Since the financial crisis, qualifying for a mortgage has become difficult for people with anything short of perfect credit. The Urban Institute’s Housing Credit Availability Index now stands at 5.1 percent, less than half the level it was in 2001, a period of reasonable credit standards.
We have estimated that because of exceptionally high credit standards, as many as 1.1 million fewer loans were made in 2015 than would have been made if the more reasonable 2001 credit standards had been in effect. Since 2009, 6.3 million fewer loans have been made.
Credit is tight in large part because lenders are imposing even more stringent standards than those required by the entities that guarantee or insure these loans: the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac and the Federal Housing Administration (FHA). For example, the FHA may be willing to underwrite a mortgage with a FICO credit score of 620, but the originator might require a 660 FICO score.
Originators knowingly drive away business because they are concerned that the costs of producing and servicing a less-than-pristine mortgage are higher than what they can earn on the mortgage. These concerns come from three sources: representations and warranties (the risk that the loans will be put back to the originator by the guarantor or insurer), litigation risk (particularly the use of the False Claims Act), and the high and uncertain costs of servicing delinquent loans.
What’s been done so far to ease access to credit?
The GSEs and their regulator, the Federal Housing Finance Agency (FHFA), have been more successful than the FHA in reassuring lenders that they will be liable only for errors in underwriting the loans and not for whether the borrower defaults on the loan. Between 2012 and 2016, the GSEs and the FHFA have systematically removed many obstacles that have caused lenders to impose more stringent standards or “overlays.”
The GSEs and the FHFA have made it clear when lenders will be held responsible for defects, have defined what the penalty will be for different defect types, and have introduced an independent dispute resolution process to settle disagreements between themselves and the lenders. Most importantly, they moved the loan review process up to shortly after loan acquisition so lenders know right away if any defects have been identified. Fannie Mae now offers Day One Certainty, waiving many reps and warrants at origination. The GSEs have also addressed many of the servicing cost issues.
The FHA has done less. It has consolidated all 900 mortgagee letters, the main vehicle by which it communicates with its lenders, into one document and eliminated inconsistent information. Although it has partially addressed the high costs of servicing FHA loans, the key problems remain. Also, lenders continue to fear the False Claims Act, under which they are liable for triple damages if the loan contains misstatements.
The FHA has more power to increase access to credit
The FHFA and the GSEs have given lenders the clarity and reassurance they sought, but credit availability is still so limited because of the FHA. The FHA, not the GSEs, has historically insured borrowers with less than pristine credit, because the FHA does not do risk-based pricing. The FHA charges the same fee for those with perfect credit and those with less than perfect credit. The GSEs, on the other hand, impose risk-based pricing through their loan-level pricing adjustments.
Moreover, all GSE mortgages with a down payment of less than 20 percent of the loan amount must also obtain private mortgage insurance, which also varies in price depending on borrower risk profile. It is more attractive for low-credit-score, small-down-payment borrowers to obtain an FHA loan rather than a GSE loan.
Lenders prefer dealing with the GSEs than dealing with FHA because of the threat of the False Claims Act and the high costs of servicing FHA loans. But for most low-credit-score, small-down-payment borrowers, FHA rates are so much more favorable that it is the program of choice. This is illustrated in figures 1, 2, and 3.
Almost all borrowers with a down payment lower than 5 percent and a FICO score less than 700 (figure below) go with the FHA, as do most of those with a FICO score above 700.
For loans with a 5 to 19.99 percent down payment (figure below), most borrowers with a FICO score below 660 go with the FHA, while most with a FICO score above 680 go with the GSEs.
For any down payment at or over 20 percent (figure below), regardless of FICO score, the borrowers seek GSE execution, which is more cost effective because there are no PMI expenses, but the FHA still charges its insurance fee.
The bottom line
To further expand credit availability, the FHA must give lenders greater assurance that they are only liable for their own errors, not subsequent performance. It’s up to the FHA now.