At meeting after meeting with mortgage industry executives, government officials ask all of us to expand mortgage availability to underserved borrowers, including those with lower credit scores or higher debt ratios. But – those officials caution industry leaders in the very next breath – don’t loosen underwriting standards and return to the go-go days of the credit crisis. Hearing these seemingly contradictory requests, the lending community is left scratching its collective head. But there are ways to bridge the divide. It all depends on how you deal with credit risk.
Broadly speaking, there are three main ways for lenders to handle mortgage credit risk: They can price it, they can manage it or they can avoid it.
Most big banks are primarily in the “avoiding” category right now, with the post-crisis flight to quality driven as much by concerns over regulatory risk as inherent credit quality. Loans to underserved borrowers have a higher propensity to go delinquent and ultimately default – and regulators look more closely at defaulted loans for possible errors that could be traced to underwriting.
That’s why the average FICO for a FHA loan was 685 in April – a slight easing from 689 last June, but still well out of reach for the 30% of the population with FICOs under 650.
Then there are the companies who tackle credit risk through pricing. Some charge higher risk borrowers rates as high as 9%, or require them to put a minimum of 20% down. Although this pricing seems extreme, some measure of risk-based pricing does seem reasonable, like the loan-level pricing adjustments the GSEs have implemented. These LLPAs reflect higher expected losses on loans to underserved borrowers, as well as the increased costs associated with underwriting and servicing those loans.
Beyond pricing, lenders need to spend more time understanding what it means to truly manage credit risk. And it all boils down to three common sense steps: seasoned underwriting, financial education and ongoing risk management.
Start with underwriting: Responsible lending to underserved borrowers requires a more sophisticated underwriting review by a seasoned underwriter trained to go beyond the Automated Underwriting response.
To create a holistic picture of a borrower’s ability to repay – one that goes beyond FICO scores – lenders need to rely on objective manual underwriting techniques to properly account for compensating factors. It is critical that lenders verify income and look at debt-to-income ratios, but thorough underwriting goes further.
Residual income is important, i.e., how much money a borrower has left at the end of the month – not only after scheduled credit card or auto payments, but also after necessities like groceries, utilities and gas. Other key factors include evaluating risk layers like reserves, payment impact and additional sources of income in relationship to their debt ratios.
Finally, it is critically important to right-size the loan. Although borrowers may want to stretch on their home, it’s better for them to accept a smaller loan, even if it means a smaller home. That way they can stay current, build credit and equity and set themselves up for a larger home in the future.
Product design is also tied to underwriting, and responsible lenders should offer fully documented qualified mortgages, ones that meet the standards of the FHA, VA or USDA.
Two final elements of prudent underwriting are tight quality control and a commitment to continuous improvement. Lenders to underserved borrowers should be prepared to conduct pre-closing quality control reviews on a much higher percentage of their loans.
This approach costs more up front, but pays off in reduced post-closing issues and improved loan performance. Lenders also need to invest in analytics to look at performance over time and identify trends, creating a continuous feedback loop to further tighten up controls, refine guidelines and identify areas where further training may be needed.
The second leg to the stool in the approach to managing credit is financial education. Any way a lender can help its borrowers better understand the requirements and responsibilities involved with taking on a loan can be critical in helping those borrowers succeed over the long term.
For example, Carrington uses a proprietary web-based module that provides borrowers with key data about their loan. Every one of our borrowers must complete our financial education training before they are able to close their loan. The training is customized to each individual borrower, drawing in actual data about their specific payment, and explaining what escrows are to help the borrower plan ahead for their actual monthly payment.
It discusses some of the pitfalls in being a homeowner – such as unforeseen maintenance expenses – and makes it clear that housing prices can go down, which could lead them to owe more than their house is worth. We believe that providing these fundamental elements of financial literacy is essential to playing our part in setting up our borrowers for success as homeowners.
Finally, lenders need to conduct ongoing risk management with all of their borrowers. One way to do this is by giving higher risk loans to a highly specialized high-touch servicer right away, one that has a demonstrated track record of working out non-performing loans and managing risk.
Effectively managing credit risk over the longer-term requires servicers to take the time to understand each borrower and their behavior. As one example, although servicers typically call borrowers three days after their payment is due, in the low-FICO arena there is a subset of borrowers who are habitually late but do, in fact, pay consistently.
For these “slow pay borrowers,” a good specialty servicer doesn’t pester them on the third day of the new month. If the servicer knows a borrower generally pays on the tenth of the month, they wait until the thirteenth before they become concerned and reach out. This type of servicing requires increased analytics and increased manpower to manage, but it is an effective way to effectively manage credit risk of more challenging borrowers.
Managing credit also means constantly monitoring loans for early signs of delinquency, and stepping in as soon as possible. One of the clear lessons from the credit crisis is that it is much easier to work out a loan that is 60 or 90 days delinquent than it is to wait until a loan is 180 days delinquent or more.
At the early stages, borrowers haven’t lost hope, they want to keep their home and lenders have a good chance of putting them on a repayment plan and getting them current. If they have a real hardship, lenders can do more active loss mitigation, including loan modifications. The servicer can also implement foreclosure alternatives for borrowers who can no longer afford to remain in their home and require a graceful exit.
Following this approach of embracing credit risk by managing it will enable lenders to reach borrowers who would otherwise be unable to become homeowners. This approach has been a breath of fresh air to a wide range of housing policy officials, as well as origination partners.
It works for mortgage brokers who want to provide loans to borrowers with lower FICO scores, if they are willing to work within the tight underwriting framework. It also works for banks that want to serve more lower-credit borrowers, but don’t have the operational capacity to underwrite loans for those borrowers or the expertise to manage them on an ongoing basis.
In summary, it is indeed possible to expand mortgage availability in today’s environment. The keys are underwriting, financial education and ongoing risk management. Lenders need to be tight in their underwriting. They need to teach their borrowers the fundamentals about having a mortgage.
The best ones will have the ability to keep and manage the credit risk that they originate, a form of natural risk-retention that helps keep a lender focused on origination quality. There’s no magic here, just a return to an old fashioned approach to mortgage banking. But the approach requires expertise, additional resources and a commitment to making all the pieces fit together to make it successful.
