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Home loans in the 21st century

How home loans are supposed to work

This is supposed to be the way our home loan system works. It is a simple deal between a bank and a borrower

1) Banks create new money by lending money to people who have some skin in the game. That is, the borrowers have (a) made a down payment on the house they are buying and (b) put the house up as collateral for the loan.
2) The banks make money by collecting interest on the loan over the life of the loan.
3) If the loan goes bad, the banks foreclose and sell off the house, thus limiting the bank’s losses to the difference between the money they have lent and they money they collect from the selling the house. If the loan was prudent, the bank’s losses will be very small.
4) Thus the banks are pressured to make prudent loans. It is that pressure that is supposed to make sure that the bank makes sensible loans that will not go bad
5) The built-in risk is the ONLY thing that keep the banks prudent.
6) The leverage that is built into fractional reserve banking practically guarantees that banks will never run out of money to lend.
7) Selling off a loan exchanges one asset of the bank, the loan, for another asset, the cash from the sale of the loan. The bank does not have to sell the loan to make more money available to the bank for future loans.
8) The selling off of a loan has ONLY ONE PURPOSE -- the avoidance of risk to the bank on a shaky loan. That should not be allowed.

 

How home loans actually work

This is the way our house-mortgage system actually works. It is a daisy-chain deal involving at least 4 lenders and a borrower.

We now have four lenders (or people and companies who look like lenders) in this Daisy Chain who are each making a profit from the buyers of homes. See bold letters (a) to (d) below. Note that these four are also borrowers. Also note that the Federal Government or the Federal Reserve System is not counted in this Daisy Chain.
1) Anyone with a computer and plenty of savvy in home mortgage lending can become (a) a loan originator if they have the money an resources to bundle loans in packages of say $5 million.
2) The loan originator gets qualified for a short term line of credit say for $10 million from (b) a commercial bank.
3) The originator then establishes a relationship with (c) a secondary lender (may be Fannie Mae or Freddie Mac) and they agree upon what software to use, what the qualifications for a borrower might be, and the loan documents that will be used.
4) The originator starts getting loan applications and those borrowers that meet the qualifications get a loan that is initially funded by using the loan originators line-of-credit at the bank.
5) Once the loan originator has $5 million worth of loans, he bundles them up and sells them to the secondary lenders such as Fannie Mae and Freddie Mac who pay off the loan originator’s line of credit and it starts all over.
6) Loan originators and secondary lenders do not operate as fractional reserve lenders. Secondary lenders get their money by selling bonds to (d) people with fat checking and savings accounts who lend the money to the secondary lender and the secondary lender lends it to the people wanting the home loan.

At this point, we, as a country, are not sure precisely where most of the recent “bad” loans came from. That fact does not affect the main thrust of our argument which is that the originator of the loans, whether they are banks “private loan originators” or “secondary lenders”, should not be allowed to sell off shaky loans.

If “private loan originators” and /or “secondary lenders” are taking over the lending functions of banks that could be the source of much mischief. That could be a way of avoiding bank inspections and loan regulations.