October 25, 2014

The housing sector today is not providing the economic stimulus we had come to expect during periods of economic recovery. A major reason is that the underwriting rules and practices that determine whether or not an applicant qualifies for a home mortgage are much stricter today than they were before the financial crisis.

In part, the tightening reflects changes in the market environment that make mortgage loans generally more risky than they were before the crisis. The major factor was the nationwide decline in house prices between 2006 and 2009, the first such decline since the 1930s. The very liberal terms that prevailed prior to the crisis were based on a widespread belief that such declines were a thing of the past. When price changes are always positive, it is very difficult to make a bad mortgage loan. Now that the market understands that house prices can decline, mortgages are considered riskier.

A second factor has been the post-crisis practice of Fannie Mae and Freddie Mac to require lenders originating loans for sale to the agencies to buy them back if they default too quickly. This has caused many lenders to impose underwriting rules (referred to as “overlays”) that are more restrictive than required by law and regulation,

A third factor has been the post-crisis tightening of underwriting standards imposed by law and regulation. The riskier mortgage types that experienced the highest default rates are no longer permitted. This includes loans that allow negative amortization where the payment does not cover the interest, and loans that allow interest-only where the payment convers only the interest.  Monthly payments today must be fully-amortizing, meaning that if continued through the life of the loan, the balance will be paid off at term.

In addition, riskier loan features that are still allowed carry a larger penalty than they did before the crisis. For example, a borrower refinancing with “cash-out” is subject to a larger price penalty relative to a no-cash refinance than before the crisis, and may also be subject to a higher credit score requirement, a higher equity requirement or both. The same is true of loans on 2-4 family properties and condos, relative to loans on single-family homes.  

But the tightening of underwriting rules following the crisis has gone beyond these rational adjustments to a riskier environment. It also included knee-jerk responses to pre-crisis abuses, particularly to the many cases of loans granted to people who obviously couldn’t repay them. A system of hastily enacted rules and procedures designed to prevent this from happening again are now blocking many good loans from being made. The following are major features of this system:

A belief that all mortgage loans should be affordable. In fact, there are numerous circumstances in which an unaffordable loan is in the interest of a borrower, and where the evidence is compelling that the loan will be fully repaid. One example is a cash-out refinance by an owner who wants to remain in the house a few more years before selling, and uses the cash to make the payment. Underwriter judgments are needed in such cases, however, and these are not a part of the new system.

Underwriter discretion is substantially narrowed. Rules have largely eliminated discretion, and the major role of underwriters today is to check for conformity with the rules.

Ratios of debt-to-income above 43% indicate over-commitment by the applicant. Given the wide range of circumstances that can affect a borrower’s capacity to meet obligations, fixation on any ratio as a maximum makes no sense. But again, the sense should be provided by an underwriter with the discretion to make a call, and that no longer exists.

The affordability requirement is absolute and not affected by the applicant’s credit score or equity in the property. Applicants making a down payment of 40% with a credit score of 800 are turned down if their income is not adequate. This makes no sense.  

Income must be fully documented. Prior to the crisis, documentation requirements ranged from full-doc to no-doc, with three or four partial- docs in-between. The less complete the documentation, the higher the price and the larger the required equity and credit score. That sensible system is now gone and all loans must be fully documented. This is why I keep getting letters from self-employed applicants who cannot qualify despite having large equity and a high credit score.

Much of the system of rules and beliefs described above stem from Dodd-Frank, and were formulated in an atmosphere hostile to lenders. But borrowers are the ones paying the price.

The issues need to be reconsidered in an atmosphere free of vindictiveness toward lenders. It could begin with Fannie Mae, Freddie Mac, and their supervisor the Federal Housing Finance Agency, which could re-examine their rules, identify those that should be liberalized, and determine which they could fix on their own and which would require new legislation,

Thanks to Jack Pritchard