The availability of credit cycles from periods of tight underwriting standards to periods of lax standards. When credit is tight is when credit-fueled markets like real estate are most stable. In a tight credit environment, lenders are very focused on ensuring the borrower can repay the loan and the lender can recover their capital if they don’t. It would seem obvious and intuitive that lenders would always be focused on those things, but competition tends to drive standards down as lenders take more risk.
In the early stages of the credit cycle, lenders begin extending credit to less creditworthy borrowers. This adds to the borrower pool, and in the case of real estate, it adds to the buyer pool. This influx of new buyers is an increase in demand which causes prices to rise. Rising prices give lenders greater assurance they will recover their capital in the event one of these less creditworthy borrowers defaults. In fact, the entire subprime business model was built on this phenomenon. Subprime always had high default rates, but as long as the inflow of new subprime borrowers was strong, prices would rise and subprime lenders would not lose much money when they foreclosed. In essence this is a Ponzi scheme because it only succeeds as long as prices are rising. Once prices stop rising, the high default rates cause huge losses which wipes these lenders out.
Once credit starts to contract, standards tighten until borrowers no longer default. If this were not the case, falling prices would cause large lender losses on the bad loans. Only the most creditworthy borrowers are extended credit, and these borrowers are required to put substantial amounts down to protect the lender’s loan capital. That’s where we are today. Credit will loosen up slowly as house prices stabilize and lenders have less risk of loss on their original capital. Once prices reverse, lenders start taking on more risk, more borrowers enter the buyer pool, and the cycle starts all over again.
Lenders’ underwriting standards appear to be tightening even further in some key areas, and the time to close a loan is getting longer.
WASHINGTON — With 30-year mortgage rates hitting new lows and recent borrowers’ payment performance the best by far in decades, you’d think that banks and other lenders might be loosening up on their hyper-strict underwriting standards.
But new national data from inside the industry suggest this is not happening. In fact, in some key areas, standards appear to be tightening even further, and the time needed to close a loan is getting longer.
The check and balance in the system today is the loan buyback. Well over 90% of the loans originated today are backed by the US taxpayer either through the FHA or the GSEs. To ensure the taxpayer does not absorb huge losses, the bureaucrats overseeing these agencies put strict standards in place regarding the loans they insure against loss. If a loan insured by the government goes bad, a forensic review is done on the file. If any irregularities in the underwriting or documentation are turned up, the originating lender is forced to buy back the loan and absorb any losses associated with it. That is what’s driving the tight lending standards in place today.
The average FICO credit score on new loans closed in August was 750, 9 points higher than it was one year earlier, according to Ellie Mae Inc., a Pleasanton, Calif., mortgage technology firm whose software is used by many lenders. The survey sample represents about one-fifth of all new loans — roughly 2 million mortgages.
At Fannie Mae and Freddie Mac, the dominant players in the conventional mortgage market, the average FICO score was even higher. For refinancings in August, the average approved borrower had a 769 FICO score, up 6 points from August 2011. The average score for borrowers purchasing homes was 763, 1 point higher than the year before.
If the average FICO scores are over 750, not many of the new loans will go bad. People with FICO scores that high don’t default very often.
FICO scores are used by virtually all mortgage lenders to gauge the credit risk posed by a borrower. Scores range from 300 to 850, with low scores representing higher probability of default, high scores indicating low risk. Fair Isaac Co., developer of the FICO scoring model, says 78.5% of consumers have scores between 300 and 749. Barely 1 in 5 consumers, in other words, scores high enough to meet today’s FICO score averages at Fannie and Freddie.
Other signs of how strict lenders’ standards have become:
• The average purchaser of a home using a Fannie-Freddie loan made a down payment of 21% in August and had a squeaky-clean debt-to-income ratio — with total monthly debt payments, including the mortgage — amounting to just 33% of income. Refinancers had an average equity stake in their houses of 30%.
• People who were rejected for Fannie-Freddie mortgages also had seemingly solid credit profiles by historical standards. The typical buyer whose application was declined had a 734 FICO score — up 2 points from a year before — and was prepared to put down 19%.
750 FICO and 20% down is the norm.
• Federal Housing Administration borrowers’ credit profiles were also impressive, especially in view of that agency’s statutory mission to serve consumers with modest incomes, low down payments and less-than-perfect credit histories. In August, according to Ellie Mae’s survey, the average FICO score for FHA refinancers was 717, up 11 points from the year earlier. FHA home purchasers had average scores of 700 — 4 points below what they were 12 months ago — but still far beyond historical norms. The FHA officially accepts FICOs as low as 500 and requires 10% down payments for borrowers below 580 but does little business at these score levels.
• In addition to — or maybe because of — the tougher standards, the mortgage process itself appears to be slowing down. The average time from application to closing for all loans during the time cycle in the Ellie Mae survey was 49 days, nine days longer than the previous August. For refinancings, the average processing time was 51 days, up from 37 days a year earlier.
What’s going on here? Given the Federal Reserve’s repeated interventions to lower the cost of money to banks, why are they keeping their credit requirements so high? Are there any prospects for relief for prospective buyers who simply don’t have 20% or 30% to put down and don’t have elite-bracket FICO scores?
Doug Duncan, the chief economist for Fannie Mae and former chief economist for the Mortgage Bankers Assn., has a unique perspective on all this. He readily acknowledges that big banks — and Fannie and Freddie themselves — are seeing their highest-quality “books of business” in decades, maybe ever, thanks in large part to their strict credit standards and rigorous documentation rules.
He believes, however, that the underwriting cycle could start to loosen up as banks begin to pare their post-housing-bust pricing add-ons for borrowers, their fears of costly buybacks of existing loans recede and long-awaited rules on mortgage lending are unveiled by the federal government.
That’s somewhere on the horizon. But in the meantime, don’t look for any dramatic relaxation. To get a mortgage, you’ll generally need high scores, big down payments — except for the FHA, which accepts 3.5% down — plenty of time and reams of documentation.
Historically, credit standards loosen very slowly. Each incremental change that loosens standards requires time to evaluate its efficacy. Any lender who relaxed too many standards too far too soon would find itself on the losing end of a long stream of buybacks — or in the past, losses on its own portfolio. What really drives lenders to loosen credit is rapidly rising prices and large demand from investors to deploy capital in new loans. Prices won’t be rising rapidly any time soon, and investor demand for 3.5% loans with 30-year amortizations probably won’t increase dramatically either, particularly as less risky and higher yielding alternatives appear when the economy improves.
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Proprietary Irvine Housing News home purchase analysis
$510,000 …….. Asking Price
$595,000 ………. Purchase Price
11/18/2004 ………. Purchase Date
($85,000) ………. Gross Gain (Loss)
($47,600) ………… Commissions and Costs at 8%
($132,600) ………. Net Gain (Loss)
-14.3% ………. Gross Percent Change
-22.3% ………. Net Percent Change
-1.9% ………… Annual Appreciation
Cost of Home Ownership
$510,000 …….. Asking Price
$17,850 ………… 3.5% Down FHA Financing
3.43% …………. Mortgage Interest Rate
30 ……………… Number of Years
$492,150 …….. Mortgage
$141,275 ………. Income Requirement
$2,191 ………… Monthly Mortgage Payment
$442 ………… Property Tax at 1.04%
$42 ………… Mello Roos & Special Taxes
$128 ………… Homeowners Insurance at 0.3%
$513 ………… Private Mortgage Insurance
$335 ………… Homeowners Association Fees
$3,650 ………. Monthly Cash Outlays
($462) ………. Tax Savings
($784) ………. Equity Hidden in Payment
$19 ………….. Lost Income to Down Payment
$84 ………….. Maintenance and Replacement Reserves
$2,506 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,600 ………… Furnishing and Move In at 1% + $1,500
$6,600 ………… Closing Costs at 1% + $1,500
$4,922 ………… Interest Points
$17,850 ………… Down Payment
$35,972 ………. Total Cash Costs
$38,400 ………. Emergency Cash Reserves
$74,372 ………. Total Savings Needed