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

Federal Reserve Governor Elizabeth A. Duke, told anrnaudience at the Housing Policy Executive Council on Thursday that despite the sustainedrnrecovery in the housing market that seems to be underway the level of housingrnmarket activity is still low.  Particularlyrnstriking, given the record low mortgage rates, is the subdued level of mortgagernpurchase originations.</p

This is most pronounced amongrnborrowers with lower credit scores she said. rnBetween 2007 and 2012 originations of prime mortgages fell about 30rnpercent for borrowers with credit scores greater than 780, but dropped about 90rnpercent for borrowers with credit scores between 620 and 680.  Originations are virtually nonexistent for borrowers with creditrnscores below 620.  Looking at it arndifferent way, the median credit score on these originations rose from 730 in 2007rnto 770 in 2013, whereas scores for mortgages at the 10th percentile rose fromrn640 to 690.</p

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

Duke said this may, in part reflectrnweak demand from potential homebuyers with low credit scores; perhaps suchrnhouseholds suffered disproportionately from the sharp rise in unemploymentrnduring the recession and thus have not been in a financial position to purchaserna home.  But there is evidence that tightrnmortgage lending conditions may also be a factor in the contraction inrnoriginations.</p

Data from lender rate quotes suggestrnthat over the last two years almost all lenders have been offering quotes onrnmortgages eligible for sale to the government-sponsored enterprises (GSEs) tornborrowers with credit scores of 750 and most have been willing to offer quotesrnto borrowers with credit scores of 680 as well.  But less than two-thirds of lenders arernwilling to extend mortgage offers to consumers with credit scores of 620.  Duke said even this statistic may overstaternthe availability of credit to these borrowers as available rates might bernunattractive, or borrowers might not meet other aspects of the underwritingrncriteria. </p

Tight credit conditions may also be affectingrnFHA-insured loans.   In the FederalrnReserve’s October 2012 Senior Loan Officer Opinion Survey on Bank LendingrnPractices (SLOOS), one-half to two-thirds of respondents indicated that theyrnwere less likely than in 2006 to originate an FHA loan to a borrower with arncredit score of 580 or 620.  Then in thernApril 2013 SLOOS about 30 percent said they were less likely to originate thatrnloan than they were in 2012.</p

Banks participating in the AprilrnSLOOS identified several reasons for that tightening but appeared to putrnparticular weight on the risk of GSE putbacks, the economic and housing pricernoutlook, and the risk-adjusted opportunity cost. In addition, several largernbanks cited capacity constraints and difficulty placing private mortgagerninsurance or second liens as factors restraining their willingness to approvernsuch loans. </p

Duke said that over time some ofrnthese factors, such as trepidation about the economy, should exert less of arndrag on mortgage credit availability.  Capacityrnconstraints that sometimes lead to lenders “prioritize the processing” ofrneasier-to-complete or more profitable loan applications should also ease.  Preliminary Federal Reserve research suggestsrnthat the increase in the refinance workload during the past 18 months appearsrnto have been associated with a 25 to 35 percent decrease in purchasernoriginations among borrowers with credit scores between 620 and 680 and a 10 torn15 percent decrease among borrowers with credit scores between 680 and 710.  These crowding-out effects should start to unwind as the refinancingrnboom decelerates. </p

Other factors holding back mortgagerncredit may be slower to unwind including lenders concerns about putback risk.rnThe ability to hold lenders accountable for poorly underwritten loans is arnsignificant protection for taxpayers but if lenders are unsure about the groundrnrules they may shy away from originating GSE loans where borrowers riskrnprofiles indicate a higher likelihood of default. </p

Mortgage servicing standards,rnparticularly for delinquent loans have tightened due to settlement actions andrnconsent orders and new servicing rules from the Consumer Financial ProtectionrnBureau (CFPB) will extend many of these standards to all lenders.  While these standbbbards provide importantrnprotections to borrowers they also increase the cost of servicing nonperformingrnloans.  Current servicer compensationrnarrangements pay the same fee for routine servicing as for managing the morernexpensive delinquent loans. This model gives lenders an incentive to avoidrnoriginating loans to borrowers who are more likely to default. A change tornservicer compensation models for delinquent loans could alleviate some of thesernconcerns. </p

Duke said it appears governmentrnregulations on qualified mortgages (QM) and qualified residential mortgagesrn(QRM) will also affect the cost of and access to mortgage credit.  The QM rule is part of a largerrnability-to-repay rulemaking that requires lenders to make a reasonable and goodrnfaith determination that the borrower can repay the loan, setting minimumrnunderwriting standards and consumer protection safeguards. In particular,rnborrowers can sue the lender or a subsequent owner of the loan for violations ofrnthe ability-to-repay rules and claim monetary damages. If the mortgage meetsrnthe QM standard, however, the lender or later investor receives greaterrnprotection from such potential lawsuits because it is presumed that thernborrower had the ability to repay the loan. </p

Loans that fall outside the QMrnstandard may be more costly to originate than loans that meet the standard forrnat least four reasons: </p<ul class="unIndentedList"<liThe possible increase in foreclosurernlosses and litigation costs. </li<liNon-QM mortgages will also notrnqualify as QRMs, so lenders will be required to hold some risk if these loansrnare securitized.</li<liInvestors may demand a premium torncompensate for concerns over being sold loans most vulnerable tornability-to-repay lawsuits. </li<liThe non-QM market may, at leastrninitially, be small and illiquid, increasing the cost of these loans. </li</ul

Initially any higher costsrnassociated with non-QM loans should have very little effect on access to creditrnbecause almost all current mortgage originations meet the QM standard throughrntheir eligibility for government guarantees. The small proportion of mortgages notrnoriginated at present for FHA, VA, or the GSEs are generally being underwrittenrnconsistent with the QM definition. </p

As lender risk appetite increasesrnand private capital returns to the mortgage market, a larger non-QM marketrnshould start to develop and two QM rule aspects may hamper development of a marketrnfor borrowers with lower credit scores. The QM requirement that debt-to-incomernratios must be 43 percent or less may disproportionately affect less-advantagedrnborrowers and QM affects a lender’s ability to price for risk.  </p

For example, if a lender originatesrna first-lien QM with an annual percentage rate that is 150 basis points or morernabove best rate available it receives less protection against lawsuits claimingrnviolation of the ability-to-repay and QM rules.  Lenders whornprefer to price for risk through points and fees face the constraint thatrnpoints and fees on a QM loan may not exceed 3 percent of the loan amount, withrnhigher caps available for loans smaller than $100,000. The extent to whichrnthese rules regarding rates, points, and fees will damp lender willingness tornoriginate mortgages to borrowers with lower credit scores is still unclear. </p

Despite the improving housingrnmarket, Duke said the above factors mean mortgage credit conditions remainrnquite tight for borrowers with lower credit scores and the path to improvingrnthis is somewhat murky. Some negative factors such as capacity constraints arernlikely to unwind through normal cyclical forces. However, resolution of lenderrnconcerns about putback risk or servicing cost seems less clear. These concernsrncould be reduced by policy changes; i.e. modifying the structure determiningrnputbacks or changing the servicer compensation model. Or lenders might reducerntheir exposure to putback risk or servicing cost by strengthening originationrnand servicing platforms. New mortgage regulations will provide importantrnprotections to borrowers but may also lead to a permanent increase in the costrnof originating loans to those with lower credit scores. It will be difficult torndetermine the ultimate effect of the regulatory changes until they have allrnbeen finally defined and lenders gain familiarity with them, Duke said. </p

The implications for the housingrnmarket are also murky. Borrowers with lower credit scores have typicallyrnrepresented a significant segment of first-time homebuyers. For example, inrn1999, more than 25 percent of first-time homebuyers had credit scores below 620rncompared with fewer than 10 percent in 2012 housingrndemand to expand along with the economic recovery, if credit is hard to get,rnmuch of that demand may be channeled into rental, rather than owner-occupied,rnhousing. </p

She said the Federal Reserverncontinues to foster more-accommodative financial conditions and, in particular,rnlower mortgage rates through our monetary policy actions and to monitorrnmortgage credit conditions and consider the implications of our rulemakings forrncredit availability. She urged her audience to continue to develop new and morernsustainable business models for lending to lower-credit-score borrowers thatrnlead to better outcomes for borrowers, communities, and the financial systemrnthan the nation has experienced over the past few years.

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