Is It Time To Grow The Mortgage Credit Box?

Mortgage Orb - Peter G. Miller - October 18, 2016

BLOG VIEW: Mortgage foreclosures and delinquencies keep hitting new lows, something that ought to elate both lenders and borrowers. But are we looking at this the wrong way? Do low levels of problem loans actually mean that the credit box is too tight, that deserving borrowers who represent the slightest risk are being frozen out of the market?

This is the basic argument made by Laurie Goodman with the Urban Institute. Goodman, a widely respected researcher, says that from 1999 to 2004, roughly two-thirds of all Fannie Mae-guaranteed borrowers had FICO scores below 750. Now, 69% of all mortgages go to borrowers with scores above 750, while borrowers with scores below 700 represent less than 10% of the marketplace.

Not only has the marketplace flipped, but it may have flipped unnecessarily. Goodman argues that because of “meticulous underwriting, borrowers with lower credit scores may well perform better than their counterparts performed in the past.”

If Goodman is right, then huge numbers of potential borrowers have been excluded from the financing system – borrowers who could substantially increase home sales. Seen the other way, enormous opportunities for more originations remain untapped.

Mortgage Care Versus Mortgage Productivity

Superficially, at least, it would appear that the lenders have become less productive. Citing statistics from the Mortgage Bankers Association, Goodman says that “the number of monthly retail applications processed per mortgage underwriter fell from 179 in 2002 to 34 in 2015.” It now takes five hours to process an application versus a single hour in the past.

Such changes in productivity are plainly a by-product of the new liabilities now faced by loan originators.

First, lenders have paid out more than $140 billion to settle government claims from the go-go mortgage era, a period that extended roughly from 2000 to 2008. No one wants to write any more settlement checks to the government, investors or consumers.

Second, use of the False Claims Act by the Federal Housing Administration (FHA) is seen as unfair by many lenders. The 1863 legislation allows the government to sue for treble damages, and under Dodd-Frank, whistle-blowers can get as much as 30% of any recovery. Disputes over the False Claims Act have caused some lenders to back away from FHA-backed loans and instead offer proprietary mortgage products with 3% down.

Third, origination mistakes under Dodd-Frank can result in big costs. “The Consumer Financial Protection Bureau [CFPB] can impose civil money penalties of $5,000 per day per violation, $25,000 per day for reckless violations and $1 million per day for knowing violations,” according to Treliant Risk Advisors.

Although it may be true that lenders are taking more time with mortgage applications, it’s also true that such care and caution are easily justified by the penalties that can arise from underwriting errors. One result is that many lenders use “layering” or “buffers” to limit risk. For example, a 2014 study by the National Association of Realtors found that nearly a third of all lenders expected borrowers to have debt-to-income ratios of less than 43%, which is the threshold established in the CFPB’s qualified mortgage (QM) rules.

Secret Numbers

Although the need for lender caution is understandable, lots of additional origination opportunities with little risk are plainly available. There are potentially thousands and thousands of creditworthy borrowers who can’t get a loan today but would have under lending criteria that have historically performed with 99% effectiveness. The evidence can be found in several little-known measures developed by the Federal Reserve to help lenders determine and manage credit risk, as follows:

  • The mortgage debt service ratio (DSR) equals the total quarterly required mortgage payments divided by total quarterly disposable personal income. The mortgage DSR parallels the front-end ratio used to qualify borrowers;
  • The consumer DSR equals total quarterly required consumer debt payments divided by total quarterly disposable personal income; and
  • The DSR equals the sum of the mortgage and consumer DSRs. It basically parallels the back ratios used by lenders to qualify mortgage borrowers.

The Federal Reserve has these figures going back to the first quarter of 1980, and if you look at the numbers, you can see that consumers are carrying remarkably low levels of debt.

For instance, the DSR was at 13.07 during the first quarter of 2008, a time when the mortgage marketplace was imploding. The same measure was at 10.62 during the first quarter of 1980 and 10.02 for the first quarter of 2016.

Consumers are cutting back on financial obligations. This means even borrowers with “lower” credit scores, say 620 or 640, are likely to have less relative debt than just a few years ago.

Figures from the Federal Reserve Bank of New York confirm this view. It reports that as of June 30, total household indebtedness was $12.29 trillion. That’s actually 3.1% less than the 2008 high. Housing debt stood at $8.84 trillion, a trillion dollars less than in 2008. Remarkably, this debt reduction has taken place even though 18 million people have been added to the population since 2008.

Will lenders now begin to open up the credit box? There’s a good chance the answer will be yes, and here’s why:

“We may finally start to see credit standards relaxed enough to allow borrowers who would have historically qualified for a loan get back into the market,” says Rick Sharga, executive vice president at, the online real estate marketplace. “More experience with the new QM regulations and more careful underwriting has taken much of the risk out of mortgage lending, and the stronger presence of non-bank lenders, who are typically willing to take on slightly more risk suggests that the pendulum may finally be swinging back toward a more rational approach to loan origination.”

“Plus more private-sector options with little down all suggest that the time might be right for fewer buffers and more loan originations,” Sharga adds. “Surely this is something the public wants and with today’s tested underwriting systems lenders are likely to welcome more applicants.”