Questions About the Failure of Mortgage Locks

December 15, 2003  �Why have lock failures increased recently? A lock failure occurs when a lender does not honor a mortgage price that a borrower had believed was guaranteed. Lock failures occur when interest rates are rising and honoring locks is costly to lenders. The bulge in lock failures in recent months reflects an increase in interest rate volatility, relative to prior years. When market interest rates are stable or declining, locks are always honored because it doesn�t cost lenders anything to do so. If a lock expires because the loan could not be fully processed within the lock period, the lender will extend it.  In a rising rate market, however, expired locks will be extended only at the new market rate. But saying that mortgage lock failures result from rising interest rates is like saying that the failure of a casualty insurance company to pay off on a fire was a result of the fire. Mortgage locks are supposed to protect borrowers against rising interest rates. The fact that the protection often fails reflects weaknesses in the lock system. �Why are mortgage locks so unreliable?� One reason is that the adverse event that triggers the insurance � a rise in interest rates �affects every locked loan in lenders� pipelines.  In contrast, the adverse event that triggers homeowner insurance is usually an isolated event.  One house fire will not seriously damage a casualty insurance company, but a rise in interest rates can force a lender who is not adequately hedged into insolvency. Most lenders hedge against a major hit to their profitability from rising rates.  They hedge by executing transactions that will increase their profits when rates increase, offsetting their lock losses.  A lender who is fully-hedged would not be affected by a rise in rates, but since hedging is costly, few lenders are fully hedged. A long period of declining interest rates weakens the lock system. Hedging during such a period is money down the drain, so lenders are tempted to do less of it. And a few may actually adopt a �go-for-broke� policy where they don�t hedge at all. They look to make as much money as they can during the low-rate period, and go out of business when it ends, leaving failed locks behind. Indeed, a significant proportion of the failed locks in 2003 can be traced to one large lender who evidently pursued such a policy. When it closed its doors, hundreds of borrowers were left stranded. Another weakness of the lock system is that some borrowers, especially among those refinancing, game the system. They lock the price with a lender, but if rates decline, they lock again with another lender. This practice raises the cost of locking, pushing lenders to find ways to protect themselves. Some lenders try to protect themselves against this practice by charging a lock fee that is credited back to the borrower at closing but is not refundable if the borrower walks from the deal.  Or the lender may insist that the borrower pay one or more fees, such as an appraisal fee, that the borrower would have to pay again if he went with another lender. These are fair conditions, but lenders who impose them place themselves at a competitive disadvantage, so they are far from universal. A less savory practice that underlies many lock failures is to load the loan approval with conditions that allow the lender to back out. Every lock is conditioned on the borrower being approved for the loan, and approval is frequently subject to conditions. Most of these are completely reasonable, for example, the removal of a lien on the property.  But some conditions are designed to allow the lender to exit the lock lawfully.  I recently heard of an interesting one from a puzzled borrower. His commitment letter stated that if the loan application, which the lender had approved, was rejected by the investor to whom the lender intended to sell the mortgage, the lender�s lock was no longer valid. This borrower was alert, caught the condition, and asked me what I thought about it. I told him that it was the lender�s responsibility, not his, to determine whether he met the investor�s requirements. The lender removed the condition. Many lenders would rather protect themselves with contractual escape clauses rather than charging a non-refundable fee because they know that most borrowers don�t read contracts but fees drive them away. Other things the same, smart borrowers should prefer lenders who charge a non-refundable lock fee.  Lenders who protect themselves from being gamed in stable and declining rate markets are more likely to honor their locks in a rising rate market.  �Does working with a mortgage broker, as opposed to dealing directly with a lender, increase or decrease the probability of a lock failure?� It can go either way.  One advantage of dealing with a broker is that brokers have the same interest as borrowers in avoiding lenders who dishonor locks.  Brokers won�t use wholesale lenders whose lock commitments include escape clauses that let them off the hook in a rising rate market.  Were this to happen, the borrower might well blame the broker. However, brokers cannot monitor how well lenders manage their finances. The single worst episode of dishonored locks in 2003 resulted from failure of a wholesale lender. The brokers caught up in this failure were forced to find new lenders and structure new deals for borrowers who could afford the higher rates; in many cases they shaved their commissions, sometimes to zero, to make the new terms less onerous for the borrower.  While borrowers who deal with brokers have some protection against gamesmanship by lenders, they are vulnerable to gamesmanship by brokers.  Having a third player in the picture, furthermore, can obscure the chain of responsibility, to the borrower�s disadvantage. Brokers and lenders can and do blame each other for failed locks. Whether on balance the broker increases or decreases the chances of a failed lock depends very much on the individual broker.  The efficient/honest broker guides the borrower in selecting a lock period long enough to process the loan, but no longer, since longer lock periods cost more. (A lock for 30 days will cost about 1/8 of a point more than a lock for 15 days, or $125 on a $100,000 loan; a lock for 60 days might cost $375 more). This broker knows how long each lender is taking to move loans through its pipeline, and performs his part of the loan processing in a timely manner.  He submits complete and accurate files that minimize the time it takes the lender to approve the application, and keeps tabs on the lender�s progress. The prices this broker locks will almost certainly be honored, unless the lender fails, a contingency no broker can control. The sloppy broker doesn�t properly inform the borrower how much time is needed, and/or fails to process the loan in a timely manner, perhaps because he is over-committed. If interest rates are rising and the lender is looking for an excuse for not closing within the lock period, this broker will provide it.  The deceitful broker doesn�t lock the loan with the lender, but tells the borrower he has.  The lock is a fake.  The broker�s intent is to pocket the price premium for a longer lock period. If the 60-day lock price is 3/8 of a point higher than the 15-day price, for example, and if the market is stable over the 60 days, the extra 3/8 of a point goes to the broker rather than to the lender.  True, if rates increase just a little, the broker might take the loss himself � that�s how they rationalize what they do.  But if rates increase a lot, the broker runs for cover and the borrower is left holding the bag. When this happens, as it did earlier this year, the deceitful brokers run in all directions looking for excuses. The most common excuse is that the lock lapsed because of the lender�s failure to process the loan within the lock period.  Divided responsibility provides a cloak for the deceitful broker to hide behind.   �Do borrowers have any recourse for failed locks?� There is seldom a cure for failed locks. Proving the culpability of lenders who deliberately allow locks to expire, is extremely difficult. Lenders can claim that the borrower should have selected a longer lock period, that the borrower was slow in meeting the lender�s reasonable requests for information, that the broker submitted an incomplete file, and on and on. Obtaining recourse against brokers may be even more difficult. How do you prove that failure to close within the lock period was due to the broker�s carelessness rather than to a deliberate slow-down by the lender? If a deceitful broker puts a lock in writing, you can take him to small claims court, but if all you have is oral assurances, forget it. Focus on prevention.  �What can a borrower do to prevent lock failure?� Lock failures can usually be prevented. The key is in the selection of the loan provider.  If you are dealing directly with a lender, the greatest risk is a lender who was not around before the most recent period of heavy refinancing.  A lender who entered the market to take advantage of a refinancing boom is not a good bet to honor locks in a rising rate market.  Referrals are always nice to have, but they aren�t much use in preventing lock failure.  The lender trying to make as much money as possible in a favorable market will meet commitments and get good references so long as the market stays favorable.  The question is, what happens when the market turns bad?  The only references of any value are those from borrowers who had locks that were honored despite a rise in market rates after the lock date. Borrowers should also check the lender�s lock requirements, which vary widely.  Some charge nothing and require submission of a limited amount of information.  Others charge a fee that is returned to the borrower only if the loan closes or if the borrower is rejected.  A �lock-jumper� who bolts in search of a better deal elsewhere, loses the fee.  Such lenders may also require submission of a full application and perhaps other documents such as an appraisal.  In general, the tougher the lenders� lock requirements, the more likely that the lender will honor a lock in a rising rate market.  Lenders who turn away business in stable/declining rate markets by making it difficult for lock-jumpers are demonstrating that they expect to be around for a long time. Borrowers should also examine the lender�s commitment letter with care.  The letter almost always specifies conditions that the borrower must meet, the only question being whether the conditions are reasonable.  Requiring that homeowner insurance and title insurance be in place is reasonable; requiring that the borrower�s application must be acceptable to the investor to whom the lender intends to sell the loan, is not reasonable. Borrowers who deal with mortgage brokers can usually depend on the broker to select a reliable lender.  The borrower�s focus should be on selecting the right broker.  A particular concern is avoiding deceitful brokers who offer fake locks.  A fake lock arises when the broker tells the borrower the loan is locked with the lender, when it isn�t.  If market rates don�t increase, the broker pockets the difference between the price quoted by the lender for a 30, 45 or 60-day lock period, and the price quoted for delivery in a few days.  If rates increase just a little, the broker may honor the lock at his own expense.  If the increase is substantial, the broker runs for cover and the borrower is stuck without a lock. To avoid this, borrowers interviewing brokers should indicate that they expect to see a written lock confirmation from the lender shortly after a lock is submitted.  Upfront Mortgage Brokers will provide this as a matter of course.  Avoiding a sloppy broker who may not get your loan processed within the lock period is more difficult.  Many brokers will never turn down a prospective client, no matter how many they already have.  Their view is that in a highly cyclical business, they have to make their money when they can.  In addition, they never know how many of their prospective clients will remain with them through closing and how many will go elsewhere.   What you want is a broker who plays hard-to-get in order to avoid wasting time on borrowers who don�t stay the course.  These brokers require that borrowers make a commitment to them.  This might be a contract making the broker the borrower�s exclusive agent in securing a loan, or it might be a requirement that the borrower pay one or more fees in advance.    This is the broker you want, but you don�t commit yourself without the broker committing to you.  That means an agreement, in writing, on the broker�s total fee, including any payment to the broker from the lender.  (This is called a �yield spread premium�).  Upfront Mortgage Brokers do this as a matter of course, but other brokers will do it as well if you request it.  Copyright Jack Guttentag 2004

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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