Borrowers Pay the Piper For Lender Misdeeds
December 5, 2015
“I have been turned down by 2 different lenders because my
last years’ tax return didn’t show enough income from my
business to qualify, despite a credit score of 800 and a
down payment of 50%. Does this make sense?”
No, it doesn’t
make sense, you and thousands of other potential home buyers
are being rationed out of the market because of the misdeeds
of lenders during the go-go years leading to the financial
crisis. How we got to this state of affairs is the subject
of this article.
The Three Prongs of Loan
rules focus on three borrower features that affect the
probability that a mortgage loan will be repaid as promised.
obligations relative to income, which measures an
applicant’s capacity to make mortgage payments.
Equity in the
property relative to property value, which measures the
applicant’s incentive to make mortgage payments.
which measures the applicant’s past reliability in meeting
loans are sold by those who originate them, acceptable
values of underwriting rules, and acceptable tradeoffs
between them, are formulated primarily by the agencies who
buy them or insure them: Fannie Mae, Freddie Mac and FHA.
Loan originators can be more restrictive than the agencies
in setting rules, but they cannot be less restrictive unless
they are prepared to own the loans themselves.
In addition to
the underwriting prongs described above, loan originators
are concerned with the degree of rigor with which the
agencies monitor underwriting decisions. An
affirmative decision by the originator that turns out to be
unacceptable to the agency results in a required buy-back or
a mortgage insurance rejection, which carries significant
cost to the originator.
Underwriting Becomes Flexible in
the Years Before the Housing Bubble
In the years
before the housing bubble, underwriting systems became
increasingly flexible, driven in part by the development of
automated systems at Fannie and Freddie, and by the
development and increasing use of credit scores. Under these
evolving rules, applicants could be weak in one underwriting
dimension so long as they were strong in the other two.
Flexibility was further increased by the development of
alternative documentation requirements falling between the
extremes of “full doc” and “no doc”. Compliance with
underwriting rules was subject to periodic spot checks by
Underwriting Deteriorates During
A bubble is a period of unsustainable price increases.
The bubble period that preceded the financial crisis ran
from September 1998 to June 2005, during which the
Case/Shiller house price index rose by 10.5% a year. Over
the preceding period from February 1975 when the index
begins to September 1998, the average annual increase had
When house prices are rising by 10% a year or more,
borrowers’ equity rises by the same amount, which makes it
very difficult to originate a bad loan – one that results in
loss to the lender/investor. Borrowers could be
qualified on the basis of reduced payments that lasted only
a few years because the loans could be refinanced when the
initial payment period ended. Those that can’t make the
higher payments can sell the house at a profit. In the worst
case where the lender had to foreclose, their costs are
fully covered by the sale proceeds.
The bubble led to a liberalization of underwriting rules,
and widespread violations of the rules that remained as
scrutiny by the agencies largely disappeared.
Underwriting Becomes Rigid
After the Financial Crisis
House prices stopped rising and began to fall after June
2005, causing enormous losses to mortgage-related firms, the
insolvency of many, and a crisis of confidence during
2007-8. Underwriting rules did a 180 during these years,
swinging from being excessively liberal to excessively
restrictive and rigid. That is where they remain today,
although house prices began to rise again starting in 2012.
Perhaps the most important of the
underwriting rule rigidities involve income documentation.
The abuses that arose during the bubble years and the losses
that occurred when the bubble burst had such a major impact
on the mindsets of lawmakers, regulators and Fannie/Freddie
that an affordability
requirement has become
the law of the land; borrowers must be able to dozcument
that their income is adequate, regardless of how good their
credit is and how much equity they have in the property.
The affordability requirement imposes an especially heavy
burden on self-employed borrowers, who face the greatest
difficulty in proving that they have enough income to
qualify. Prior to the crisis, a variety of alternatives to
full documentation of income were available, including
“stated income,” where the lender accepted the borrower’s
statement subject to a reasonableness test and verification
Stated income documentation was designed originally for
self-employed borrowers, and it worked very well for years.
Then, during the bubble period, the option was abused and
stated income loans became “liars loans”. After the crisis,
instead of curbing the abuses, the option was eliminated.
My mailbox is crammed with letters from self-employed loan
applicants with high credit scores and ample equity whose
applications were refused because of an inability to
document their income adequately.
The problem is heightened by the much strengthened
surveillance over compliance, which increases risk to the
originators. Assessing the income documentation provided by
a self-employed applicant is a judgment call that carries a
high cost to originators if they get it wrong. The loss on a
required loan buyback can wipe out the profit on multiple
good loans. The prudent path is not to invest any time in
such loans, which is the policy taken by the lenders
consulted by the frustrated applicant whose letter to me is
cited at the beginning of this article.