One of the main questions hanging over the Federal Reserve’s plan to buy up to $40 billion a month in mortgage-backed securities (MBS) to help spur the housing market is whether continuing tight underwriting requirements will offset any positive impact the effort will have on lowering mortgage interest rates.
NAR Chief Economist Lawrence Yun and other analysts have said that interest rates, already at historical lows, don’t need to come down further to spur home buying. What needs to happen instead is a change in lenders’ underwriting policies. Since the downturn, lenders have been imposing underwriting restrictions on borrowers that go above and beyond what Fannie Mae, Freddie Mac, and FHA require for loans. For example, borrowers in some cases need to have a credit score 100 points higher than what Fannie, Freddie, or FHA require.
These restrictions, or overlays as they’re sometimes called, on federally backed loans are crucial, because Fannie, Freddie, and FHA comprise so much of the mortgage lending market today. Lenders say they need these higher standards to ensure they don’t make loans on which borrowers subsequently default and then face having to take them back if Fannie, Freddie, or FHA say the loan violated the “representations and warranties” the lender made when they originated the loans.
As Yun said in his monthly press conference yesterday, to release August existing-home sales figures, despite improvement in home sales and prices, these standards are keeping otherwise creditworthy households from getting financing, which could lead to wide and troubling disparities in home ownership rates down the road. “The tight underwriting standards are not a trifle matter,” he said. They’re “limiting who can become home owners and setting the stage for possible highly unequal wealth distribution in five years, because who will be getting [home price] appreciation over the next five years? They’re limiting the number of people in the middle who can become home owners.”
Federal Reserve Chairman Ben Bernanke, at a press conference he held last week to announce the MBS purchase plan, known as QE3, (for “quantitative easing 3, because it’s the third such measure the Fed has taken since the downturn), said these tight underwriting standards are in fact easing. “As house prices have begun to rise, as the economy has gotten a little stronger, lending standards have eased just a bit,” he said. “There have also been other changes which are useful. I note for example that the FHFA (Federal Housing Finance Agency) and the GSEs (Fannie and Freddie) have recently changed their policy on put-backs, so that banks will have more certainty under what conditions a mortgage will be put back to them if it defaults. So, there are a number of things in train that will make the mortgage market a little bit more open. That is one factor actually that could make our policy more effective, rather than less effective over time. If more people have access to more credit, more people will have access to the low rates we’re providing.”
Other than the policy clarification on put-backs, also known as loan repurchases or loan buy-backs, Bernanke didn’t specify what those eased lending standards are. And, whatever they are, they don’t appear to be trickling down to many real estate practitioners on the ground. NAR just last week released survey findings that suggest tight standards continue to be a problem. In one of the findings, in about 75 percent of loans to Fannie and Freddie last year, borrowers had credit scores of 740 or above, compared to just 40 percent of borrowers between 2001 and 2004 who did so. The years 2001 to 2004 are considered stable and healthy, before the housing boom. The difference in credit scores suggests up to 700,000 more loans could have been made last year had that the tight restrictions not been in place.
”Financial institutions appear to be focusing on making loans only to individuals with the highest levels of credit scores,” Jed Smith, NAR manager of quantitative analysis, says in his anlaysis of the survey findings.
All this is just another way of saying, as many of the reporters at Chairman Bernanke’s press conference last week were saying (see first video), that the MBS purchase plan might be all the Fed can do, given it’s mandate to focus on monetary policy (matters affecting the supply of money in the economy), but it misses the point. The problem is in lenders’ underwriting policies. And interest rates that go lower than even today’s historically low rates seem unlikely to have much impact on those.
In the first video above, Bernanke makes some key housing market points, including about easing loan standards, as he talks about the Fed’s MBS purchase plan. In the second video, Yun talks about the continuing tight underwriting standards.
The federal government is taking steps to ease a problem lenders have been complaining about for several years, and that’s the buy-back risk they face if they underwrite a federally backed loan that goes bad and the guarantor of the loan—whether FHA, Fannie Mae or Freddie Mac—determines that the loan was never underwritten in compliance with their “representation and warranty” requirements.
Lenders in the wake of the mortgage meltdown cited this buy-back, or repurchase, risk as one of the reasons they were imposing their own set of underwriting requirements above and beyond what the federal guarantor was requiring. With these credit overlays, as they’re called, loan applicants who met the requirements of FHA, Fannie or Freddie could still find themselves getting turned down for a loan, because they didn’t meet these more stringent lender overlays.
NAR in public statements has urged lenders to align their requirements on federally backed loans to what the federal government was requiring. Indeed, NAR Chief Economist Lawrence Yun has estimated that the home sales rate could improve considerably if these overlays were aligned with federal agency requirements.
Yet lenders remain concerned about the risk they face, and in fact earlier this year, in February, Bank of America announced it would stop selling loans to Fannie Mae because of its concerns over the company’s buy-back policies. (Bank of America shortly after the onset of the financial crisis took over Countrywide Home Loans’ book of business, increasing its exposure to buy-back risks from that lender’s loan activity during the housing boom.)
To be sure, banks have made it clear that this buy-back risk is only part of the equation when it comes to their credit overlays. As Chase executive Kevin Watters said a couple of weeks ago in a webinar he participated in with NAR, Chase’s credit overlays are based on its own internal analyses of how well borrowers do under its different loan products. It’s “less about repurchase risk and more about borrower ability to repay,” Watters said during the webinar. “We look at payment history on a specific program, so even though agencies say, ‘Here’s our credit box; it’s okay for you to sell to us,’ if our data indicates that the default rate is high for a borrower with a particular credit profile, we won’t make that loan. Even if the agencies’ credit box is a little wider than ours, we want to make sure we’re comfortable with it.”
Still, action taken yesterday by the Federal Housing Finance Agency (FHFA), the conservator of Fannie and Freddie, could go some way in addressing banks’ concerns over buy-back risk. In a release it issued yesterday, FHFA set out language that clarifies when Fannie and Freddie will, and will not, require lenders to buy back their loans.
Among the clarifications it issued is a 36-month performance standard, in which Fannie and Freddie won’t seek loan repurchases if borrowers make 36 months of consecutive, on-time payments.
For refinance loans that are originated under federal Home Affordable Refinance Program (HARP) guidelines, borrowers only need to make consecutive, on-time payments for 12 months. HARP is the federal program enacted during the mortgage crisis to give incentives to lenders and servicers to refinance loans of underwater borrowers. Borrowers get incentives, too.
The release also says Fannie and Freddie will start their quality control reviews earlier, make more information available to lenders about exclusions to their “rep and warranty” requirements, and provide more tools to keep lenders in compliance.
The new policy takes effect for loans originated beginning Jan. 1, 2013.
“We have listened to lenders and heard their concerns about the repurchase process,” FHFA says in an FAQ it distributed as part of its release.
NAR is looking at the changes and will provide input as needed once it has a better sense of how effective they’ll be at improving the lending environment for home buyers.
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