AUTOMATED UNDERWRITING VERSUS REAL LIFE

To: The Federal National Mortgage Association and The Federal Home Loan Mortgage Corporation
I thought it would be appropriate to post this message to you.

I want to thank you for so wisely investing tens of millions of dollars developing an automated underwriting system that uses the most complex algorithms and risk assessment modules to determine Joe Six Pack’s capacity to pay his debt. I also want to thank you for allowing ALL the lender’s underwriters, loan officers, and processors to become dependant upon your forward thinking underwriting systems so they no longer have to perform the monotonous and time consuming tasks of common sense thinking and manually analyzing Joe’s Six Pack’s capacity to pay his debt. I am sure you have saved the mortgage and banking industry hundreds of millions of dollars in people hours, paper, and ink over the years and reduced the probability of human error in the final underwriting analysis and at the same time made hundreds of millions of dollars in automated underwriting usage charges.


To: The Federal Housing Administration and The U.S. Department of Housing and Urban Development, who at one time had the RIGHT IDEA. But for some unknown reason, on October 20th, 1989 you decided to “conform” your processing to the general practice within the lending industry and make it easier for lenders to process FHA loan applications and issued Mortgagee Letter 89-25 - Use of Effective Gross Income To Calculate Borrower Qualifying Ratios and Changes to Underwriting Investor Applications, which changed FHA’s qualifying ratio rules from the "net effective income" approach to using the "effective gross income" ratios of 29%/41% to promote a more accurate analysis of the adequacy of Joe Six Pack’s income and capacity to pay his debt.
And to further conform to the general practice within the lending industry and step forward into the automated underwriting age, you invested millions of dollars developing TOTAL Mortgage Scorecard. Combining TOTAL Mortgage Scorecard’s credit analysis with the functionalities of the multi-million dollar complex algorithms and risk assessment modules of the automated underwriting systems developed by The Federal National Mortgage Association and The Federal Home Loan Mortgage Corporation has also reduced the monotonous and time consuming tasks of gathering documentation, minimizing common sense thinking and manually analyzing Joe’s Six Pack’s capacity to pay his debt. And if that wasn’t enough, on April 13, 2005 you issued Mortgagee Letter 05-16 - Revised Qualifying Ratios and Treatment of Child Support, which increased the gross qualifying ratios to 31%/43% for manually underwritten loan files to enhance homeownership opportunities for low-and moderate-income individuals and families.

WHAT WERE YOU ALL THINKING?

To: The Department of Veteran Affairs, I applaud you on your discipline and sticking to your GUNS by never losing sight of G.I. Joe’s capacity to pay his debt and protecting him by continuing to use old-fashioned conservative methods of “net income analysis” so G.I. Joe can obtain and maintain the American Dream of Homeownership and afford to buy a six pack.


Unfortunately, as you all should be aware by now, something went wrong and the Joe Six Packs of the United States have been defaulting on their mortgages at an unprecedented rate, which is causing HUNDREDS OF BILLIONS OF DOLLARS in losses.
So, in light of this historical event now known as the “Mortgage Meltdown”, I thought that I would take heed of the Department of Veteran Affairs old-fashioned conservative method of analysis to determine Joe’s Six Pack's capacity to pay his debt and maybe offer you a lesson on “Basic Arithmetic 101”. In this lesson, I have chosen to use a very inexpensive $70.00 device, a Hewlett Packard financial calculator, a $0.01 piece of paper, and a $0 .10 pencil with an eraser to put things in perspective for you.



So let’s begin your lesson.


A few years back, Joe Six Pack and his wife Jane, who were First Time Buyers, were thrilled to have received an Automated Underwriting System approval for a Conventional mortgage at a 95% LTV. The automated underwriting system accepted their

Payment-To-Income Ratio of 34.25% and

Debt-To-Income Ratio of 46.89%.

Joe Six Pack’s Credit Score was 730
His wife Jane’s Credit Score was 720

At that time they were living in the City of Philadelphia and renting for $1,200 per month. Their family had grown with the addition of a baby so they decided it was time to purchase a single home in the suburbs outside the City of Philadelphia for $325,000 with a $16,250 down payment and obtained a Conventional fixed rate 30 year mortgage for $308,750.
They locked their interest rate in at 6.50% with zero points and NO Origination Fee.
The real estate taxes were $3,500 per year
The Home Owners Insurance was $812.50 per year.
The total cost of acquisition was $27,500

Joe Six Pack’s parents contributed a gift for $10,000 toward settlement charges and Joe Six Pack and Jane contributed the rest from their own savings and had 4 months PITI in cash reserves.
Sounds good so far eh! Slam dunk loan for any Automated Underwriting System.

Unfortunately, Joe and Jane have now defaulted on their mortgage even though they are still employed. After careful review of their “REAL LIFE” living expenses an interesting discovery has come to surface:

JOE SIX PACK’S EMPLOYMENT PROFILE
Joe had a 12 1/2 year work history at the time he closed on his new home, but had only been employed at a Center City Philadelphia marketing firm for 1 year and was and still is subject to Philadelphia City Wage tax of 3.5392%. In addition, due to the location of his employer, Joe had to drive 8 miles to and from work and was also subject to monthly parking and transportation expenses.
Joe’s Annual Gross Earnings were = $50,000
Monthly Gross Income = $4,166.67


JANE’S EMPLOYMENT PROFILE
Jane had been employed at a South New Jersey computer firm for 2 1/2 years and as a result of the purchase of their new home had to drive 20 miles to and from work each day and was subject to bridge tolls and transportation expenses.
Jane’s Annual Gross Earnings were = $39,200
Monthly Gross Income =$3,266.67

COMBINED MONTHLY GROSS INCOME = $7,433.33

JOE AND JANES FAMILY PROFILE
Joe and Jane had 2 children, a 13 year old who was in public school and a 2 year old. Since Joe and Jane both worked, they were subject to monthly day care expenses for their 2-year old child.

NEW HOUSING EXPENSE BREAKDOWN
Principal & Interest = $1,985.66
R.E. Taxes = $ 291.67
Home Owners Ins. = $ 67.71
Mortgage Insurance = $ 200.69 @ .78% back then
TOTAL = $2,545.72
PAYMENT-TO INCOME RATIO = 34.25%

RECURRING DEBT
Joe's Auto = $325
Jane's Auto = $225
Joe's Student Loan =$ 90
Charge Cards =$300
TOTAL RECURRING DEBT =$940

DEBT-TO-INCOME RATIO = 46.89%

JOE’S WITHHOLDINGS AND MEDICAL
Monthly Gross Income =$4,166.67
Federal Tax =$ 559.79
PA State Tax =$ 116.67
Philadelphia City Tax = $ 147.47
Social Security =$ 245.83
Medicare =$ 54.17
PA Unemployment = $ 2.50
Medical = $ 291.00
Dental =$ 45.00
NET MONTHLY INCOME = $2,704.24


JANE’S WITHHOLDINGS AND MEDICAL
Monthly Gross Income =$3,266.67
Federal Tax = $ 424.79
PA State Tax = $ 91.47
Philadelphia City Tax =$ 0.00
Social Security =$ 192.73
Medicare =$ 42.47
PA Unemployment = $ 1.96
Medical =$ 0.00
Dental =$ 0.00

NET MONTHLY INCOME = $2,513.25

COMBINED NET MONTHLY INCOME = $5,217.48

JOE’S TRANSPORTATION EXPENSES
Monthly Parking Cost = $200.00
Distance from new home
to employer = 8 miles
Automobile = 16 miles per gallon
Gas = $2.50 per Gallon
Usage = 1 Gallon per day @$2.50
Monthly cost @ 20 work days = $ 50.00
Auto Insurance = $ 90.00
TOTAL TRANSPORTATION =$340.00

JANE’S TRANSPORTATION EXPENSES
Monthly Bridge Toll Cost = $ 40.00
Distance from new home
to employer = 20 miles
Automobile = 20 miles per gallon
Gas = $2.50 per Gallon
Usage = 2 Gallons per day
Monthly cost @ 20 work days = $100.00
Auto Insurance = $ 80.00
TOTAL TRANSPORTATION = $220.00

COMBINED TRANSPORTATION COST = $560.00

ADDITIONAL HOUSING & FAMILY EXPENSES
Gas & Electric =$300.00
Water = $ 55.00
Cable TV/Internet/Telephone = $175.00
1 child in day care = $500.00
At Home Food Cost =$500.00
Clothing =$125.00
Gifts/Birthday/Christmas =$125.00
Cell Phones =$150.00
Gasoline for Private Use =$ 50.00

TOTAL LIVING EXPENSES =$1,980.00



SUMMARY OF FUNDS LEFT OVER FOR FAMILY SUPPORT

Combined Net Monthly Income =$5,217.48
New Housing Payment - ($2,545.79)

Recurring Debt -(940.00)
Transportation Costs -($ 560.00)
Living Expenses -($1,980.00)

MONTHLY FUNDS LEFT OVER FOR FAMILY SUPPORT

-($808.31)

IRS REFUND = $4,540 / 12 = $378.33

NET MONTHLY FUNDS LEFT OVER FOR FAMILY SUPPORT =

-(429.98)

AND FINALLY,
To: The Members of The Senate, The House of Representatives, The House Committee on Financial Services, The Federal Reserve, The Federal Deposit Insurance Corporation, and U.S Department of The Treasury, it may be a good idea that you pay attention as well to this “Basic Arithmetic 101” lesson since collectively you all have now decided to spend HUNDREDS OF BILLIONS of Joe Six Pack and possibly even G.I. Joe’s and their children’s future contributions to U.S Department of The Treasury to bail out the mistakes made by the multi-million dollar analytical software that was supposed to save the lenders and banks hundreds of millions of dollars in people hours, paper and ink while at the same time accurately predict Joe Six Pack’s capacity to pay his debt. Maybe ALL OF YOU should have invested in an inexpensive $70 financial calculator and a little common sense and just maybe, you could have prevented the

IMPLODING OF THE AMERICAN DREAM

AND thank you Dennis Harms, the little Iowa farm-boy-turned-PhD for developing the HP 12C financial calculator in 1981 and to Hewlett Packard for continuing to produce and make available this most valuable tool.

Knowledge Unshared Is Worthless
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FHA TIP: PART-TIME VS FULL TIME/PRIMARY EMPLOYMENT

When using Automated Underwriting Systems (AUS) such as DU, LP or the lender’s own AUS for FHA loans, pay close attention to the findings that the AUS returns in regards to the documentation required for employment and income. In most cases, if the AUS returns an Approve/Eligible or Accept it will require less documentation than a manual underwrite. FHA TOTAL Mortgage Scorecard guidelines do not address part-time or second job employment and income. Therefore, you must follow the FHA guidelines described in HUD Handbook 4155.1 when using part-income/second job earnings as qualifying income. The underwriter will be required to determine the stability, consistency and likelihood of continuance of part-time employment based on the supporting documentation you provide in the loan file. It will be necessary for you to analyze the borrower’s employment and income more carefully and thoroughly and be prepared to document your file appropriately to satisfy any discrepancies or uncertain issues that may be apparent in your loan file.

Defining Part-Time Employment

Many times full-time employment that is less than 40 hours per week is misconstrued as part-time employment. The first thing I want to do is explain FHA's definition of part-time employment and or a second job. Part-time employment or second job is considered to be any employment that is “in addition” to a full-time/primary job. Therefore, if the applicant has a full time job working 40 hours per week and on the weekends the applicant works for another employer, the applicant has two jobs and the weekend job is considered part-time employment or a second job. The second job happens to be part-time because it is only a weekend job. But, if the borrower has a job that he or she does not work a full 40 hours per week and it is the ONLY job then this would be considered full time employment and the applicant’s primary job. If the applicant is working less than 40 hours per week, and the employer considers the job part-time for payroll and benefits reasons and it is the applicant’s ONLY job, this is considered the applicant’s primary job for qualifying purposes. Therefore, you should follow the guidelines established for full time/primary employment per FHA TOTAL Mortgage Scorecard guidelines for Approve/Accept and HUD Handbook 4155.1 for Refer manual underwrites. Seasonal employment (e.g., umpiring baseball games in summer, working at a department store during the holiday shopping season) is considered uninterrupted and may be used as qualifying income. However, you [b]must[/b] document that the borrower has worked the same type of job for the past two years and expects to be rehired during the next season. The important thing to remember about employment and income is “stability, consistency and reasonable expectation that the income will continue to be received in the foreseeable future” (usually for three years). In addition, as it pertains to part time and second job income, you must verify that the employment and income has been [b]uninterrupted for the previous one - two years [/b]AND that it has a strong likelihood of continuance.

Determining The Stability and Likelihood of Continuance of Part-Time Employment

Problems arise with part-time income and a second job when you are unable to document the following: The borrower having a long enough uninterrupted history of simultaneously working two jobs. A track record of working “X” amount of hours per week on a consistent and regular basis becaue the amount of hours worked at both the full time and part-time jobs fluctuate and it becomes unclear to the stability and consistency of the earnings. Carefully review and compare the income on the AUS findings with the documents you will be submitting in the loan file for discrepancies. Remember, regardless of the documentation that an AUS requires in it’s findings, the underwriter must still validate all the documents you submit in the loan file to make sure that they support the information that was entered into the AUS which caused it to return favorable results. FHA currently requires an uninterrupted 2-year history of part-time/second job employment but will accept a one -year uninterrupted history if supporting documentation establishes a strong likelihood of continuance.

Documentation That Can Assist in Establishing Stability, Consistency and Likelihood of Continuance
W-2 forms for current & previous employers for ALL jobs for the specified working period. (1 - 2 years).

1. Most recent 30 day pay-stubs for ALL jobs showing TOTAL year-to-date earnings.
2. Signed VOE form or written & signed confirmation from current and previous employers. It is imperative that you document the minimum or average amount of hours the borrower has been working, hourly rate, and year-to-date earnings in their current part-time & full time jobs, and the start/end dates of previous full-time & part-time jobs for the past 1-2 years.
3. Last two years Federal Income Tax Returns IF the borrower:

• Has inconsistencies in earnings & employment history revealed on Pay-stubs, W-2 Forms and VOE’s


• Receives commissioned or bonus income from either job that is greater than 25% of his or her gross income regardless whether or not the borrower receives a W-2 form (employee) or 1099 form (independent contractor).


• Is an Independent Contractor (such as a consultant, real estate agent, insurance agent for instance) and receives Form 1099 MISC from the paying employer.


• Pay-stubs reveal reimbursements for business expenses such as automobile allowances, travel expenses, mileage reimbursements, etc. if this income is going to be used as qualifying income. Automobile allowances cannot be used to offset the auto or lease payment.


• Is receiving income derived from self-employment as a Sole Proprietor, S-corporation, Corporation, or receives income from a Partnership or Limited Partnership.


• Using rental income as qualifying income - If the borrower is receiving rental income from real estate that was acquired and rented before the current year, which includes the borrower’s primary residence if it is producing rental income (such as 2-4 units) and any investment properties that are producing rental income. If the borrower is part of a Partnership this will be revealed on Schedule E and a copy of Schedule K1 of form 1065 will also be required documentation.

Analyzing and Reviewing Documentation

It is your responsibility to review all required employment and income documentation for accuracy and discrepancies before including such information in the loan file and submitting to an underwriter. Information that should be reviewed:

• 30 days recent pay-stubs for all jobs,


• W-2 forms,


• Verification of Employment form,


• dates of hire for all jobs,


• the total hours worked, minimum hours worked, the hourly rate for regular pay, shift differential and/or overtime,


• weekly, bi-weekly, monthly and total year-to-date earnings,


• deductions on pay-stubs such as child support, alimony, garnishments, loans, union dues, 401k, etc
  

Chances are the underwriter is going to average the borrower’s part-time/second job income based on how many hours the borrower has been working. The important thing you should remember is to present ALL the facts, including the dates that the borrower started with current and previous employers and the end date with each previous employer. Underwriters have the right to request additional documentation, including and not limited to 2-years Federal Tax Returns to validate the AUS findings if they feel the documentation you submitted does not support the income used that resulted in a favorable AUS decision.

Borrower Working Two Jobs In Same Profession

There will be times when the borrower has two jobs in the same field such as the medical profession and split his or her hours between two employers. Situations such as this can be analyzed differently than those situations within unrelated fields or professions. For instance, let' s say that a nurse has been working 60 hours per week for the same hospital for seven years. The nurse receives an offer from another hospital to work 30 hours per week at a higher hourly rate. To do this, the nurse decides to cut back the hours on the current employer by at least 30 hours. But the nurse will still be working a total of 60 hours between both employers. Now let’s say this arrangement has only been in effect for one year. Since the borrower is in the health care profession, and these types of arrangements are very common, any experienced underwriter will see the light and should use both incomes for qualifying purposes because of the consistency of the borrower working 60 hours per week in the same profession for the past 7years. Of course it will be your job to document the loan file thoroughly with VOE’s, pay-stubs, W-2 forms AND signed letters from both employers breaking down the amount of hours the nurse has been working, AND what the minimum amount of hours that are available to the borrower. To strengthen the documentation further, the employer can also make positive statements about the nurse’s ability and performance as an employee. The bottom line is the loan file should have enough documentation in the file to prove the stability, consistency and likelihood of continuance for the income to be used as qualifying income.

Borrower Working Two Jobs In Unrelated Fields

If a borrower only works 25 hours per week at one job during the daytime and 10 hours per week at another unrelated job during the evenings and weekends, you would have one full-time primary job and one part-time job or second job. The primary job that the borrower works 25 hours per week would be considered full time employment and not a part-time job as long as the 25 hours were “consistent”. The fact that the borrower only works 25 hours per week does not make it part-time for FHA guidelines. The employer, on the other hand, may consider it to be part-time for payroll purposes. The unrelated second job that the borrower works 10 hours per week would be part-time employment. Both the documentation and qualifying income calculations would have to be analyzed based on FHA's part time employment guidelines.

Switching From Part-Time Status To Full Time Status With Two Different Employers In Unrelated Professions

If an applicant has been working both a full-time and part-time job for the last two years and has recently change to full time status with the part-time employer and part-time status with the full-time employer (did I lose you?) make sure that you document your loan file properly. The applicant can only have one full-time employer AND one part-time employer, NOT two full-time employers. Be sure to provide written verification from the new full-time employer as to when the applicant changed to full-time status, how long the applicant has been working for the company, including the applicant’s current wages such as hourly rate, weekly pay, bi-weekly pay, etc., the minimum hours the applicant has been working, the current position, etc. Again, you will need to focus on the total amount of hours that the applicant has been able to work in the past two years. It all comes down to clearly documenting the applicant’s consistency and ability of hours worked and likelihood of continuance.

Calculating Qualifying Iincome For Part-Time Eearnings

You should have a good idea how to calculate regular base pay earnings for full time employment. Part-time employment should be no different if the applicant receives the same amount on a consistent basis on specified time intervals. However, if the earnings are not received in that manner you must average the earnings over the one-two year period of time.
_________________

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