How Mortgages Work, the Basics lender loan down down ...

How Mortgages Work, the Basics

When someone wants to buy a property to use as a home, they often cannot afford to simply pay full price and purchase the property outright. They can ask a bank or a mortgage company (a "lender") to issue them a loan to purchase a property/home. The loan is sometimes referred to as a "mortgage," though that is technically incorrect. The money issued is a "loan." The borrower/purchaser/future homeowner often pays a certain percentage of the purchase price towards the home. This is called putting money "down" or making a "down payment." The lender then finances the remainder of the home's price, paying the seller of the property and signing a "mortgage" with the homeowner. The mortgage is actually the legal contract for repayment, otherwise known as the instrument evidencing the debt. However, in common usage, the word "mortgage" can also be a verb, meaning to take a loan for a security against a property (to mortgage), a noun describing the whole process (to obtain a mortgage), and an adjective (the mortgage market). In legal terms, the lender or party entitled to receive payments on a loan is called the "mortgagee" and the party making payments, the homeowner, is referred to as the "mortgagor." Often, the "sales contract" covers terms such as whether the seller or the buyer pays brokers' fees (generally 6% of the property price, with half going to the agent finding the buyer and half to the seller's agent), which party covers property and title inspections, and any other negotiable terms, while the mortgage deals only with the financial terms of the loan (including the sale price, the amount put down by the homeowner, and the terms of repayment).

With very few exceptions, when executing a mortgage, the homeowner signs a promise to pay (referred to as the "note" or "mortgage note") promising to repay the mortgage according to the agreed upon terms and allowing the lender to "foreclose" upon the purchased property if the terms of the agreement are not met (which usually means non-payment according to the terms of the mortgage). "Foreclosure," or "foreclosing upon," a home simply means that the lender takes ownership of, or possesses, the home in order to satisfy the remaining debt, unpaid by the homeowner. The lender, usually, then resells the home to recover its unsatisfied debt and any losses (usually unpaid interest). In purchasing a property, the homeowner is issued a "deed" evidencing the homeowner's ownership of the property or the existing deed is transferred from the seller. The vast majority of U.S. jurisdictions require deeds and the mortgages pertaining to property to be "recorded" with local governments (usually counties/parishes). This simply means that the deed and the mortgage are registered with the local records department for later reference, if needed. This generally allows anyone interested in a certain property to quickly and easily determine its legal owner and any claims against the property, such as any mortgages or other liens. This system of recording is also important as a way to protect different parties' interests in the property and, if necessary, to determine ? often in court, which parties' rights are to be enforced. However, if the mortgage note is not contained within the mortgage, most jurisdictions require these promises to repay the mortgage to be recorded. Thus, to give an overview, purchasing a property using a mortgage requires:

1. A sale/purchase of a property, usually including a house or "home" upon the property;

2. A seller; 3. A purchaser/borrower/homeowner/mortgagor; 4. A bank/mortgage company/similar institution acting as a lender/mortgagee; 5. A sales contract/contract of sale; 6. A loan (from the lender to the seller); 7. A mortgage containing the terms of the loan agreement (the legal document for the loan); 8. A deed transferred from the seller to the purchaser; 9. A promise to repay the loan, often contained within the mortgage itself, known as the

mortgage note.

Deeds of Trust, Lien Theory States vs. Title Theory States, and Judicial vs. Non-Judicial Foreclosure States

The origin of U.S. property law stems from older English property law, in which there was a requirement for a third party to hold both the title (from the seller) and the money (from the buyer and, in later times, the lender) until both the seller and buyer/lender could meet their obligations under their agreement and the seller was ready to receive the money and transfer title. This third party was known as a "trustee." A ceremony was held ? the "livery of seisin," where the property was officially transferred ? to finalize the transfer. This would be most closely associated with a formal closing ceremony today. Some states still require some form of using this third party and are known as "Deed of Trust" states, where the homeowner issues a title to the third party for the purpose of securing the debt (the loan). The main reason for such an archaic and nuanced difference existing in the modern mortgage process, other than tradition and a failure to modernize, is that most deeds of trust include a "Power of Sale Clause," allowing the trustee to sell the property without going to court to obtain a judicial decree. Judicial and non-judicial foreclosure states are determined by statute, either requiring a party to go to court to foreclose or not (or, sometimes, in certain situations and not others). An easier way to think of a Deed of Trust is as a mortgage note held by a third party. Further, there are "Title Theory" states and "Lien Theory" states. The main difference is that in a lien theory state, the homeowner has full title to the home and the lender simply has a lien (a legal claim) against the property (evidenced by the mortgage note). In a title theory state, the legal title, or right to use and live upon a property, is transferred to the homeowner, while the lender retains equitable title, the right to ultimately claim ownership of the property should the homeowner fail to fully satisfy the requirements of the mortgage. Wikipedia actually has a very nice overview of the differences in this section, found here. However, the article does err in one regard, referring to a mortgage as a security interest in a property. The security interest is a separate thing. A mortgage is the instrument evidencing the debt, while the note promising repayment actually creates the security interest against the home ("attaching" the interest to the property). A mortgage, a mortgage note, and the security interest attached to the property are three distinct legal concepts that are often conflated, intermingled, and confused with one another. All of the technicalities of this section are fairly unnecessary to the basic understanding of "how mortgages work" but, in a judicial proceeding, such as a foreclosure or lawsuit to settle ownership issues (or "quiet title" to a property), the

mechanics of these issues become more important, especially as additional parties are introduced to the chain-of-title (order of possession of the property and/or the mortgage rights against the property). Sloppy practices pertaining to the assignment of mortgages and the endorsement of mortgage notes were at the epicenter of the mortgage crisis in the United States.

Mortgage Servicing

A practice prevalent in the mortgage industry is known as mortgage "servicing." Servicing a mortgage simply means collecting the mortgage payments, tracking and recording the status of the repayment of the loan, and communicating with the homeowner and the lender (often issuing statements to both). Servicers usually charge a fixed fee or a percentage of the total repayment in exchange for their services. Some lenders have in-house servicing departments while many use thirdparty servicers who specialize in the field. The advantage to the lender is that the servicer can focus on collecting payment and communicating with homeowners while the lender focuses on what it does best ? lending money, or issuing mortgages, to potential homeowners the lender deems worthy of a loan. Servicers, due to their specialization, can also simplify things for homeowners by giving them one, specialized, point-of-contact for all questions, concerns, and issues pertaining to the homeowner's mortgage. The Consumer Financial Protection Bureau ("CFPB") has a succinct and accurate write-up differentiating a lender from a servicer here. As a general rule, servicers can collect and often foreclose on behalf of mortgage owners (lenders) but cannot transfer ownership of mortgages to other parties, absent a delegation of power-of-attorney ("POA") from the owner to the servicer.

Assignments of Mortgages

Commonly, at least in the U.S., a lender will sell the rights to collect upon a mortgage to a third party ("assign" the mortgage). When assigning a mortgage, the lender executes an "assignment of mortgage" document. Most jurisdictions require this assignment to be recorded in the local records pertaining to the property, alongside the deed and the original mortgage which is now being transferred to a third party. This allows anyone accessing the records to know who now stands in the original lender's place as the owner of the right to receive payments on the mortgage. Additionally, under Uniform Commercial Code (the "UCC," enacted in some form in all 50 states) requirements for the formation of a contract, language pertaining to the giving of a minimum amount of money and "other good and valuable consideration" (or similar) is included. Finally, the promise to repay note must be transferred to the mortgage purchaser, as well. This signing over is called an "endorsement," and the note is "endorsed" to the new owner. This note is either endorsed from the original lender to the mortgage purchaser specifically or it is "endorsed in blank," making it a UCC-defined "bearer note" under Article 3 of the UCC. A bearer note is simply an instrument that allows the holder of the note to collect on the instrument rather than a specifically-named party. This means that if the purchasing party then sells the rights to the mortgage down the line to any other parties, the eventual holder of the note is the one entitled to receive payments made to satisfy the

original

mortgage.

An everyday example of this is found in the form of a check ? the original is written from Party A to

Party B. Party B can then use the check to pay Party C and endorse it specifically to Party C, using

the language "pay to the order of Party C" or similar. Alternatively, Party B could endorse the check

as "pay to bearer" or simply sign Party B's signature. This means that Party C or any later holder of the

check can cash it. The proper form of assigning mortgages and endorsing notes was also central to

the U.S. mortgage crisis and the ensuing fraud by the banks.

Securitization

"Securitization," or the "securitizing of mortgages," is the process by which a mortgage or group of mortgages is pooled together to form an asset (a trust fund) which is then used as the collateral in an asset-backed security (or "ABS"). Mortgage-specific ABSs are commonly called mortgagebacked securities ("MBSs") or, sometimes, residential mortgage-backed securities ("RMBSs"). Commercial mortgage-backed securities are known as "CMBSs." The security instrument is generally a bond or a "pass-through certificate" where the investors are paid according to the amount of mortgage payments collected on the mortgages bundled into the trust.

Here is how the securitization process works:

1. A bank or other institution issues a mortgage. It profits by charging several percentage points as an "origination fee." It then sells the mortgage to a purchaser for payment;

2. This purchaser takes hundreds or even thousands of purchased mortgages and combines the rights to receive payment on the mortgages into an asset (a fund held in trust) which receives all of the mortgage payments. The institution then issues a bond or certificate which pays investors an amount (the "coupon rate") based on the payments of the mortgages into the trust. This is an asset-backed security, using the underlying mortgages as the assets/the trust backing the bond (the security) specifically known as an MBS or RMBS. The securitizing institution charges a fee (usually around 2%) to the investors for the opportunity to invest in the bonds;

3. The investors purchase the bonds, giving money to the institution creating the MBS, replacing the cost of having purchased the mortgages pooled in the MBS. The institution can then purchase more mortgages from other institutions, who can then issue more mortgages and so on;

4. The investors receive bond payments, at a stated percentage (the coupon rate), minus the fees of the firm creating the MBS, minus any defaults (mortgages payments that are not made) and any early payoffs (no more interest is to be received on the mortgage). Historically, the mortgage is one of the first payments a household makes when paying bills and, thus, was usually considered very safe. Additionally, the Pooling Service Agreement ("PSA"), the document governing the MBS, often provides that the lender selling the mortgage to the securitizing institution, should the mortgage default, must replace the mortgage with a

"performing mortgage" (one where the homeowner is making payments, meaning not in default) or a cash equivalent. Thus, MBSs were historically considered extremely safe investments;

The concept of securitization started as a simple idea run mainly by the U.S. Government, with the stated purpose being to infuse money into the mortgage market and allow for more Americans to purchase homes. The idea later grew into a private investment tool and improper practices in the industry led to and exacerbated what is commonly referred to as the Financial Crisis of 2008 (or 20078) or just the "Financial Crisis."

A History of Mortgages in the U.S. and Government Involvement

Origins and Historical Overview

The modern residential mortgage dates back to the 1930s and exploded in the Post-WWII boom of the late 1940s through the 1960s. As part of Franklin D. Roosevelt's "New Deal" legislation, the U.S. government formed several institutions to facilitate a more liquid credit market with access to mortgages made available to a higher percentage of Americans. This included the creation of the Federal Housing Authority ("FHA") in 1934 and the Federal National Mortgage Association ("FNMA," almost always referred to colloquially as "Fannie Mae") in 1938. This effort has been aided through the following decades in various way, including the 1965 formation of the Department of Housing and Urban Development ("HUD") of which the FHA is now a part, the Civil Rights Act of 1968, known as the "Fair Housing Act," the 1968 Housing and Urban Development Act, which created the Government Mortgage National Association ("GNMA" or "Ginnie Mae"), and the 1970 formation of the Federal Home Loan Mortgage Corporation ("FHLMC" or "Freddie Mac").

Government Insurance/Guarantees, Fannie Mae, Freddie Mac, and Ginnie Mae Government-Backed Loans

The FHA, the United States Department of Agriculture ("USDA") Rural Development Program ("RD") (managing what was formerly the Farmers Home Administration ("FmHA") Program), the Veterans Administration (the "VA"), and the Office of Pubic and Indian Housing ("PIH") offer insurance on loans that meet certain underwriting requirements. This means that, should the homeowner default and the sale of the property be insufficient to cover the lender's losses on the loan, these government institutions will cover the lender's losses. This incentivizes lenders to issue loans conforming to the agencies stated underwriting standards as they are essentially "zero risk" loans for the lender. These insured loans are known as "conforming loans." All of these loans can collectively be referred to as "government-backed" loans. Historically, loans that were not government-backed were generally referred to as "conventional loans." Since 2000, many "exotic loans" have proliferated ? this is discussed below, under the "Private-Label MBSs" section.

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