My mailbox today is stuffed with letters from borrowers encountering a problem that did not exist before 2007: They are being barred from the conventional (non-FHA) market by underwriting rules that have become increasingly detailed and rigid.
In many cases the rules leave no room for discretion by the loan originator, and where there is discretion, originators are often too frightened to use it because of the heightened risk of having to buy back the mortgage or incur other penalties.
Fannie Mae and Freddie Mac are the major source of the problems, but the large wholesale lenders who acquire loans from thousands of small lenders and mortgage brokers have their own rules, which in many cases are even more restrictive than those of the agencies.
Before the financial crisis, compliance with underwriting rules was subject to casual spot checks. Today, every loan is carefully scrutinized, and those that don’t past muster must be repurchased by the seller. The loss on a buyback wipes out the profit on about eight loans of the same size.
The most important of the underwriting problems involve the documentation of income. The abuses that arose during the go-go years before 2007 had such a major impact on the mindsets of lawmakers, regulators and Fannie/Freddie that an affordability requirement has become the law of the land; all loans must be demonstrably affordable to the borrower.
I have already written about the absurdity of this requirement, which makes ineligible many perfectly good loans to good people — such as the lady with a lot of equity and perfect credit who wants to borrow the money she needs to stay in her home for a few years before she sells it.
The affordability requirement imposes an especially heavy burden on self-employed borrowers, who face the greatest difficulty in proving that they have enough income to qualify. Prior to the crisis, a variety of alternatives to full documentation of income were available, including "stated income," where the lender accepted the borrower’s statement subject to a reasonableness test and verification of employment.
Stated-income documentation was designed originally for self-employed borrowers, and it worked very well for years. Then, during the go-go period preceding the crisis, the option was abused. Instead of curbing the abuses, we eliminated the option, which is akin to outlawing knives after an outbreak of hari kari. Rejection of loan applications by self-employed borrowers with high credit scores and ample equity are now commonplace. This letter is typical.
"We were preapproved, found a home for less than the amount approved, paid for appraisal, inspection, earnest money, title company, then a few days before closing the lender told us they cannot honor the approval because our business income was 40 percent lower in 2009 than 2008 … can they do this?"
In this case, I have not been able to determine whether there was a rule change — from using the average of the two years to using the lower of the two years — or whether it was the interpretation that changed, but the result is the same: rejection. Before the crisis, this home purchase would have been saved by using stated-income documentation.
Note that in this particular case, the cost of rejection to the buyer was raised by the incompetence of the lender. Allowing the buyer to proceed almost all the way to a closing before checking their tax statements is inexcusable. Any homebuyer whose income is business-related should be sure to get their income approved before putting down earnest money and incurring other mortgage expenses.
Loan underwriting, the process of deciding whether a loan application should be approved or rejected, used to be a profession that demanded a high level of discretion and judgment. That is no longer the case, as illustrated by this letter.
"My wife recently applied in her name only for a mortgage to purchase a single-family home, which will be our residence. She earns a $70,000 salary that is more than enough to cover the mortgage and has a credit score of 800. We have no debt.
"I work from home trading stocks. In the market crash of 2008-09 I sustained losses in my trading account of $90,000. We file our taxes jointly. Today my wife’s application was refused citing Fannie/Freddie guidelines that state that tax losses must be deducted from her income … We are stunned."
This case is typical of many that used to involve a judgment call by the underwriter. The issue is whether the husband’s capital loss actually indicated a potential threat to the ability of his wife to service the mortgage. If the husband had $400,000 in his trading account, for example, the plausible judgment would be that such a threat was remote and the loan should be approved.
But in this case, the underwriter did not explore the circumstances — the rejection was automatic based on the rule. With no alternative types of documentation available, the loan was not made.
Why didn’t the underwriter use the judgment for which he is presumably being paid? He acted like a robot instead of an underwriter because his employer had instructed him to stay within the letter of the rules. The risk from making a judgment call that turns out to be mistaken has become so high that lenders find it more prudent to avoid such calls altogether.
In addition to curtailing unduly the number of potential borrowers who qualify for loans, the current policies of Fannie and Freddie have shrunk the number of acceptable borrowers who qualify for the best prices to a very small group.
To get the lowest rate possible on a mortgage sold to Fannie Mae, the borrower must have a credit score of 740 and a ratio of loan to property value of no more than 60 percent. The property must be single-family but not manufactured, and in an area not subject to an "adverse market delivery charge." The mortgage cannot have an interest-only provision, and any second mortgage has to be included in the 60 percent limit noted above.
Fannie and Freddie are working at cross purposes to the Federal Reserve. The Fed is trying to counter economic weakness by forcing down long-term interest rates, including those on prime mortgages, to all-time lows. Fannie and Freddie have made it increasingly difficult for potential borrowers to qualify, and cut the number who qualify for the very best rates to a trickle.
Thanks to Jack Pritchard for helpful comments.