In a recent article (Sub-Prime 2013 Edition: It is Government Insured!), I pointed out that mortgage lenders today can make a loan with only 3% down to a borrower with a steady job but a credit score of only 570, and have it insured by FHA. But lenders can’t or won’t accommodate a self-employed physician who can’t adequately document enough income, even if the physician can put 30% down and has a credit score of 800! Considering that the likelihood of default is at least ten times higher on the first mortgage, this is insane.   

The insanity is best viewed in the broader context of how the current market differs from the one we had before the financial crisis. Some types of borrowers do better in the current market while others such as the physician mentioned above, fare much worse.   

How Borrower Have Fared Depends Heavily on Their Risk Status 

1. Transactions Viewed as Low-Risk:  The market is even more receptive to this group than it was before the crisis. Loans are as readily available to them today as they were before the crisis, but the rates are lower. These borrowers are better off now.

2. Transactions Viewed as Moderate-Risk: Loans are available in the current market, but the rate spread between moderate risk and low risk transactions is larger than it was before the crisis. Hence, these borrowers don’t enjoy the full benefit of the unusually low market rates.

3. Transactions Viewed as High-Risk: Loans that were available before the crisis at premium rates, are not available today at any rates. These borrowers are shut out of the market altogether. 

Private Mortgage Insurance Premiums Tell the Story 

One useful way to see these dynamics at work is to look at mortgage insurance premiums, which are entirely based on judgments of default risk. Before the crisis, insurers based their premiums on the ratio of loan amount to property value (LTV, 4 categories), type of mortgage (3 categories), and term (4 categories). An entire premium structure could be displayed on one page, which I did on my web site in September 2005.  I haven’t tried to update it because the premiums today are derived from complicated algorithms that defy easy summarization.

In 2005, the annual premium rate on a 30-year FRM with an LTV of 95% was .78. Today, the premium is .59, but only on transactions that meet a bunch of other conditions that did not exist in 2005. To qualify for the premium of .59, the borrower must have a credit score of 760. If the score is 620, the premium is 1.20 instead of .59. If the borrower with a score of 620 is buying a manufactured house, the premium is 1.70. 

Furthermore, the current premium structure is replete with transactions that don’t qualify for insurance at any premium rate, but would have qualified in 2005.  Here are a few:

·        On a cash-out refinance, insurance is not available at an LTV above 85%, no matter what the borrower’s credit score is.

·        If the property is a second home, insurance is not available at an LTV above 90%, no matter what the borrower’s credit score is.

·        If the property has 3 or 4 units, or if it will be held as an investment, mortgage insurance is not available, regardless of LTV or the borrower’s credit score.

Piggyback Loans Are Gone

Before the crisis, mortgage insurers competed against second mortgage lenders for the business of borrowers who could not put 20% down.  These were called piggybacks and were classified as 80/20/0, 80/15/5, 80/10/10 and 80/5/15, where the first number is the percent of the property value provided by the first mortgage, the second number is the percent provided by the second mortgage, and the third number is the percent down payment. The riskiest of these to the second mortgage lender was the 80/20/0, with the risk declining as the borrower’s down payment increased.

80/20/0 deals were available until September 28, 2007, 80/15/5s until December 28, 2007, 80/10/10s until February 8, 2008, and 80/5/15s until March 28, 2008. That was the end of the piggybacks.  Borrowers who put less than 20% down today have only the mortgage insurance option. 

Alternative Documentation Is Gone 

The potential borrowers that are most seriously disadvantaged today relative to the pre-crisis period are those who cannot adequately document their income. Before the crisis, for a modest rate premium they could select from a menu of alternative modes of documentation, but those are all gone. Full documentation is the rule today.

The insanity is that the full documentation rule goes well beyond the needs of risk control. Rather, it is an unfortunate consequence of hasty knee-jerk enactment of rules in the immediate aftermath of the financial crisis -- a reaction to reports of borrowers being given loans they clearly could not afford.

While loans with less than full documentation will not be insured by FHA or purchased by Fannie Mae or Freddie Mac, it would appear that lenders could make them very profitably at their own risk, but don’t. Why they don’t is the subject of a forthcoming article.