Until recently, most lenders refrained from lending to borrowers with credit scores far below 600, even when government loan programs such as the Federal Housing Administration permitted it. The lenders worried having to buy the loans or indemnify the FHA for losses if the borrowers defaulted, not to mention the reputational risk connected with subprime lending in the wake of the housing crash.
But as lender operating costs have increased, due partially to new regulation compliance costs, and margins have shrunk in addition to volume, stretching underwriting standards has become more compelling.
“Banks that are attempting to earn money lending in the mortgage market need to find other borrowers, so the natural development is to move down the credit curve,” says James Frischling, the president and co-founder of NewOak Capital Markets LLC, an advisory firm in New York.
Lenders began relaxing credit score requirements late last year, after long-term rates started to increase in response to the Federal Reserve’s announcement that it would phase out its bond buying program.
The average minimum FICO score for the 15 lenders with the lowest minimums was 571 during the fourth quarter, below 599 for those same loan providers a year earlier, according to National Mortgage News’ Quarterly Data Report.
Knowing what we know during the downturn, lowering credit score minimums needs to be done carefully, says Ray Brousseau, an executive vice president at Carrington Mortgage. His Santa Ana, Calif., company will lower its minimum FICO score for government loans to 550, effective Monday.
“Not everyone is positioned to go down the credit spectrum and delve deeper … but if you’ve got a history of dealing with a client that is less than pristine” it could be done, says Brousseau, who says his company has this experience to endure the risk.
“You’ve can have the resources to do it,” he says. “We wouldn’t do this if we just weren’t retaining servicing.”.
The word “subprime” originally was used to describe lower credit score borrowers. But throughout the subprime crisis it became connected with other loose underwriting practices, such as making loans without proper documentation, a few of which performed abysmally despite high credit scores. Brousseau says Carrington’s lending will steer clear of such risks.
An approximated one in three consumers has a FICO score below 650, according to Carrington, that plans to specialize in this area.
While FICOs as low as 500 are allowed by FHA and were common in mortgage loans prior to the recession, ever since lenders have watched out for going much lower than 600. Lower FICOs could be harmful for a company, not only because of indemnification risk but also because the FHA assesses lenders’ performance by looking at “comparable ratios” in which their delinquency rates are judged against their peers’.
Frischling says he’s not stressed over lenders lowering credit score requirements– however.
“I do think that today it’s more a capability of ‘we’ve rather exhausted the refinancing game’ than a return to the abusively loose underwriting that resulted in the downturn, he states.
“I consider them as ‘non-investment-grade’ borrowers but plainly the word ‘subprime’ or ‘second chance’ or ‘alternative’ are being used. I don’t think it’s difficult because I do think banks in this space are going to be very diligent about proper documentation, due diligence and are heading to pursue a standard that they fit with.”.
On the other hand, if too many lenders start making loosely-underwritten loans and start trying to outdo each other to participate, as they often do, underwriting could get stretched too far.
“It’s the next phase that makes me worried,” Frischling says.
Most lenders stay hesitant to move down the credit curve, although financial pressure on them to do so is growing, says Anthony Hsieh, CEO of lender loanDepot. His Foothill Ranch, Calif., company has managed to manage costs using automated efficiencies.
Lowering credit score thresholds now can be premature– it’s difficult to tell “whether you’re on the leading edge or the bleeding edge,” states Hsieh. He stays wary of such a move, but recognizes it could help the industry serve the full spectrum of borrowers.
“Private sector and government employees all agree Americans do not have sufficient credit,” first-time homebuyers and minorities in particular, Hsieh says. But “it’s difficult for the industry since there’s still a lot of scar tissue” from the subprime debacle. The industry “does not want to get its head removed” by regulators for extending its reach, he says.
As volumes have fallen, lenders have been exploring looser underwriting in areas other than credit, and there are different theories about that are more practical than others. But limited documentation shows up the riskiest and least practical, given post-downturn reform.
Lenders today typically want as much paperwork as possible to secure them from liability under present regulation, including rules that hold lenders responsible for ensuring borrowers’ ability to pay back. Likewise, secondary mortgage investors, skittish from huge losses on residential real estate finance assets in the course of the downturn, have been demanding transparency.
The return of lower FICOs and possibly other relatively looser credit standards could test the performance of reform measures designed to avoid lax underwriting from spiraling uncontrollable as it did between 2005 and 2007.
One key distinction this time around is that some of the loosening is occurring in FHA, Department of Veterans Affairs and other government-insured loans, that today control mortgage lending. By comparison, during the heady days of 2005-2007, the relaxation of guidelines happened largely in the private market.
FHA and other government programs offer borrowers a bit more leeway when it concerns underwriting, in an effort to reach underserved populations like first-time homebuyers, veterans or those in rural areas.
Some officials seem to be interested in seeing lenders serve more borrowers and anticipate there will be more lending further down the credit curve as the economy recovers.
“Mortgage credit is very difficult … still to obtain without excellent credit scores,” Federal Reserve chairman Janet Yellen noted last week.
The government remains to send mixed messages when it comes to whether lenders should expanding their requirements, says Larry Platt, partner at law firm K&L Gates’ Washington, D.C. office.
The government sometimes urges lenders to make loans “and then slams them when they do,” he says. “It’s what I call mental illness in housing policy. You can get sued in either case.”.
There are other signs that signify well for simpler mortgage credit. For instance, last week Fitch Ratings became the second rating agency to lay out its criteria for evaluating securitizations without government guarantees for loans originated as the qualified mortgage and ability-to-pay rule became law. This is significant because how companies like Fitch evaluate this risk is a key consideration in how much credit enhancement a securitization may require to receive ratings that draw investors. If credit enhancement requirements are too high and costs sellers too much, it can hinder securitization (and thus not directly deter lending).
Since loans take a while to securitize, none of the few private securitization deals done, or those in the works this year, have yet included loans emerged under the auspices of the Ability-to-Repay and Qualified Mortgage rules. A deal done just last week had loans with application dates prior to Jan. 10, when the rule became effective, according to Suzanne Mistretta, an analyst at Fitch Ratings in New York.
Some mortgage bankers, in their look for more volume, have shown interest in originating “jumbo” loans– those that are too big for government guarantees– with an eye towards securitization. These loans are typically are thought of safer than lower-FICO product and are made to borrowers with high credit scores.
But the shift to higher rates tempered growth in the securitized portion of the jumbo market this year and banks have been competing heavily to make or purchase these loans, reducing the potential profits for non-bank originators. Jumbo rates are usually above on equivalent government loans, showing the greater credit risk without a federal guarantee, but lately they have been lower.
Carrington is leaving of any competition in the wholesale channel for this higher credit score product along with other, more conventional loans. (It also has a retail channel.) It has eliminated jumbo as well as conventional loans from wholesale production starting April 1. The company also will limit its acceptance of 680-plus FICO wholesale submissions for any borrowers outside the government’s program for veterans, refocusing its resources in this particular loan channel on the new product segment.
Lenders that handle more credit risk should be sure they can handle it, Platt says. Prior to the downturn lenders could shift some risk to third parties, but reform has put a lot of oversight mechanisms available to ensure they will be responsible if something fails with the loans they made.
“If a borrower goes into default, only bad things can happen to lenders,” Platt says.