Submitted by Ramsey Su via Acting Man blog,
I remember Ben Bernanke saying that lenders are overly stringent on underwriting, unnecessarily so. I assume Ms. Yellen is parroting the same message, and so are all those in the business, hoping for a return of no-qualification-needed financing.
Are current underwriting practices overly stringent? Yes and no. With the exception of the sub-prime era, underwriting has never been easier (read on before you start calling me names). At the same time, it has never been more difficult for many qualified borrowers to get a loan. This strange phenomenon is among the unintended consequences of ill-guided public policies.
Round peg/round hole, that is the best description current underwriting guidelines. It started with the conservatorship of Freddie Mac and Fannie Mae. Combined with VA and FHA, these agencies have taken over the mortgage finance business with a 90% market share. In the meantime, Bernanke has purchased $788 billion of securities backed by agency loans in 2013. The Treasury/Fed monopoly has been born. This combination of the Treasury guaranteeing and the Fed buying at manipulated rates made it impossible for any private label mortgage backed securities to compete against the GSEs. The private sector is left with a sliver of the business, mainly in the jumbo and oddball products.
With the dominance of the agencies, agency guidelines became the law of the land. These guidelines are even more restrictive with the introduction of the CFPB's QM (qualified mortgage) guidelines.
Once upon a time there was an occupation known as loan officers. They evaluated a borrower's credit history, ability to pay, collateral and other factors in order to make lending decisions. Today, the title of loan officer may still exist but they are nothing more than children playing with a toy, the one that inserts pegs of different shapes into holes of the same shape. The mortgage version of this toy has only round holes. Round pegs will fit into this hole with ease. Good luck if your pegs are not round. A round peg borrower is a W-2 household, or one with a few years of steady tax returns. A so-so credit score in the low 700s is more than adequate. Even a 580 score is enough to get you an FHA loan. Do you have any idea how irresponsible you have to be in order to have a credit score that low? Speaking of the FHA, borrowers now may become eligible for an FHA loan just one year after a short sale, foreclosure or bankruptcy as long as they can show they experienced financial hardship due to extenuating circumstances, such as unemployment. You have to read this HUD instruction to believe it. FHA also allows co-signers, including blending the family members' income credit to arrive at an acceptable ratio and to cover the down payment as a gift. How much easier can it get?
Do not confuse cumbersome documentation with easy underwriting. Do not confuse easy qualifying with deteriorating qualification of borrowers. Just imagine how many borrowers have been knocked out of the market during 2013 with mortgage rates rising about 1% and double digit house price appreciation.
The mortgage industry is flawed. Underwriting guidelines are flawed. The secondary market is flawed. Policies are heading in the wrong direction. Any system, even sub-prime loans and sub-prime MBS, will work as long as property values appreciate enough to offset the flaws. It is when less than optimal economic conditions occur that the weaknesses surface. I could write a book on this subject but I will only use one simple illustration.
Here are two loan applications, from Joe Sr. and Joe Jr., both plumbers. They have an identical credit score, income, the minimal required down payment and are perfect round pegs at just under the 43% overall debt ratio. The Consumer Finance Protection Bureau has determined that these are Qualified Mortgages. The borrowers are well protected and have the ability to repay.
As it turns out, Joe Sr. is 60 with not many years left that he can bend under the sink. Joe Jr. is only 30 with a full career ahead. Both have no retirement savings (not required). Joe Sr. is going to be living off social security as soon as his back gives out. It is obvious that while these loans are both round pegs, one of them has a high probability of default. In reality, both loans are not likely to survive an economic downturn if the income of both borrowers declines. Both are hand to mouth borrowers with no ability to survive a few missed paychecks. Would you call these underwriting guidelines too stringent?
Anyway, I digressed. My point is underwriting today is not about sound lending practices. It is about how policy makers want to manipulate the market.
A truly healthy mortgage system requires the breakup of the Treasury/Fed monopoly and the return of portfolio lending by community banks. Neither are possible at this time. Therefore, it is useless to analyze the logic behind sound underwriting. It is far more important to anticipate what policy makers are going to do. We know the FHA is already the sub-prime lender of today. We know that with Mel Watt, the probability of more accommodation from Freddie and Fannie is likely. The easiest route is to quietly pass the cost of default insurance to the government, which would only be discovered when we have another down cycle. The Treasury would have to pick up the guarantees but let's not worry about that until we have to. Right?
Mortgage applications have been declining. The mini housing bubble is deflating. Borrower qualifications are not keeping pace with rising rates. What will Ms. Yellen do? Whether it is $40 billion or the tapered $35 billion per month, the Fed is already buying all agency purchase mortgage originations.
In conclusion, I eagerly await some clarification of policies from the new people at the helm of the Treasury/Fed mortgage monopoly, the Watt/Yellen combo. We shall see in the next few weeks.