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 percent 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 originations.

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 criteria.

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 concerns.

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 market, 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, housing.

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.