals they knew through
personal experience in two categories of performance:
overall satisfaction and whether they would highly
recommend them to a friend.

The March 2010 issue of San Diego Magazine will
have a list of the award winners.


I am hopeful that if you were one of the people
surveyed that you, too, would be able to say that
you are satisfied with my approach to the mortgage
business, my ability to communicate, and my
perseverence in working through any obstacles
that may be encountered.

And, I hope that I could earn your enthusiastic
recommendation to your friends.

If you, or someone you know, is looking for a
mortgage professional that will listen to what is
important to you, will educate you and communicate
to you what needs to be done, and who will tell you
the truth, then I am the one you are looking for.

FHA Planning on Tighter Requirements

FHA has been an increasingly popular program in
the last few years. Especially here in San Diego
County, where FHA previously was not a very
relevant program, the higher loan limits has made
it the most popular for first-time home buyers.

But there is a price for such success. Some industry
estimates are that about 30% of all mortgages last
year were FHA-insured. This increase in lending
volume has put some strains on the FHA system.

A borrower who obtains an FHA loan is required to
pay mutual mortgage insurance (MMI) into the fund
that creates reserves against losses in the FHA
program. This MMI comes in two parts: an up-front
mortgage insurance premium (MIP) that is most often
financed on top of the base loan amount, and a monthly
MMI premium.

Because of the higher volume of FHA loans, and the
emphasis on helping first-time buyers and those with
lesser credit scores, there has been more late payments,
defaults, and foreclosures in the program. As a result,
the reserves have fallen below what is required for the
FHA program.

The new changes are designed to increase revenue to
the reserves, to decrease some of the risk from the
more marginal qualifiers, and for borrowers to rely
less on contributions from the sellers in buying their
homes.

The following changes will be effective with case
numbers that are issued on or after April 5, 2010.
This means that a borrower will need to be under
contract on their home by about April 1 to beat
the deadline for these changes.

First, the MIP has been 1.75% of the loan amount.
After the changes take place, this will go to 2.25%
of the loan amount. On a $300,000 loan, this will
add an additional $1,500 to the amount financed
and increase the monthly payment by about $10
per month.

Second, if a borrower has a credit score of 580 or
less, they no longer will be able to purchase with
the minimum down payment of 3.5% of the purchase
price. Those borrowers will now have to have 10%
down payment, and get a loan of 90% of the value.

Third, in the past sellers could negotiate to pay as
much as 6% of the sales price of the home toward
the buyer's closing costs. FHA will now limit that
contribution to only 3%. Part of the reason for this
change was because FHA was discovering that
sellers were inflating the sales price to cover the
larger contributions, and FHA was insuring loans
even higher than the 96.5% that the program
allowed.

All in all, it will be somewhat more expensive for
a borrower to obtain an FHA loan. It will still be
a viable program for borrowers with small down
payments and who need some forgiveness on their
credit scores.

The important thing is to know what changes are
coming so that you are not surprised when you are
ready to enter into your contract.

Forecasting Interest Rates

Interest rates have been staying low for quite a while
now. It's always difficult to try to predict rates, but
there seems to be a consensus building that may give
us some idea when rates may make an upward move
that will stay in place for some time.

To generalize, fixed rates on conforming loans - those
that get sold to FNMA and FHLMC with loan amounts
up to $417,000 - have been in the 4.75% to 5.25%
range for quite some time.

These rates have sustained because the Federal
Reserve is trying to spur a housing recovery by
keeping interest rates low.

In turn, lenders are willing to make long-terms loans
at these loan rates, because they have no intention
of keeping these loans on their books and carrying
the interest rate risk that goes with it. They know
that they have a ready buyer for these loans through
FNMA and FHLMC.

It is one of the main reasons why lenders are under-
writing the loans so stringently. They have to make
sure that the loan they are making is one that FNMA
and FHLMC will purchase from them. Strict adherence
to Fannie and Freddie's guidelines is vital so that the
lender does not have to keep the loan on their books,
and suffer the risk of that low-interest rate loan being
a money loser in the future when rates go up.

FNMA and FHLMC have been allotted more than
$400 billion to guarantee their recovery. But an
announcement was made on Christmas Eve, without
any fanfare, that they were given an unlimited financial
lifeline and removed the requirements to shrink
their holdings by 10% per year. Currently they are
instrumental in about 75% of mortgages made, and
their holdings amount to about $770 billion.

Additionally, there are loans that are created by lenders
that get bundled into pools of mortgages and then sold
to investors through a vehicle known as a Mortgage-
Backed Security (MBS). FNMA and FHLMC also put
together MBS pools to reduce their holdings.

Traditionally, these pools of mortgages have been sold
through Wall Street to investors, pension plans, etc.
But when the performance of mortgages began it's
decline a couple of years ago, the Wall Street investor
market dried up.

They suffered unexpected losses because the quality
of the loans in their MBS investments were not as good
as they were represented to be. Once burned, twice
shy. The investors have not rushed back into the
market to buy these new MBS issues.

To keep fluidity in the market, the Federal Reserve
has been purchasing MBS issues, since non-govern-
ment investors have been dormant.

So, the Federal Reserve is keeping rates low to stim-
ulate the economy. The interest rates are not market
driven, so investors are not excited about them unless
they can move the loans to someone else to absorb
the risk. The only players for buying these loans are
FNMA and FHLMC (Government-sponsored entities)
and the Federal Reserve buying MBS issues. It's a
giant circle, and the free market never touches it.

Now here is the indicator that rates may start to go
up: Federal Reserve policy makers are expressing
a desire to pull back on purchasing MBS issues when
they see some recovery in the economy. If this
happens, to attract investors other than the government
(since they are backing away) interest rates would
have to go higher.

When you start to hear the news reports that the
economy is recovering and that the Federal Reserve
is reducing their investment in MBS issues, be prepared
to expect higher interest rates. Some commentators
are thinking they could go up 1 to 2% from the low
rates that we have enjoyed.

Looking Backward and Forward

As we close out 2009, it gives me an opportunity
to look back and also make some acknowledgements.

This last year put us further along a path that began
a few years back.

There is no debate that there were lots of abuses in
the mortgage business. Originators took advantage
of borrowers. Borrowers blindly followed without
questioning where they were headed. Lenders
created these loans knowing that they were not
being looked at closely and passed them along to
investors without caring about the outcome. Investors
sold pieces of these mortgages to other investors,
representing them as solid investments.

Everyone wanted to believe that the loans were good
for the borrowers and good for the investors. Some
deluded themselves into thinking that property values
would never go down. And there was a lot of pain
that will continue for the forseeable future.

The government does not want this to happen again.
So, where previously the pendulum had swung far
in the direction of little scrutiny, now it has swung
in the direction that everything is checked and re-
checked.

In addition, many loan products are no longer avail-
able. For example, stated income loans and loans that
allowed for deferred interest. Equity loans, and interest-
only loans are vastly reduced in availability.

Through the course of 2009, we have seen the intro-
duction of new appraisal ordering systems that remove
direct contact between the originator and the appraiser.
This was done in an effort to keep originators from
exerting undue influence on the appraisers to "hit a
number".

We saw the introduction of new disclosure requirements
that protect the borrower from paying for services
such as the appraisal until they have had an opportunity
to review their truth-in-lending disclosure. And if the
Annual Percentage Rate (APR) changes more than
.125%, you are entitled to a new disclosure and a
mandatory 3-day waiting period before you can proceed
to the next step. This may delay closing transactions
on time.

Coming in 2010, are even more disclosure changes.
You will now see that some fees are set at the beginning
of the disclosure process and cannot be changed, some
fees can be changed based on changes in the market,
and others can be changed but have a cumulative limit
of 10% change. They are also tying these advance
disclosures to your final settlement statement that you
will receive at closing so that the comparisons are
crystal clear.

Be prepared for these changes. Don't think that because
you have experience with buying or refinancing that
you won't have a new learning curve. And be prepared
for possible delays and some confusion. All of these
changes are new to everyone and it will take a little
time to work through all the new requirements.

Acknowledgements:

I want to say "Thank You" to all of you with whom I
worked in this past year.

Being a mortgage professional is how I feed my
family, and I never want to take your confidence in
me and your loyalty for granted.

With that being said, please let me know how I can
improve my service to you. Send any suggestions
to me at doug@dougbrennecke.com.

I want to continue to earn your business.

Have a safe and healthy Happy New Year! I will
talk to you again in 2010.