Last weekend, Fortune magazine published a feature: Mortgage lending standards are so tight that homebuyers must have "pristine" credit histories. The article was largely based on a study, Mortgage Lending Standards Are Too Tight, by Pew.
Fortune linked home sales heading for a 31-year low to these ultra-tough lending criteria. And we can certainly see some relationship between the two.
But we suspect that high 7%+ mortgage rates and skyrocketing homeownership costs (such as homeowners insurance, property taxes, maintenance and repair costs, and so on) amid a general affordability crisis may have at least as much to do with it.
Why Lending Standards Are So Tough
Many readers may remember how mortgage lending worked in the first half of the 2000s. "Liar" or NINJA ("No Income, No Job, No Assets") loans were commonplace. Applicants could claim to have stable employment and high incomes, safe in the knowledge that the lender would never check.
Complex hybrid adjustable-rate mortgages (ARMs) were sold to financially naive customers who didn't understand that the uber-low teaser mortgage rate that made the loan affordable would climb sharply after two or three years. Many loans came with zero down payments. And balloon mortgages were far from rare.
"Since the 1980s, the adoption of adjustable-rate mortgages as a part of the mortgage market has quickly picked up," says an undated study from Duke University. "Exotic features of mortgage loans emerged and included teaser rates, balloon payments, and “pick-a-pay” options. In particular, minority families and individuals more likely to agree to loans with fewer credit requirements and lower down payments were disproportionately impacted by these emergent exotic ARMs."
Duke’s report added that following the 2008 financial crisis, exotic ARMs have become far less commonplace. Last year, adjustable-rate mortgages made up just 8.16% of the purchase mortgage market.Back in the early-to-mid 2000s, low-quality loans were bundled together with sound ones to create mortgage-backed securities, aka MBSs or mortgage bonds. And credit rating bureaus certified bundles with AAA scores, seemingly regardless of their content. So, financial institutions around the world bought them with confidence as very safe investments.
Gradually and then suddenly, it became clear that many MBSs were either worthless or worth much less than assumed. And governments in many countries had to prop up their banks whose balance sheets, without MBSs, became unsustainable.
"In the wake of the 2008 financial crisis, the U.S. Congress created a sweeping financial regulation that its proponents hailed as a safeguard against future crises," wrote the Council on Foreign Relations. "That legislation came to be known as Dodd-Frank, short for the Dodd-Frank Wall Street Reform and Consumer Protection Act."
The Dodd-Frank Act ultimately included provisions such as the "Volcker Rule," which prohibited banks from trading with their own funds, and also provided for heightened monitoring of systemic risk, tighter regulations on financial products, and the introduction of a number of consumer protection initiatives.
Some Help for Aspiring Home Buyers with Nontraditional Creditworthiness
Although it's unlikely that it intended to, Dodd-Frank effectively excluded many creditworthy people from homeownership who didn't borrow a lot. Many of these were from low-income or minority communities.
They paid their rent, utilities, and other bills on time, but they lacked credit cards, auto loans, personal loans, and the like. Traditional credit scoring is based on such borrowing, so it returned low or no scores for these consumers.
On Tuesday, we published FHA Credit Score Rule Change Could Help More Borrowers Qualify for a Mortgage. The new rules mean more creditworthy borrowers with limited credit histories could soon be approved for mortgage loans.
The change allows lenders to use new scoring technologies, FICO 10T and VantageScore 4.0, which both use "trended" data to explore applicants' creditworthiness. So, on-time payments of rent, utilities, and other frequently excluded expenses, count.
These technologies claim to be better at predicting delinquencies and defaults than traditional ones. VantageScore 4.0 is available for Fannie Mae and Freddie Mac-backed mortgages, with FICO 10T implementation expected soon, and both can be used for FHA loans from Jan. 1.
It's Still Hard to Qualify for a Mortgage
"Americans with a moderate credit score — which The Pew Charitable Trusts defines as 600 to 699 — have been hit especially hard," continues Pew. "In 2000, banks and other lenders originated approximately 1.08 million home purchase mortgages to applicants with a credit score of 601 to 660; 25 years later, they issued just 293,000—a 73% decline ... As a result, millions of potential borrowers have been shut out of the mortgage market."
To be clear: borrowers can still get approved for a mortgage with a modest credit score. While Fannie Mae and Freddie Mac set no fixed minimum, conventional lender overlays typically allow as low as 620. And the score required for FHA loans is even lower: 580 with a 3.5% down payment or 500 with a 10% down payment.
However, those with low scores tend to be offered higher mortgage rates, all other things on the application being equal. So, some may be excluded simply because they can't afford the monthly payments.
Other factors that can result in an application being declined or a higher mortgage rate being required include a patchy employment history, limited savings, high debt-to-income ratio, or a minimum down payment compounded with other issues.
Read: Improve Your Credit Score Before Buying a House. Here's How
The Pros and Cons of Tough Lending Standards
Pew says that mortgage delinquency rates (homeowners late on their payments) are near 25-year lows. And default rates (when foreclosure proceedings may begin) are at all-time lows.
That's great news for homeowners. And it's obviously good for those who own mortgage-backed securities because they're losing less money, which means they're getting a better overall return on their investments. And that has a positive knock-on effect on mortgage rates.
When investors get a better return on MBSs, they'll likely buy more of them. That increased demand pushes up MBS prices, which lowers — as a mathematical inevitability — yields and mortgage rates. Those rates may be high at the moment, but they'd likely be even higher if it weren't for this effect.
However, the price for this is the exclusion of millions of responsible aspiring borrowers who could comfortably manage a mortgage. VantageScore says that its VantageScore 4.0 technology alone could reach "nearly 5 million additional mortgage-ready consumers."
That's a terrific start, according to many. The question now is: Should we be doing more, or will that reintroduce systemic risk into the mortgage industry?
