Relaxing Underwriting Easier Said Than Done

After years of heightened focus on improving loan quality after the housing crisis, lenders, and even some government officials, say the pendulum has officially swung so far in the direction of tighter lending criteria that low-to-moderate income borrowers can't get mortgages.

But while both sides agree it's a problem, finding a solution is easier said than done.

Julian Castro, the Secretary of the Department of Housing and Urban Development, for example, has stepped up his encouragement of lending closer to their existing minimum credit score thresholds in an effort to reach more borrowers with low-to-moderate incomes.

Historically, lenders have needed no urging to loosen up underwriting standards, particularly when refinancing ebbs. But to the extent that standards started to relax in 2013 — when rates first rose from historic lows — it didn't filter down to low-mod borrowers, even with government-mandated affordable lending requirements in place. One-to-four family home loans made to borrowers with incomes less than 80% of the median income in their local area fell to 26% of the total originations last year, down from 31% in 2012, Home Mortgage Disclosure Act numbers show.

The low-mod income segment of mortgage applicants represented 28% of all applications recorded in the recently released 2013 HMDA data. The low-mod demographic is an even greater segment overall population. More than 30 million of the 78.6 million families in the U.S. in 2011 — about 38% — were classified as low or moderate income, according to the Kansas City Federal Reserve Bank.

But roadblocks to increasing low-mod lending lie in the recourse the government can take against lenders for small procedural mistakes during underwriting, as well as an increase in lending costs that's made it tough for lenders to profit off making smaller, more affordable mortgages.

"Look at the cost of manufacturing a loan. Look at the yield spread and service-release premiums. If a lender has got a $250,000 loan and if the lender is trying to sell that at 102 [service-release premium], it should be a really good rate for the customer and a really decent yield, but it isn't, the math doesn't work," said Steve Calk, chairman and CEO of The Federal Savings Bank.

The average cost to produce a loan increased dramatically over the course of the past year, according to quarterly survey data. It was more than $3,668 per loan during the second quarter of 2014, up from just over $2,725 during the second quarter of 2013. That's down slightly from more $4,000 in the first quarter, when new regulatory requirements first took effect. And with yet another large regulatory implementation coming next summer, costs could also go up again.

There was some hope that non-qualified mortgage "near miss" portfolio loans outside of government lending programs could also contribute to low-mod lending, but they are particularly costly to make, given their increased level of liability. As a result, those loans tend to be loans made to wealthier borrowers, Calk said.

In addition to liability and cost concerns, millennial-generation borrowers delaying homeownership has put downward pressure on current low-mod lending volumes.

Calk said despite all these concerns, millennials and low-mod borrowers are still demographics worth courting.

"I'm doing it because the statistics regarding the millennials is undeniable. Since I'm not going to be able to compete with a balance sheet of larger bank, I have chosen to become the industry expert on first-time homebuyers, including low- and moderate-income borrowers. It's a method of survival," he said.

Thus, while profitability is lacking when it comes to low-mod lending, making these loans does serve other ends, such as demographic targets or niche strategies.

Union Bank, a California institution that is part of the Mitsubishi UFJ Financial Group, has traditionally focused on jumbo mortgage originations because of the large jumbo market where it operates. But recently, it has been going in the opposite direction, finding opportunities in Federal Housing Administration lending, according to executive vice president James Francis.

Such niches have appeal for banks and other lenders facing stiff competition for more profitable, larger loans offered by big banks. Larger players have been slashing jumbo prices below conforming rates to compete, and relying on the opportunity to cross-sell to jumbo borrowers to make up the difference.

But some smaller lenders find the niche business' rising costs outweigh the relative lack of competition in the low-mod space, particularly if they are startups, according to Calk.

"You're going to spend $3 million before you make a penny: $1 million on software and compliance and third-party services, and then another $2 million on personnel to get it up and running. Then you have to do enough volume to feed the machine," he said. This suggests consolidation pressure and led some lenders to outsource mortgage operations. Indeed, HMDA numbers show the number of lenders declining.

Whether existing lenders have generally been loosening underwriting standards in 2014 to make loans accessible to a wider range of borrowers has been subject to debate. Credit score survey results compiled by NMN suggest they have. And statistics suggest the market is more open to relaxing credit than down payment or documentation requirements, although there have been some isolated and anecdotal signs of give in all three areas.

Some firms, like Carrington and MountainView, for example, have been lowering minimum scores they will accept on loans they fund or buy.

Within the confines of the third-party lending channel — one of the more aggressive parts of the market — mortgage guidelines are expanding, but the market is still gun-shy, according to SecondaryWire President James Mullen.

"You're certainly seeing more relaxed guidelines than we're seeing in a long time, but the market's still skittish, let's face it," said Mullen. His company runs a platform that third-party lending market participants use to trade and fund loans.

Even with some loosening of guidelines, there has been an alarming lack of low-mod lending recently, said Marietta Rodriguez, director of national homeownership programs at NeighborWorks America.

Calk agrees low-mod lending is down, but said if U.S. officials really want to encourage more of it, they'll have to do more to provide relief from regulatory costs and liability to the industry.

"If we want low-to-moderate lending and homeownership to increase in this country, we must have regulatory relief from both documentation and a compliance standpoint and, most importantly, recourse if a loan was made to standard when it was underwritten," Calk said. "You can't give a borrower relief from a loan obligation because there is a clerical error on one of the hundreds of documents produced. You should be able to correct a simple error."

Kate Berry contributed to this report.