October 14, 2013
Some mortgage applicants will be accepted by every lender
and others will be rejected by every lender. However, there
is a group of “marginal applicants” who will be rejected by
some lenders and accepted by others.
During the period 1920-34, before the development of
secondary markets and mortgage insurance, the risk
associated with every mortgage loan was entirely borne by
the lender making the loan. The number of marginal
applicants was sizeable in that period because each lender
had its own underwriting requirements, which varied widely,
depending on their business model. Those focusing on
generating large loan volume would have more liberal
requirements, but would also charge higher rates to cover
the larger losses resulting from that policy. The rates
charged by more selective lenders would tend to be lower.
The mortgage professor of that era, if there had been one,
would have advised borrowers who could meet the requirements
of a selective lender to patronize such a lender. Borrowers
with strong credentials who unwittingly placed themselves in
the hands of a volume-oriented lender with liberal
requirements, would usually overpay.
Flash forward to the market structure that existed in 2000
and lasted until the financial crisis of 2007-8. By then the
Federal Government had become a major player, setting the
underwriting standards and assuming the risk of loss over a
sizeable segment of that market. Nonetheless, a sizeable
chunk of the market remained private, and was divided into
“prime” and “sub-prime” components.
The mortgage professor of that era (me) warned borrowers who could meet the requirements of prime lenders to avoid sub-prime lenders, who would charge them sub-prime prices, but many fell into that trap. Much of the restrictive legislation that followed the crisis was a reaction to this and other abuses associated with the sub-prime market.
Now flash forward to the market structure that exists in
2013. The private sub-prime market is gone, and the private
prime market is less than 10% of the total. The
qualification standards today are dominated by Fannie Mae,
Freddie Mac and FHA, which purchase or insure more than 90%
of all new mortgages. Yet even with the Government setting
the standards, there are mortgage applicants who will be
rejected by some lenders and accepted by others. Some
lenders use underwriting rules, referred to as “overlays.”
that are stricter than those set by the Government. They may
set a higher required credit score, for example, or a lower
maximum ratio of loan amount to property value on some types
of property, such as condominiums or 4-family structures.
The reason is that lenders retain some risk on loans sold to
or insured by the agencies. Fannie Mae and Freddie Mac keep
records on the performance of loans they purchase from each
loan originator. That performance record affects the price
they pay the originator. FHA also maintains performance
data, and if it is poor they will terminate the lender’s
access to the FHA program.
In addition, loan underwriting includes some judgment calls,
exposing lenders to the risk that their judgment might be
over-ruled by the relevant agency. The adequacy of property
appraisals is an important example. If Fannie Mae or Freddie
Mac determine that an appraisal is unsatisfactory, they will
make the lender buy back the loan, while FHA will refuse to
insure it.
Lenders differ in their willingness to expose themselves to
these risks. Those who are most judgmental and have the most
restrictive overlays want to minimize their exposure, at the
cost of passing on loans that they might otherwise make.
Other lenders are willing to take these risks because they
can generate more volume and charge higher prices.
A good illustration is how lenders set minimum credit scores
on FHA loans. FHA does not impose one, so it is left
strictly to the lender. Most lenders set a minimum score of
640, but a few go to 580. They do this because they can make
more money on the 580 borrower who has no place else to go,
knowing that they are endangering their performance record
with FHA which could get them kicked out of the program. In
an earlier article I referred to this as the “FHA sub-prime
market”.
In its essentials, therefore, the problem is the same as it
was in the 1920s, and the best advice to consumers is also
the same. If you are a marginal applicant acceptable only to
a small number of high-priced lenders
If you are in the conventional market with strong
credentials, you may do better dealing with a lender who has
overlays that are more restrictive than Fannie or Freddie
requirements. There is no simple way to identify these
lenders, but if you shop effectively on a multi-lender web
site, it won’t matter because these lenders will emerge with
the best prices.
