December 5, 2015

“I have been turned down by 2 different lenders because my last years’ tax return didn’t show enough income from my business to qualify, despite a credit score of 800 and a down payment of 50%. Does this make sense?”

No, it doesn’t make sense, you and thousands of other potential home buyers are being rationed out of the market because of the misdeeds of lenders during the go-go years leading to the financial crisis. How we got to this state of affairs is the subject of this article.

The Three Prongs of Loan Underwriting

Underwriting rules focus on three borrower features that affect the probability that a mortgage loan will be repaid as promised. These are:

·       Payment obligations relative to income, which measures an applicant’s capacity to make mortgage payments. 

·       Equity in the property relative to property value, which measures the applicant’s incentive to make mortgage payments.

·       Credit score, which measures the applicant’s past reliability in meeting financial commitments.

Because most loans are sold by those who originate them, acceptable values of underwriting rules, and acceptable tradeoffs between them, are formulated primarily by the agencies who buy them or insure them: Fannie Mae, Freddie Mac and FHA. Loan originators can be more restrictive than the agencies in setting rules, but they cannot be less restrictive unless they are prepared to own the loans themselves.

In addition to the underwriting prongs described above, loan originators are concerned with the degree of rigor with which the agencies monitor  underwriting decisions. An affirmative decision by the originator that turns out to be unacceptable to the agency results in a required buy-back or a mortgage insurance rejection, which carries significant cost to the originator.

Underwriting Becomes Flexible in the Years Before the Housing Bubble

In the years before the housing bubble, underwriting systems became increasingly flexible, driven in part by the development of automated systems at Fannie and Freddie, and by the development and increasing use of credit scores. Under these evolving rules, applicants could be weak in one underwriting dimension so long as they were strong in the other two. Flexibility was further increased by the development of alternative documentation requirements falling between the extremes of “full doc” and “no doc”. Compliance with underwriting rules was subject to periodic spot checks by the agencies.

Underwriting Deteriorates During the Bubble

A bubble is a period of unsustainable price increases.  The bubble period that preceded the financial crisis ran from September 1998 to June 2005, during which the Case/Shiller house price index rose by 10.5% a year. Over the preceding period from February 1975 when the index begins to September 1998, the average annual increase had been 5.5%.

When house prices are rising by 10% a year or more, borrowers’ equity rises by the same amount, which makes it very difficult to originate a bad loan – one that results in loss to the lender/investor.  Borrowers  could be qualified on the basis of reduced payments that lasted only a few years because the loans could be refinanced when the initial payment period ended. Those that can’t make the higher payments can sell the house at a profit. In the worst case where the lender had to foreclose, their costs are fully covered by the sale proceeds. 

The bubble led to a liberalization of underwriting rules, and widespread violations of the rules that remained as scrutiny by the agencies largely disappeared.

Underwriting Becomes Rigid After the Financial Crisis

House prices stopped rising and began to fall after June 2005, causing enormous losses to mortgage-related firms, the insolvency of many, and a crisis of confidence during 2007-8. Underwriting rules did a 180 during these years, swinging from being excessively liberal to excessively restrictive and rigid. That is where they remain today, although house prices began to rise again starting in 2012.

Perhaps the most important of the underwriting rule rigidities involve income documentation. The abuses that arose during the bubble years and the losses that occurred when the bubble burst 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; borrowers must be able to dozcument that their income is adequate, regardless of how good their credit is and how much equity they have in the property. 

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 bubble period, the option was abused and stated income loans became “liars loans”. After the crisis, instead of curbing the abuses, the option was eliminated.

My mailbox is crammed with letters from self-employed loan applicants with high credit scores and ample equity whose applications were refused because of an inability to document their income adequately.

The problem is heightened by the much strengthened surveillance over compliance, which increases risk to the originators. Assessing the income documentation provided by a self-employed applicant is a judgment call that carries a high cost to originators if they get it wrong. The loss on a required loan buyback can wipe out the profit on multiple    good loans. The prudent path is not to invest any time in such loans, which is the policy taken by the lenders consulted by the frustrated applicant whose letter to me is cited at the beginning of this article.