Until recently, most lenders refrained from lending to borrowers with credit scores far below 600, even when government loan programs like the Federal Housing Administration allowed it. The lenders feared having to repurchase the loans or indemnify the FHA for losses if the borrowers defaulted, not to mention the reputational risk associated with subprime lending in the wake of the housing crash.
But as lender operating costs have mounted, due in part to new regulations, and margins have shrunk along with volume, stretching underwriting guidelines has become more compelling.
“Banks that are going to make money lending in the mortgage market are going to need to find other borrowers, so the natural progression is to move down the credit curve,” says James Frischling, the president and co-founder of NewOak Capital Markets LLC, an advisory firm in New York.
Lenders began relaxing credit score requirements late last year, after long-term rates began to rise in response to the Federal Reserve’s announcement that it would phase out its bond buying program.
The average minimum FICO score for the 15 lenders with the lowest minimums was 571 during the fourth quarter, down from 599 for those same lenders a year earlier, according to National Mortgage News‘ Quarterly Data Report.
Given the experience during the downturn, lowering credit score minimums has to be done carefully, says Ray Brousseau, an executive vice president at Carrington Mortgage. His Santa Ana, Calif., company will lower its minimum FICO score for government loans to 550, effective Monday.
“Not everyone is positioned to go down the credit spectrum and delve deeper…but if you’ve got a history of dealing with a client that is less than pristine” it can be done, says Brousseau, who says his company has this experience to manage the risk.
“You’ve got to have the resources to do it,” he says. “We wouldn’t do this if we weren’t retaining servicing.”
The word “subprime” originally was used to describe lower credit score borrowers. But during the subprime crisis it became associated with other loose underwriting practices, such as making loans without proper documentation, some of which performed abysmally despite high credit scores. Brousseau says Carrington’s lending will steer clear of such risks.
An estimated one in three consumers has a FICO score below 650, according to Carrington, which plans to specialize in this area.
While FICOs as low as 500 are allowed by FHA and were common in mortgage loans prior to the downturn, since then lenders have been wary of going much lower than 600. Lower FICOs can be dangerous for a company, not only because of indemnification risk but also because the FHA assesses lenders’ performance by looking at “compare ratios” in which their delinquency rates are judged against their peers’.
Frischling says he’s not worried about lenders lowering credit score requirements – yet.
“I do believe that right now it’s more a function of ‘we’ve somewhat exhausted the refinancing game'” than a return to the abusively loose underwriting that led to the downturn, he says.
“I think of them as ‘non-investment-grade’ borrowers but clearly the word ‘subprime’ or ‘second chance’ or ‘alternative’ are being used. I don’t think it’s problematic because I do think banks in this space are going to be very diligent about proper documentation, due diligence and are going to hold to a standard that they are comfortable with.”
However, if too many lenders start making loosely-underwritten loans and start trying to outdo each other to compete, as they tend to do, underwriting could get stretched too far.
“It’s the next phase that makes me concerned,” Frischling says.
Most lenders remain reluctant to move down the credit curve, although financial pressure on them to do so is growing, says Anthony Hsieh, CEO of lender loanDepot. His Foothill Ranch, Calif., company has been able to manage costs through automated efficiencies.
Lowering credit score thresholds now could be premature – it’s hard to tell “whether you’re on the leading edge or the bleeding edge,” says Hsieh. He remains wary of such a move, but acknowledges it could help the industry serve the full spectrum of borrowers.
“Private sector and public officials all agree Americans do not have enough credit,” first-time homebuyers and minorities in particular, Hsieh says. But “it’s difficult for the industry because there’s still a lot of scar tissue” from the subprime debacle. The industry “does not want to get its head cut off” by regulators for extending its reach, he says.
As volumes have fallen, lenders have been exploring looser underwriting in areas other than credit, and there are different theories about which are more viable than others. But limited documentation appears the riskiest and least feasible, given post-downturn reform.
Lenders today generally want as much documentation as possible to protect them from liability under current regulation, including rules that hold lenders responsible for ensuring borrowers’ ability to repay. Also, secondary mortgage investors, skittish from huge losses on residential real estate finance assets during the downturn, have been demanding transparency.
The return of lower FICOs and potentially other relatively looser credit standards could test the effectiveness of reform measures designed to prevent lax underwriting from spiraling out of control as it did between 2005 and 2007.
One key difference this time around is that some of the loosening is occurring in FHA, Department of Veterans Affairs and other government-insured loans, which today dominate mortgage lending. By contrast, during the heady days of 2005-2007, the relaxation of guidelines occurred largely in the private market.
FHA and other government programs give borrowers a little more leeway when it comes to underwriting, in an effort to reach underserved populations such as first-time homebuyers, veterans or those in rural areas.
Some officials seem to be interested in seeing lenders serve more borrowers and expect there will be more lending further down the credit curve as the economy recovers.