The voices of Urban Institute's researchers and staff
August 31, 2016

Squeaky-clean loans lead to near-zero borrower defaults—and that is not a good thing

August 31, 2016

There’s something interesting and important going on in the mortgage market today: borrowers who took out mortgages in the past five years have rarely defaulted, making them better at paying their mortgages than any other group of mortgage borrowers in history. 

This is happening for two main reasons: only the best borrowers are getting loans today and these loans are so thoroughly scrubbed and cleaned before they’re made that hardly any of them end up going into default. A near-zero-default environment is clear evidence that we need to open up the credit box and lend to borrowers with less-than-perfect credit.

There have been almost no defaults on mortgages originated in the past five years

The default rate on new mortgages is tracking well below mortgages originated from 1999 to 2003, a period with reasonable lending standards and fairly low default rates. This chart illustrates by origination year the rate at which mortgages guaranteed by Fannie Mae have gone six months delinquent (or liquidated before that point). We refer to this as the default rate. The really poor performance of the 2006–08 vintages jumps off the page.

Housing finance chart

Looking at the better-performing vintages, it is clear that with three years of seasoning, the 2009–10 vintages are defaulting only marginally less than the 1999–2003 vintages. The 2011–Q2 2015 (second quarter 2015) vintages with three years of seasoning are hardly defaulting at all. The “default fingers”—charts showing default by loan age—for Freddie Mac look identical to those for Fannie Mae (see page 38 of our monthly chartbook).

This is a particularly low-risk group of borrowers

Part of this better performance can be explained by the shift in originations toward more pristine borrowers, thanks to lender wariness of lending to anyone with even a hint of risk, as judged by borrowers’ FICO credit scores. From 1999 to 2004, roughly one-third of Fannie Mae–guaranteed borrowers had FICO scores below 700, another third had FICO scores from 700 to 750, and the final third were above 750.

From 2011 through Q1 2015, less than 10 percent of borrowers had FICO scores below 700, 22 percent were from 700 to 750, and a staggering 69 percent were above 750. The numbers are very similar for Freddie Mac.

This group is performing better than past borrowers with the same risk profiles

But the distribution of credit scores is not the only factor. If we compare mortgages with the same credit profiles, each group has performed better than it has in the past. This chart shows the historical default fingers for Fannie Mae–guaranteed mortgages that have loan-to-value ratios of 80 to 90 and FICO scores below 700.

Housing finance

Defaults on the most recent origination are tracking well below 2001–04 mortgages at the same age. Across many credit buckets, the results are identical.

What’s the difference? Meticulously originated, squeaky-clean loans

The credit box is tight, and it appears that every loan being made now is cleaner than a loan with the same characteristics made between 1999 and 2003. Why is this the case?

As anyone who has taken out a mortgage recently can tell you, the amount of underwriting time and attention to detail is extraordinary, making mortgage origination a very time-intensive business.

According to a study by the Mortgage Bankers Association, the number of monthly retail applications processed per mortgage underwriter fell from 179 in 2002 to 34 in 2015. Originators are spending much more time on each application: in 2002, they were spending about an hour; in 2015, they were spending about five hours. And we don’t expect that number has changed much.

This near-perfect performance is more evidence that it’s time to ease lending standards

The performance of mortgages originated over the past few years has been extraordinarily good by historical standards. Not only is the credit box exceptionally tight, but even controlling for credit characteristics, mortgages are also performing much better. This suggests that there is plenty of room to safely expand the credit box.

Our analysis suggests that given this environment of meticulous underwriting, borrowers with lower credit scores may well perform better than their counterparts performed in the past. 

Put simply, it’s time to lend again to borrowers with less-than-perfect credit. 

Natalia Mendez, left, goes over mortgage terms with Raul J. Alvarez, Senior Loan Officer for Paramount Residential Mortgage Group, as she hopes to get a mortgage before rates possibly go up as the Federal Reserve announced that it will raise interest rates on December 16, 2015 in Miami, Florida. Photo by Joe Raedle/Getty Images

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