Among the casualties of the mortgage market’s response to the housing crisis was the 97% LTV loan, one of several affordable housing products in use for many years in the industry. Hemorrhaging losses from prime and subprime mortgages that in the years leading up to the crisis were heavily laden with risky attributes, the market sharply reduced minimum LTVs and in the process overcompensated for product guideline relaxation that took place in the years before 2008.
The consequences to stabilization of the housing market are noticeable; many creditworthy first-time homebuyers have sat on the sidelines of the housing market since the crisis for several reasons including a lack of entry-level affordable mortgage products compared to historical standards, and income and debt constraints on critical segments of the Millennial age group. This represents a significant impediment to complete recovery of the housing market.
Since FHA has effectively been the only outlet for 97% LTV mortgages in recent years, affordable mortgage products have been largely subsidized by taxpayers, further exacerbating the imbalance between private and public capital in the housing finance system today.
With the housing market healing and new GSE programs for 97% LTV lending available to borrowers, the pieces are in place to bring balance back to the market both in terms of first-time homebuyers and private-public capital in mortgage markets.
The mortgage market has yet to fully recover from the damage sustained during the crisis and a sign of remaining weakness in the market is the decline in first-time homebuyers.
This group, according to National Association of Realtors data, historically accounted for about 40% of home purchases, but in 2014 made up 33% of this market.
Moreover, a study by Harvard University reported that more than one-half of first-time homebuyers are in the 25-34 year-old age group, a segment that has experienced a sharp decline in its rate of homeownership since 2004.
A number of factors contribute to this trend, including:
- mounting nonmortgage debt (including student loans)
- a poor job market
- and stagnant wage growth
These financial headwinds, combined with a lack of affordable mortgage products, explain why first-time homebuyers have had difficulty in recent years in entering the market.
While new affordable products such as the GSEs’ 97% LTV programs are making their way back to the market, widespread acceptance of high LTV lending by originators and credit investors depends on how these loans are underwritten and will eventually perform.
THE RIGHT RECIPE
The recipe for designing an affordable mortgage product that provides first-time homebuyers the best chance at maintaining their mortgage over time requires application of sensible underwriting policies, strong underwriting controls and homebuyer education programs.
The effectiveness of prudent underwriting is clear in the historical GSE data.
If we compare default rates on loans (the default event is defined as a loan 180 days or more past due) between 90-95% and 95.01-97% LTVs by origination year from 2000-2009 where we have a longer window to observe mortgage performance, we see somewhat higher default rates for loans with less than 5% down payment. Over this period, default rates for 90-95% LTV loans averaged just over 10.4%, while loans between 95.01-97% LTVs averaged 11.8%.
However, if we apply a minimum FICO overlay of 680 (equivalent to Freddie Mac’s minimum FICO for its 97% LTV Home Possible Advantage program for manually underwritten fixed-rate, no cash-out refinance products) or even 720 for the 95.01-97% LTV loans of this period, the default rates of 95.01-97% LTV loans are at or below the default rates for 90-95% LTV loans.
Imposing a higher FICO requirement on 97% LTV loans is an example of a compensating factor applied in underwriting to offset another risk factor such as higher LTV. But there is a tradeoff.
Imposing a minimum FICO of 680 on 97% LTV loans reduces the number of eligible borrowers by 22%, while raising that FICO minimum to 720 reduces the number by nearly 50%.
Setting the minimum FICO at a point such as 680 achieves the goal of reducing relative risk while providing the greatest possible opportunity for first-time homebuyers.
Even a minimum FICO of 660, which the Freddie program allows for purchase transactions, measurably mitigates risk of the 97% LTV while expanding the opportunity of homeownership to first-time homebuyers.
By imposing just one compensating factor, in this case higher FICO score, the risk of a 97% LTV loan can be modulated to be at or below that of a 95% LTV loan.
BEYOND MINIMUM FICO STANDARDS
However, the 97% LTV products available to the industry today go beyond the minimum FICO requirement by imposing a number of other compensating factors on these loans that further reduce risk. Limiting these loans to owner-occupant, fixed-rate 30-year products and purchase-only or rate-and-term refinance loans reduces the relative risk of these programs as well.
For instance, by imposing these additional compensating factors, projected lifetime default rates of newly originated 95% and 97% LTV loans are comparable according to my estimates.
Moreover, taking mortgage insurance into account, a 97% LTV loan with private mortgage insurance actually poses less exposure to taxpayers than an 80% LTV loan by placing well-capitalized private mortgage insurance companies in a first-loss position.
Augmented with homebuyer education, these 97% LTV programs provide an effective vehicle for first-time homebuyers to gain entry into the housing market while also reducing taxpayer risk.