Editor’s note: This is the second in a three-part series.
The first article in this series argued that a rollback of Fannie Mae and Freddie Mac lending terms to where they were before the financial crisis was needed to prevent a second round of home-price declines.
In addition to benefiting homeowners and the economy, this would reduce Fannie-Freddie losses on both old and new loans, which makes it a requirement of responsible conservatorship.
This article and the one that follows will discuss a few of the many specific changes in underwriting rules that are needed.
Modify rigid affordability rules
The post-crisis rule that every mortgage loan must be affordable to the borrower was a knee-jerk reaction to the excesses of the bubble period, when many adjustable-rate loans to subprime borrowers were not affordable past the initial rate period — usually two years.
The blanket affordability requirement that emerged is preventing loans from being made that are safe to the lender and useful to a borrower who can’t meet affordability tests.
Mortgage loans are distinguished from all other loans by their collateral, and for a long period in our history, lenders based their decisions only on the collateral value. Incorporating credit and income affordability into the decision process was an advance, but making affordability an absolute requirement was a step backwards.
In some situations, unaffordable loans are in the interest of borrowers facing temporary problems. If the property value is sufficient, there is every reason such loans should be made.
Eliminate income documentation requirements for sterling borrowers
The rule-restricting frenzy that produced the blanket affordability requirement also created the full-documentation rule. This abruptly terminated an industry trend toward increasing flexibility in documentation requirements.
As an example, before the crisis a borrower who could not document income but was top drawer in all other respects would have been approved under one or another alternative documentation rules.
The sensible presumption was that such a borrower knew more about what he could afford than the underwriter, and in the unlikely case where the presumption was wrong, the lender was protected by the property.
Today, such borrowers are being rejected out of hand. Because alternative documentation provisions were grossly abused during the bubble period preceding the crisis, all of them were eliminated in the mindless frenzy of rule tightening. The blanket rule today is full documentation of income for at least two years.
If the cardinal sin of the bubble period was providing credit to the hopelessly unqualified, the cardinal sin today is denying credit to the exceptionally well-qualified — many of whom are independent contractors. They are the "disadvantaged group" of the post-crisis era, and their numbers are growing rapidly.
A useful if partial step toward sensible documentation rules is simply to eliminate the income documentation requirement for otherwise sterling borrowers. Such a borrower might be defined as one with a credit score of 740 or higher, down payment of 20 percent or more, and payment reserves of six months or more.
Eliminate the requirement for appraisals on purchase transactions
The price at which a willing buyer and a willing seller agree to transact is a better measure of the true value of the property than an appraisal based on prior prices of similar properties. Because many transactions are not getting done because of faulty appraisals, it makes sense to eliminate the appraisal requirement on purchase transactions.
The traditional underwriting rule, that loan amounts be based on the lower of sale price and appraised value, had little force before the crisis because appraisals rarely fell below the price agreed upon by the buyer and seller. It matters a great deal now because the quality of appraisals has declined markedly, and all too many come in below the price. When that happens, the likelihood is high that the transaction will be aborted.
I have written about the decline in appraisal quality before. The number of transactions has declined markedly, forcing appraisers to check the sale prices of properties that are much different than the subject property.
The physical structure and amenities may be very different, they may be located further away where the market may be different, and the transactions may be foreclosure sales or short sales at concessionary prices.
Furthermore, because of the structural changes in the appraisal market resulting from the Home Valuation Code of Conduct, appraisers are now being paid less per appraisal and invest less time per appraisal than was the case before the financial crisis.
Appraisals are unavoidable on refinance transactions where there is no market test of property value. On purchase transactions, they are a costly and unnecessary nuisance that can sabotage transactions.
Eliminating appraisals does not mean elimination of property inspections, which may still be required to assure lenders that the property has no major physical flaws.
Next week we’ll discuss more needed changes.