Weakening credit conditions affecting future mortgage quality: Moody's

While all portions of mortgage credit underwriting standards have slipped since the early post-crisis period, it is the deteriorating conditions that most increases vulnerability for future loan quality, a Moody's report said.

Underwriting strength was measured by looking at the "5 Cs of credit" — character, capacity, collateral, capital and conditions.

Slipping origination quality has both direct and indirect effects on lenders and residential mortgage-backed securities issuers, Moody's said.

The indirect effects have broader implications for the market. "Many RMBS and related securitizations — including deals tied to mortgage warehouses and servicing contracts — often depend at least partly on the strength of originators because of their representations and warranties and servicing responsibilities," the report said.

"And, originations that are more likely to default will also be generally more likely to result in future costs to lenders, such as via repurchase demands, higher servicing expenses or credit losses on retained loans," the report's authors — Jody Shenn, Yehudah Forster and Warren Kornfeld — said.

Origination quality also affects home values, which when combined with increased mortgage defaults weakens consumer sentiment about home prices, which in turn impacts homebuilding and economic growth, and that hurts a homeowner's ability to make their payment.

It is that last "C," conditions, that is causing the most concern to Moody's. "Origination quality is not receiving much support from the conditions surrounding the granting of loans. In particular, the risk of a weaker macro environment over the initial years after loan origination are building."

Home price growth is moderating and appreciation is slowing along with reduced affordability. Meanwhile, sharp price growth in certain markets increases the risk of unsustainable values.

Downside risks for both the stock and bond markets could hurt homeowner wealth and reduce their resources to pay their mortgage.

Cash-out refinancings, the highest risk purpose for a borrower to take a new mortgage, have increased their share.

"The share of cash-out refinancings among all refi has been climbing as higher interest rates have reduced the incentives for rate-and-term refis, and cash-out refis have grown even relative to overall volumes. Going forward, slower home price appreciation and rising interest rates could slow cash-out refi levels," the report said.

Underwriting around character has remained strong, with only slight weakening in the past few years, Moody's noted. But the share of new mortgages going to first-time homebuyers is relatively high; this group tends to be unprepared for unexpected homeownership costs.

Meanwhile, the share of third party originations, while still below the level seen before the crisis, has grown, and traditionally these loans have not perform as well as retail production, Moody's said.

Capacity currently is strong as well, but borrower debt-to-income ratios, which never returned to precrisis levels are rising to levels last seen in 2005 and 2006.

Still, "a greater post-crisis focus on borrowers' ability to repay their debts, including as a result of new regulations and lenders' deeper appreciation of legal risks and distressed servicing costs, is serving as a strong check against deterioration," the report said.

Documentation practices remain strong, but the government-sponsored enterprises using a single W-2 and pay stub instead of the two years of paperwork typical in nonagency lending.

But on the nonagency side, the growth of bank statement programs, rather than tax returns and/or pay stubs, is a concern.

"Many of those programs include strong checks and balances but some — such as programs relying solely on a single month of bank statements — may result in lower confidence around borrowers' listed incomes," the report said.

When it comes to collateral, combined loan-to-value ratios for purchase loans are high relative versus before the financial crisis with the median consistently exceeding 90%.

That risk is offset by changes to private mortgage insurer rescission policies.

Appraisal quality has been strong but is weakening slightly as the secondary market increases its reliance on automated valuation models instead of appraisers. And now some originators are considering weaker approaches to quality control, such as by increasing use of review products that lessen the role of licensed appraisers in assessing valuations, the report said.

Capital conditions, defined as the availability of borrower reserves as well as if the applicant needed to use down payment assistance programs, remained moderate.