Fed’s Duke Sees Challenges and Opportunities For Low Score Borrowers


Federal Reserve Governor Elizabeth A. Duke, told an
audience at the Housing Policy Executive Council on Thursday that despite the sustained
recovery in the housing market that seems to be underway the level of housing
market activity is still low.  Particularly
striking, given the record low mortgage rates, is the subdued level of mortgage
purchase originations

This is most pronounced among
borrowers with lower credit scores
she said. 
Between 2007 and 2012 originations of prime mortgages fell about 30
percent for borrowers with credit scores greater than 780, but dropped about 90
for borrowers with credit scores between 620 and 680.  Originations are virtually nonexistent for borrowers with credit
scores below 620.  Looking at it a
different way, the median credit score on these originations rose from 730 in 2007
to 770 in 2013, whereas scores for mortgages at the 10th percentile rose from
640 to 690.

Consequently many borrowers have turned
to mortgages insured or guaranteed by the Federal Housing Administration (FHA),
the U.S. Department of Veterans Affairs (VA), or the Rural Housing Service
(RHS); the share of these purchase mortgages rose from 5 percent in 2006 to
more than 40 percent in 2011.  But here
too, originations appear to have contracted for borrowers with low credit
scores. The median credit score on FHA purchase originations increased from 625
in 2007 to 690 in 2013, while the 10th percentile has increased from 550 to 650.

Duke said this may, in part reflect
weak demand from potential homebuyers with low credit scores; perhaps such
households suffered disproportionately from the sharp rise in unemployment
during the recession and thus have not been in a financial position to purchase
a home.  But there is evidence that tight
mortgage lending conditions may also be a factor in the contraction in

Data from lender rate quotes suggest
that over the last two years almost all lenders have been offering quotes on
mortgages eligible for sale to the government-sponsored enterprises (GSEs) to
borrowers with credit scores of 750 and most have been willing to offer quotes
to borrowers with credit scores of 680 as well.  But less than two-thirds of lenders are
willing to extend mortgage offers to consumers with credit scores of 620.  Duke said even this statistic may overstate
the availability of credit to these borrowers as available rates might be
unattractive, or borrowers might not meet other aspects of the underwriting

Tight credit conditions may also be affecting
FHA-insured loans.   In the Federal
Reserve’s October 2012 Senior Loan Officer Opinion Survey on Bank Lending
Practices (SLOOS), one-half to two-thirds of respondents indicated that they
were less likely than in 2006 to originate an FHA loan to a borrower with a
credit score of 580 or 620.  Then in the
April 2013 SLOOS about 30 percent said they were less likely to originate that
loan than they were in 2012.

Banks participating in the April
SLOOS identified several reasons for that tightening but appeared to put
particular weight on the risk of GSE putbacks, the economic and housing price
outlook, and the risk-adjusted opportunity cost. In addition, several large
banks cited capacity constraints
and difficulty placing private mortgage
insurance or second liens as factors restraining their willingness to approve
such loans.

Duke said that over time some of
these factors, such as trepidation about the economy, should exert less of a
drag on mortgage credit availability.  Capacity
constraints that sometimes lead to lenders “prioritize the processing” of
easier-to-complete or more profitable loan applications
should also ease.  Preliminary Federal Reserve research suggests
that the increase in the refinance workload during the past 18 months appears
to have been associated with a 25 to 35 percent decrease in purchase
originations among borrowers with credit scores between 620 and 680 and a 10 to
15 percent decrease among borrowers with credit scores between 680 and 710.  These crowding-out effects should start to unwind as the refinancing
boom decelerates.

Other factors holding back mortgage
credit may be slower to unwind including lenders concerns about putback risk.
The ability to hold lenders accountable for poorly underwritten loans is a
significant protection for taxpayers but if lenders are unsure about the ground
rules they may shy away from originating GSE loans where borrowers risk
profiles indicate a higher likelihood of default.

Mortgage servicing standards,
particularly for delinquent loans
have tightened due to settlement actions and
consent orders and new servicing rules from the Consumer Financial Protection
Bureau (CFPB) will extend many of these standards to all lenders.  While these standbbbards provide important
protections to borrowers they also increase the cost of servicing nonperforming
loans.  Current servicer compensation
arrangements pay the same fee for routine servicing as for managing the more
expensive delinquent loans. This model gives lenders an incentive to avoid
originating loans to borrowers who are more likely to default. A change to
servicer compensation models for delinquent loans could alleviate some of these

Duke said it appears government
regulations on qualified mortgages (QM) and qualified residential mortgages
(QRM) will also affect the cost
of and access to mortgage credit.  The QM rule is part of a larger
ability-to-repay rulemaking that requires lenders to make a reasonable and good
faith determination that the borrower can repay the loan, setting minimum
underwriting standards and consumer protection safeguards. In particular,
borrowers can sue the lender or a subsequent owner of the loan for violations of
the ability-to-repay rules and claim monetary damages. If the mortgage meets
the QM standard, however, the lender or later investor receives greater
protection from such potential lawsuits because it is presumed that the
borrower had the ability to repay the loan.

Loans that fall outside the QM
standard may be more costly to originate than loans that meet the standard for
at least four reasons:

  • The possible increase in foreclosure
    losses and litigation costs.
  • Non-QM mortgages will also not
    qualify as QRMs, so lenders will be required to hold some risk if these loans
    are securitized.
  • Investors may demand a premium to
    compensate for concerns over being sold loans most vulnerable to
    ability-to-repay lawsuits.
  • The non-QM market may, at least
    initially, be small and illiquid, increasing the cost of these loans.

Initially any higher costs
associated with non-QM loans should have very little effect on access to credit
because almost all current mortgage originations meet the QM standard through
their eligibility for government guarantees. The small proportion of mortgages not
originated at present for FHA, VA, or the GSEs are generally being underwritten
consistent with the QM definition.

As lender risk appetite increases
and private capital returns to the mortgage market, a larger non-QM market
should start to develop and two QM rule aspects may hamper development of a market
for borrowers with lower credit scores. The QM requirement that debt-to-income
ratios must be 43 percent or less may disproportionately affect less-advantaged
borrowers and QM affects a lender’s ability to price for risk.  

For example, if a lender originates
a first-lien QM with an annual percentage rate that is 150 basis points or more
above best rate available it receives less protection against lawsuits claiming
violation of the ability-to-repay and QM rules.  Lenders who
prefer to price for risk through points and fees face the constraint that
points and fees on a QM loan may not exceed 3 percent of the loan amount, with
higher caps available for loans smaller than $100,000. The extent to which
these rules regarding rates, points, and fees will damp lender willingness to
originate mortgages to borrowers with lower credit scores is still unclear.

Despite the improving housing
, Duke said the above factors mean mortgage credit conditions remain
quite tight for borrowers with lower credit scores and the path to improving
this is somewhat murky. Some negative factors such as capacity constraints are
likely to unwind through normal cyclical forces. However, resolution of lender
concerns about putback risk or servicing cost seems less clear. These concerns
could be reduced by policy changes
; i.e. modifying the structure determining
putbacks or changing the servicer compensation model. Or lenders might reduce
their exposure to putback risk or servicing cost by strengthening origination
and servicing platforms. New mortgage regulations will provide important
protections to borrowers but may also lead to a permanent increase in the cost
of originating loans to those with lower credit scores. It will be difficult to
determine the ultimate effect of the regulatory changes until they have all
been finally defined and lenders gain familiarity with them, Duke said.

The implications for the housing
market are also murky. Borrowers with lower credit scores have typically
represented a significant segment of first-time homebuyers. For example, in
1999, more than 25 percent of first-time homebuyers had credit scores below 620
compared with fewer than 10 percent in 2012 housing
demand to expand along with the economic recovery, if credit is hard to get,
much of that demand may be channeled into rental, rather than owner-occupied,

She said the Federal Reserve
continues to foster more-accommodative financial conditions and, in particular,
lower mortgage rates
through our monetary policy actions and to monitor
mortgage credit conditions and consider the implications of our rulemakings for
credit availability. She urged her audience to continue to develop new and more
sustainable business models for lending to lower-credit-score borrowers that
lead to better outcomes for borrowers, communities, and the financial system
than the nation has experienced over the past few years.

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