Without some last-minute gymnastics, underwater homeowners participating in Fannie and Freddie’s ambitious new plan to allow short sales by borrowers who haven’t missed a loan payment could see their credit scores dented just as severely as if they’d gone into foreclosure after months of nonpayment.
For the first time ever, on Nov. 1 Fannie and Freddie plan to allow mortgage servicers to begin accepting short-sale packages from nondelinquent borrowers who can demonstrate hardships like the loss of a job or death of a spouse. Under previous rules, only delinquent homeowners could qualify.
The program offers huge potential relief for hundreds of thousands of underwater homeowners who have continued paying their albatross mortgages on time to finally get rid of them.
That’s great. But there’s a looming, disruptive problem.
As of today, under current national credit reporting practices, those nondelinquent borrowers are likely to be treated the same for credit scoring purposes as severely delinquent owners who go to foreclosure after months of nonpayment, or who simply toss back the house keys and walk away in strategic defaults.
That’s because there is no special coding that loan servicers and lenders can use to report short sales to the credit bureaus where no delinquency preceded the transaction. The system assumes that a short sale involved months of nonpayment by the borrower, which is frequently the case. As a result, credit scoring models such as FICO lump them into the same category as foreclosures.
Though the penalties vary case by case, participants in this government-designed program now face the prospect of getting hit hard on their FICO or Vantage scores — anywhere from 150 to 175 points or more.
They might have high 780 FICO scores before participating, and 610 scores after closing — making it much more difficult to obtain credit on home rentals, auto purchases or leases, and credit cards.
This is not conjecture. Officials at the Federal Housing Finance Agency (FHFA) — the overseer of Fannie and Freddie and developer of the new short-sale program — acknowledge that there’s an inequity here, and agree that people who’ve made monthly payments on time deserve better treatment than borrowers who did not.
Now for a little good news. Last Friday, officials at FHFA confirmed to me that the agency is exploring possible fixes to the scoring problem.
"FHFA is in discussions with the credit industry," said an agency spokesperson, who would not provide details beyond that.
Sources outside the agency said, however, that the credit industry’s main trade group, the Consumer Data Industry Association (CDIA), whose members include the three national credit bureaus — Equifax, Experian and TransUnion — is involved in the effort.
Precisely what can be worked out is not clear. However, Stuart Pratt, president and CEO of CDIA, told me his group has come up with solutions before. The Treasury Department, for example, asked the industry not to report borrowers who signed up for trial loan modifications under the HAMP program as delinquent on their payments.
For its part, Fair Isaac Co., developer of the FICO score, does not seem inclined to make any quick changes to its risk-modeling software. In a post earlier this month on FICO’s banking industry blog, Joanne Gaskins, senior director of scores and analytics for the company, specifically addressed the new Fannie-Freddie program.
Do borrowers who’ve "never gone delinquent … deserve a break in the way FICO scores assess their short sales?" she asked.
That’s a "judgmental question," wrote Gaskins — one that’s difficult for score developers to answer "without any data to prove or disprove the point."
Typically, she noted, FICO’s "scientists need a minimum of 24 months of data about consumer credit behavior following a significant change or innovation in the credit industry to thoroughly evaluate a potential change in the model. Only by analyzing that data can we determine if a change should be made to our scoring model."
So if FHFA is looking to FICO for a helping hand on the new short-sale program, it appears that’s not going to happen for at least two years.
What can be done? Here’s one idea that’s practical, straightforward and immediate: Why not instruct lenders and servicers involved with the new short-sale program to report transactions involving nondelinquent borrowers as "paid as agreed"? After all, isn’t that a fact?
On one side of the table, you have homeowners who have continued to make timely payments on their mortgages month after month, despite being underwater, and who are essentially invited by a federal agency (FHFA) to participate in a short-sale program provided they can show that they have one of a number of financial "hardships" (examples include employment transfers, loss of employment, decrease in income, death of a spouse or co-payer on the mortgage, among others.) They are not deadbeats, they are not delinquents or strategic defaulters. Quite the opposite.
On the other side of the table, you have lenders who have agreed to settle for less than the original principal amount on the note, in recognition that the property valuation is less than they anticipated, thanks to the housing bust and recession. Fannie and Freddie have blessed the transaction and recognize that on-time short-sellers are very different from short-sellers who have not made payments on their loans for extended periods.
Sounds like paid as agreed to me.
Could this work? I asked Terry Clemans, executive director of the National Credit Reporting Association, which represents independent credit reporting companies, and he said: "If Fannie/Freddie directed lenders to report the status (of a mortgage) as current through the account closing with no reference to any short sale or foreclosure, that would totally change (the situation), with no negative impact on the score."
Meanwhile, the clock is ticking toward Nov. 1. Potential participants in the program, and the real estate professionals who advise them, need to know: Will borrowers get hit with credit score penalties that could wound them for years if they take part? The only fair answer from the federal government and the credit industry is: No.