Editor’s note: The loss of homes, jobs and wealth, coupled with an environment of tighter lending, has barred some consumers from owning a home again for at least several years. This article, Part 3 of a "Rebuilding Homeownership" series, explores whether lenders will make allowances for borrowers with checkered credit histories. Part 1 explored the scope of bankruptcies and foreclosures and the impact to would-be homeowners, and Part 2 explored the assistance that real estate agents can offer in helping consumers get back on firm financial footing.

While bankruptcies and foreclosures could lock millions of would-be homebuyers out of the real estate market, the long-term impacts may depend on whether lenders are willing to make allowances for previously responsible borrowers who lost their home through circumstances beyond their control.

But ask lenders if, when the economy recovers, they’ll be willing to make allowances for borrowers who may have been victims of circumstance, and the silence is deafening.

None of the top mortgage lenders contacted by Inman News were willing to provide their insight on thorny questions like whether a shrinking pool of eligible borrowers could dampen demand for homes, putting further downward pressure on prices.

Industry groups like the Mortgage Bankers Association and the National Association of Realtors also declined invitations to share their views on whether lenders will be willing to look at borrowers on a case-by-case basis, instead of plugging numbers like FICO scores and loan-to-value (LTV) ratios into automated underwriting systems and approving or rejecting borrowers regardless of extenuating circumstances.

Mortgage financiers Fannie Mae and Freddie Mac were silent when asked whether borrowers who fall behind on their mortgage payments, but are "cured" by a loan modification, will also find it difficult to obtain a mortgage once they are again above water and ready to sell their home and buy another.

There’s little doubt that under the tightened standards in place today, bankruptcies, foreclosures, short sales and loan modifications would prevent millions of borrowers from obtaining a mortgage, or increase the cost of borrowing for those who are still deemed creditworthy (see Part 1).

And while real estate professionals can help their clients start the process of restoring their credit ratings, there are limits on what they are allowed to do (see Part 2).

The new normal

With secondary markets that funnel investment dollars into mortgage lending still fragile, lenders are for the most part limited to funding loans that meet with the approval of Fannie, Freddie or the Federal Housing Administration (FHA), all of which have tightened standards.

In cases where borrowers are making downpayments of less than 20 percent, the underwriting standards of private mortgage insurers — also tightened in the face of rising claims — also come into play.

But the tighter standards in place today are still less restrictive than those in force a generation ago, and banking industry consultant Alan Riegler thinks lenders will be loosening their purse strings sooner than many might expect.

Riegler, a consultant with Phoenix-based CCG Catalyst, recalls that after the Savings and Loan crisis of the 1980s, "People were saying, ‘Nobody is ever going to get a loan again.’ "

When a crisis is at its worst, people can lose site of the obvious: "We’re going to come out of this; there are people (who) are going to have to have mortgages, and companies that have to make money (will be) making those loans," Riegler said.

Because bankrupt debtors have discharged all their unsecured debts, they should "constitute attractive fodder for mortgage lenders," said University of Michigan law professor John Pottow, an expert on bankruptcy and commercial law.

Few would advocate a return to the permissive lending standards in place during the boom, in which some lenders often made loans without verifying a borrower’s income and assets, or evaluated their ability to repay a loan at an introductory "teaser" rate.

But Riegler said he believes that as home prices stabilize and secondary markets that provide funding for mortgages recover, lenders will be increasingly motivated to finance home purchases based on a true understanding of a borrower’s ability to repay.

Individuals vs. statistics

In order to do that, Riegler said lenders need to revisit their entire process, from loan origination through funding and closing, and rely less on automated underwriting and more on the circumstances of individual borrowers. …CONTINUED

Pottow’s hunch is that "the lender who figures out how to do more of this case-by-case stuff cost-effectively is going to end up ahead of the pack."

Community banks that thrived before the rise of subprime lenders "knew the borrower as a person — they didn’t know them as a statistic," Riegler said. "That personal connection (with the borrower), that judgment of the person, got lost."

But J. Michael Collins, an assistant professor in consumer science at the University of Wisconsin, doubts that lenders will move away from hard numbers.

"FICO, LTV and income reign," Collins said. "Story loans are few and far between. The exotics are all DOA (dead on arrival)."

Roberto Quercia, the director of the Center for Community Capital at the University of North Carolina, said there’s no reason that has to be the case.

"I think we know what to do — we did it in the mid-1990s," Quercia said. "We know how to write sustainable loans. It was community banks, or banks that had a local presence, that took the time to do the proper underwriting, and had other relationships with the customer — like they were a depositor. It’s not as simple as running (a loan application) through a computer."

Similarly, Quercia said borrowers should not be at the mercy of a computer algorithm’s assessment of their past.

Quercia and others say borrowers who were targeted with subprime loans during the boom should be granted some sort of amnesty that protects their credit scores.

"I’m not saying, ‘Give a mortgage to anybody,’ like subprime lenders did," Quercia said. "But in the past, you didn’t just reject somebody because they fell out of some box because of their credit score or credit history. There has to be an alternative (because) now we’ll have a much larger group of people who fall out of the box."

Like Riegler, Quercia thinks some housing markets will turn around sooner than many expect, despite fears that another wave of foreclosures and tight lending standards will derail a recovery. Demographic trends and immigration continue to support growth in household formation, Quercia said.

In their 2009 State of the Nation’s Housing Report, economists at the Joint Center for Housing Studies of Harvard University said they expect minorities will fuel 73 percent of household growth from 2010 to 2020, with the minority share of households projected to increase from 29 percent in 2005 to 35 percent in 2020 (see story).

Lenders who aren’t prepared to serve that market — which has traditionally had a higher proportion of low-income borrowers with thinner credit histories — will be at a competitive disadvantage, Quercia said.

Keeping consumers in mind

Barry Zigas, director of Housing Policy for the Consumer Federation of America, said lenders are still trying to get a handle on the foreclosure problem, and that it’s probably too early to say how they will approach the issue of borrowers with impaired credit.

"Right now, both companies (Fannie Mae and Freddie Mac) are reeling from losses, and have tightened up their credit standards. I would expect for the short term for them to continue that," said Zigas, who worked on community lending programs at Fannie Mae for 13 years. "The ball they are juggling is to rebuild a solid book of business."

Zigas said that Fannie and Freddie have amassed considerable expertise in community lending over the years, and "I wouldn’t expect them to revert to hard and fast, formulaic underwriting. I would expect them to behave as if they have learned something in the last 10 to 15 years."

From the Consumer Federation of America’s point of view, "the key is that consumers get access to safe and stable products that are underwritten to a realistic view to what consumers can actually pay," he said. …CONTINUED

Much at stake in debate

The government’s dominant role in mortgage lending is the subject of intense debate. As Congress weighs the future of Fannie and Freddie — and new financial regulations including proposals to expand the Community Reinvestment Act — such debates are likely to intensify.

The outcome of that debate could affect how flexible lenders are allowed to be when borrowers with flawed credit histories come to them for a loan.

On the right, critics argue that efforts to increase the rate of homeownership — by encouraging lending in underserved communities and setting affordable housing goals for Fannie Mae and Freddie Mac — led to irresponsible lending practices during the boom.

On the left, critics of financial deregulation blame the government for failing to curb the excesses of subprime lenders who skirted Fannie and Freddie by bundling loans into "private label" mortgage-backed securities.

Edward Pinto, who was the chief credit officer at Fannie Mae in the late 1980s, is among those who blame government policies aimed at increasing homeownership for eroding underwriting standards.

In a widely cited Wall Street Journal editorial, Pinto — now a mortgage finance industry consultant — argued that the affordable housing goals Congress instituted for Fannie and Freddie in 1992 forced the companies to purchase loans originated by banks under the Community Reinvestment Act, or CRA.

Half of the high-risk loans that eventually forced the government to place Fannie and Freddie under conservatorship are estimated to be CRA loans, Pinto said, and much of the rest were "useful to (Fannie and Freddie) in meeting their affordable-housing goals," he said.

Now, Pinto said, "history may repeat itself" with affordable housing advocates pushing lawmakers to expand CRA to cover all mortgage lenders and credit unions, possibly setting "the stage for another catastrophe," Pinto warned.

Quercia said that it’s appropriate to debate what the government’s role in mortgage markets should be. But the evidence "strongly suggests that the Community Reinvestment Act had nothing to do with" the boom and bust, he said.

Quercia and his colleagues at the Center for Community Capital have done considerable research on the topics, including recent papers comparing the performance of CRA loans with subprime loans (the CRA loans studied had a 70 percent lower risk of default), and documenting a "spillover effect" from subprime lending on CRA loan defaults.

There’s some truth to claims that Fannie and Freddie got into trouble buying up pools of subprime and Alt-A loans, Quercia said — a view seconded by University of California, Berkeley, economist Dwight Jaffee, who looked into the role Fannie, Freddie and the Community Reinvestment Act played in the boom and bust in a 25-page report for a Congressional commission looking into the roots of the financial crisis.

But Quercia, Jaffee and others think the primary motivation for Fannie and Freddie’s purchases was not to meet affordable housing goals, but to satisfy demands for greater profits by shareholders of the quasi public-private companies.

Jaffee’s report to the Financial Crisis Inquiry Commission found "no evidence that CRA incentives played a significant role in expanding high-risk lending during the housing bubble."

Previous studies cited in the report included a Federal Reserve analysis that noted CRA did not apply to non-bank lenders who made most subprime loans, and that only 6 percent of subprime mortgages made in 2006 were made to CRA-qualified borrowers or neighborhoods by CRA-covered institutions.

FHA, because it allowed subprime lenders and Fannie and Freddie to take away its market share during the boom, "played a minor, and basically irrelevant, role in creating or expanding the mortgage crisis," Jaffee concluded.

During the boom, lawmakers were considering eliminating the FHA’s minimum downpayment requirements to help the program compete with subprime lenders.

Now, under pressure to stem claims and restore capital reserve ratios to statutory minimums, FHA is in the process of raising its upfront mortgage insurance premiums, and will require borrowers with credit scores below 580 to make downpayments of at least 10 percent (see story).


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