The Dichotomy of Prudent Lending and Credit Availability

The following is a print article featured in MReport's July issue, out now.

In the post-crisis era, lenders face the challenge of striking a delicate balance between judicious lending practices and access to financing for creditworthy consumers.

The deluge of mortgage defaults and foreclosures that has plagued the industry over the past half decade was set into motion by a subprime mortgage crisis characterized by lax lending standards, easy credit, and higher-risk mortgage products.

Regulatory changes surrounding mortgage underwriting were explicitly outlined in the Dodd-Frank Wall Street Reform and Consumer Protection Act and seek to limit risky mortgage characteristics linked to higher rates of default. For example, the Ability-to-Repay rule instituted by the Consumer Financial Protection Bureau (CFPB) requires lenders to make a "reasonable and good-faith determination" that a loan applicant has a "reasonable ability to repay the loan." Before approving a mortgage, lenders must evaluate and verify a number of measures, such as the applicant's income or assets, employment, and other debt obligations.

These new underwriting standards are designed to protect consumers from certain risky loan features—such as negative amortization or interest-only—that allow borrowers to take out mortgages they cannot afford. While safeguards such as the Ability-to-Repay rule codify what many consider to be commonsense lending principles, a 2012 study published by the University of North Carolina's Center for Community Capital and the Center for Responsible Lending concluded "underwriting thresholds such as minimum credit scores and loan-to-value (LTV) ratios are a blunt policy instrument to sort credit risk that may disproportionately disadvantage" groups of prospective borrowers, particularly first-time homebuyers and low- and moderate-income households.

Industry data show average down payments for mortgages, which correlate to LTV ratios, are already on the decline—the result of a five-year recession that left many Americans financially strapped and unable to build up their savings. According to a report released in late April by LendingTree, down payments for 30-year fixed-rate loans fell to an average of 15.78 percent in the first quarter of this year, down from 16.01 percent in the fourth quarter of 2013. At the same time, the company found average credit scores for borrowers matched with lenders on its network dropped 6 percent year-over-year, opening up the credit pool to a wider population of borrowers. "As the housing market improves and refinance activity declines, lenders are adapting their guidelines to improve credit accessibility for borrowers," said LendingTree founder and CEO Doug Lebda. "Relaxed lending guidelines translates to a larger pool of qualified homebuyers that could boost the housing recovery. While lenders still need proof that a borrower has the financial ability to repay the loan, lenders have started to accept lower down payments and credit scores from potential borrowers."

Freddie Mac's Home Possible Mortgage

Freddie Mac offers first-time homebuyers and low- to moderate-income borrowers a purchase or refinance (no cashout) loan option that requires only 5 percent down through its Home Possible Mortgage program. The GSE promotes its Home Possible Mortgages to lenders as a way to "increase your origination volume, lower your costs, and increase your Community Reinvestment Act-eligible volume."

Home Possible Mortgage loans are available only to owner-occupants who, as of the note date, do not have an individual or joint ownership interest in any other residential properties. The borrower's annual income must be equal to or less than the area median income; however, exceptions to the income requirement come into play when the property is located in an "Underserved Area," as designated by the CFPB.

The GSE's Home Possible Mortgages provide for more stable monthly payments with their fixed rates, although 5/1 (2/2/5 caps), 7/1, and 10/1 adjustable-rate mortgages (ARMs) are also options. Whether carrying a fixed or adjustable rate, the loan’s original maturity cannot be greater than 30 years. The program also offers lower coverage levels for mortgage insurance, various funding options for closing costs, and flexible debt-to-income ratio conditions.

Homeownership education is required before the note date for at least one qualifying borrower if all borrowers are first-time homebuyers. And additional flexibilities are built into the program for teachers, firefighters, law enforcement officers, healthcare workers, and members of the U.S. Armed Forces.

Fannie Mae's MyCommunityMortgage

Fannie Mae offers MyCommunityMortgages with low or no down payment to help low- and middle-income families achieve homeownership. Options are also available for consumers whose income or credit history prevents them from qualifying for a traditional mortgage.

With a MyCommunityMortgage, no loan-level-price adjustments (LLPAs) are made to compensate for risk because of the borrower's credit score, the down payment size, property type, or because of subordinate loans. The same interest-rate pricing is applied across the board.

Like Freddie's, Fannie's program includes fixed-rate as well as 5/1 (2/2/5 caps), 7/1, and 10/1 ARM loans with a term of up to 30 years. It also mimics the occupancy and ownership interest requirements of Freddie Mac's offering. Fannie Mae's program offers reduced mortgage insurance coverage levels, down payment/closing cost assistance, and exceptions to the minimum credit score requirement of 660. Special mortgage options are also available for public employees and borrowers with disabilities.

If all borrowers are first-time homebuyers or if all borrowers are relying solely on nontraditional credit to qualify for the mortgage loan, at least one borrower must complete prepurchase homebuyer education and counseling.

State-Led Homeownership Programs

A number of state programs have been put in place to ensure credit availability for certain borrowers. Unveiled in June 2013, Massachusetts' Homeownership Compact is a prime example. It creates a shared goal between the state and its participating financial institutions—including Citizens Bank, Sovereign Bank, Eastern Bank, Rockland Bank and Trust, Enterprise Bank, and Blue Hills Bank—of providing 10,000 mortgage loans over the next five years to first-time homebuyers with household incomes below the area median income.

"As Massachusetts emerges from the Great Recession, the availability of mortgage financing on reasonable terms serving families at a range of household incomes is critical to the future of the Commonwealth and to the strength of our local communities," according to MassHousing and the Massachusetts Housing Partnership (MHP).

In conjunction, MHP transitioned its two-loan structure to one mortgage, simplifying the program for firsttime homebuyers and making it easier for participating lenders to underwrite and administer the loans. The one-loan structure also makes it possible for the loans to be sold on the secondary market, something that couldn't be done previously.

Clark Ziegler, executive director of the MHP, said the state was "trying to do something that was much more reflective of the current state of bank regulation," while maintaining the original twoloan program's identity in terms of interest rates and payments for borrowers. The CFPB singled out MHP by name in explaining that certain mortgage products with outstanding loan histories would be exempt from the Ability-to-Repay rule. Because of MHP's track record of success and tight underwriting, banks that issue ONE Mortgage loans aren't saddled with additional liability from the regulator.

"Part of what [CFPB] is saying is that the programs like ours, there's built-in discipline and quality control," Ziegler said. "This is a public mission, to help borrowers and make sure that they're successful. So to put banks through the wringer when that's already hardwired into what we do, doesn't make sense." Officials for the state-run initiative stated, "While irresponsible mortgage lending by largely unregulated financial institutions was a primary cause of the national financial crisis, responsible mortgage lending by banks and credit unions doing business in Massachusetts kept our local foreclosure crisis from being far worse and is already supporting a strong economic recovery."

FHA's Mortgage Offerings

Since it was established in 1934, the Federal Housing Administration (FHA) has enabled homeownership for more than 34 million low- and moderate-income families. The agency has updated the combination of FICO scores and down payments allowable for new borrowers, increasing the pool of eligible consumers who may qualify for a government insured loan under the new, lower FHA mortgage limits.

New borrowers must have a minimum credit score of 580 to qualify for FHA's 3.5 percent down payment program. New borrowers with less than a 580 credit score are required to put down at least 10 percent.

FHA's formerly proposed credit score thresholds would have lumped borrowers with nontraditional or insufficient credit with all borrowers who possessed a credit score up to 619. The agency described this method as "overly broad." The use of the 580 threshold is consistent with HUD's current guidance for manually underwritten loans.

Three lines of credit are necessary to apply for an FHA loan. However, in the event a borrower does not have sufficient credit history, FHA will allow substitute forms. In analyzing a borrower's credit, the overall pattern of credit behavior is reviewed rather than isolated cases of slow payments.

Additionally, FHA believes that by providing more flexible front-end and back-end ratios, it can better define compensating factors. The agency reserves the right to establish additional compensating factors in response to changes in the housing market landscape or the population of borrowers served.

High-Cost Mortgage Loans

High-cost mortgages are defined by the CFPB as loans with high points and other fees, a high annual percentage rate (APR), or certain prepayment penalties. (Points are a type of fee paid at closing by the borrower to the mortgage lender. Each point equals 1 percent of the loan amount.) The bureau does mandate that high-cost mortgages cannot contain certain loan features that are considered abusive, such as prepayment penalties.

These loans are typically offered to consumers with relatively low credit scores, and as such, the CFPB says lenders tend to view these applicants as riskier borrowers. The bureau's high-cost mortgage rule requires the lender to disclose cost information to consumers before they agree to this type of loan. A borrower must also participate in homeownership counseling before receiving a high-cost mortgage.

Homeownership Counseling

In addition to high-cost mortgage recipients, the CFPB requires homeownership counseling for all first-time homebuyers who are considering a loan that allows for negative amortization. In fact, the agency's new mortgage regulations stipulate that every applicant for a mortgage receive a list of homeownership counseling organizations within three days of applying for a mortgage loan.

"This new disclosure is one of the important consumer protections in the Dodd-Frank Act," according to Cassandra Duhaney, a senior policy analyst at the FDIC, and provides borrowers with "an opportunity to learn about the homebuying process from an informed, objective source."

Untapped Market Share

Lenders must marry sensible credit standards with the needs of creditworthy homebuyers who on the surface may not fit the mold of a prime borrower. The turbulence and instability that accompanied the Great Recession severely diminished household incomes, eroded families' savings, and took a toll on credit scores. At the same time, lenders are dealing with rising interest rates, stagnant income growth, and weak household formation.

First-time homebuyers accounted for 27 percent of national home sales at the end of last year, according to the National Association of Realtors. That's the lowest market share reading for first-time buyers since the trade group began tracking them in 2008 and far below the 40 percent typically claimed by first-timers.

Data from FICO indicates about 4 percent of new mortgage originations between August and October of 2012 involved borrowers whose credit scores fell below 620. In 2006, an estimated 18 percent of new mortgages went to these higher-risk homebuyers.

According to a research paper released by the Urban Institute's Housing Finance Policy Center in March, "As measured by average purchase loan credit scores, which have risen from 680 to 734 over the past 13 years, access to credit has tightened and will likely remain tight without intervention."

The Institute's researchers analyzed the link between declining credit access and the drop in purchase mortgages, and by their calculations, with 2001 credit standards in effect, an additional 1.2 million loans would have been originated annually in recent years.