Creative Refinancing in the OC

As each month passes, the mortgage finance business in the middle of this decade sounds more and more like the business of investment banking at the end of the last. What is legal and profitable today will one day be looked back upon as yet another symptom of a once great, free market economy run amok.

More and more, Yankee ingenuity is applied to financial processes and products that remain many steps ahead of regulators who seem either uninterested or uncaring.

In a bubble economy, the great American creative spirit is channeled to where the monetary rewards are greatest - what constitutes acceptable behavior is easily adapted to the mood of the populace and the reality on the ground.

It all sounds so familiar - everyone turns a blind eye as long as the bottom line pleases. After a while it all seems normal, routine. Time has a strange way of making things seem ordinary, until one day they don't seem ordinary anymore.

From yesterday's L.A. Times comes this story of creative refinancing in Orange County, California, home base to many large mortgage lenders where a median price hovel now fetches about $620,000.

Real estate has been a swell deal for just about everyone who owned a home in California during the last few years.

For hundreds of Orange County homeowners, it's been even better. Thanks to their mortgage broker, they essentially get paid to borrow money.

Mark Gallagher, the founder and president of Park Place Funding in Laguna Hills, uses a technique that unscrupulous brokers employ to bilk clients.

Gallagher's innovation was to cut his customers in on the action, giving them a share of the premium he earns for placing loans with high interest rates.

American business innovation circa 2006 - homeowners refinance every four months at above the prevailing interest rate resulting in a premium earned by the mortgage broker which is then split with homeowner. Repeat in four months.

"In boom times, all sorts of crazy things happen," said James Croft, executive director of the Mortgage Asset Research Institute near Washington. "New programs are invented that have no history. You say, 'This is going to work,' and then you find out three years later it wasn't such a great idea."

With the housing market cooling off, the evaluation period Croft is talking about seems set to begin. The mortgage industry, and some mortgage holders, may be in for an extensive period of second thoughts.

Ordinary people become swept up in extraordinary circumstances. What five years ago would have seemed outlandish, today seems unexceptional as house prices double in just a few years time, illegal immigrants are courted as an untapped source of a home buying public, and ordinary people collectively recalibrate their ideas of what is normal and what is not.

Broker bounties are standard in the home lending industry. The higher the interest rate is over the prevailing rate, the more valuable the loan and thus the greater the premium. The lender usually pays the broker 1% to 4% of the value of the loan.

In California, the bounties must be noted on the closing papers of the loan. But many brokers don't talk much about them, consumer advocates say, and therefore few home buyers are fully informed. In the worst cases, a high premium can tempt a broker to put unwitting clients into expensive loans. Such fraud occurs regularly, according to authorities.

But Park Place, a relatively new brokerage that Gallagher started in his home in the late 1990s, saw opportunity in this type of arrangement. In radio ads, Park Place touted the way the loans could make a house help pay for itself, a sort of perpetual-motion real estate machine.

Some refinancing customers came in, were told the risks — if rates rose before their next refinancing, for instance, they could be stuck paying more than they wanted — and decided to pass on the idea. But most, Gallagher said, responded, "This sounds awesome. Where do I sign?"

Bill Cusato, who lives in Long Beach, refinanced with Park Place in September and was recently in the midst of doing it again. "It's a very easy transaction, minimal fuss and muss," he said. The Park Place agent was out of his kitchen in half an hour.

These loans then become part of the single greatest mortgage innovation in the last half-century - mortgage backed securities, popularized by the accounting-challenged GSEs Fannie Mae and Freddie Mac. The loans originated by Park Place Funding wound up in the hands of unwitting investors seeking a little higher return for a little higher risk.

And here is where it all fell apart. One investor, Gallagher said he was told, bought an investment pool with an unusually large number of Park Place loans in it.

This investor apparently thought he was going to get nice, fat interest payments for at least a couple of years, courtesy of a bunch of foolish Southern California homeowners who were inexplicably paying more than they should have.

Instead, the investor got a surprise. The homeowners refinanced, and the investor's rich yield disappeared almost instantly. He complained, which started a chain of accusations and recriminations.

Everyone involved with the loans promptly identified who was at fault, and it wasn't them.

Sounds more and more like the late 1990s and what is currently known about real estate and lending practices is likely just the tip of the iceberg. There will be much hand-wringing and many a congressional inquiry to be sure - mortgage lenders, mortgage brokers, realtors, appraisers, buyers, and sellers, all seduced by easy money.