Dec192016

Can lenders loosen credit standards without inflating another housing bubble?

Lenders lower standards to qualify more borrowers and increase business, a precursor to another bubble, but only if risk is again mispriced.

The recipe for a housing bubble includes many ingredients such as loose lending standards. However, loose standards merely qualify more borrowers. While qualifying more borrowers may extend the rally, it requires a gross mispricing of risk and enormous capital flows into unstable loans before prices get pushed up into bubble territory.Nemo_loan_teaser_rate

Let’s assume for a moment all qualification standards were eliminated and anyone who wanted to borrow money could get a loan, similar to what happened in 2004 through 2006. Would this cause a housing bubble?

In my opinion, it would not.

It would inflate prices, and it would cause a great deal of downward substitution of quality to get a property, but it wouldn’t necessarily create a housing bubble if the loans were based on verifiable income and reasonable debt-to-income ratios on conventionally amortizing mortgages.

The loose lending standards of 2004-2006 allowed many people to buy homes, but it was the combination of liar loans, unlimited debt-to-income ratios, and negatively amortizing loans that allowed the army of borrowers to finance loan balances double what they should have been.

Housing demand is measured two ways: (1) by the total number of buyers, and (2) by the total amount those buyers can put toward housing. Increasing the number of borrowers can inflate prices through the substitution effect, but increasing the total amount buyers can put toward housing is what propels prices into orbit.

Toxic loan programs like the option ARM were not invented during the housing bubble; they were long-standing niche products with a hefty price tag to properly price the risk of default. It was the gross mispricing of risk on Wall Street that created an insatiable demand for these products that drove the price down and put these weapons of financial destruction in the hands of unqualified borrowers. Prices wouldn’t have inflated nearly so much during the housing bubble if the risk hadn’t been mispriced through ruinous credit default swaps and collateralized debt obligations given AAA ratings by a corrupted rating system.

We all should be concerned about the return of some dangerous loan products. I expressed my belief that the new mortgage regulations will prevent future housing bubbles because the “Ability to Repay” rules will prevent reckless lending, but I could be wrong. These toxic loan products don’t conform to the new mortgage regulations, so right now they are very expensive and uncommon. If Wall Street misprices risk yet again, they could fund these non-conforming loans and inflate another housing bubble. We must pin our hopes on changes at the ratings agencies, new regulations, and institutional memory on Wall Street — we all have reason to worry.

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Can Consumers Without FICO Scores Be Trusted with Mortgages?

By Lew Sichelman, December 12, 2016

Many consumers without traditional credit scores are nevertheless creditworthy and could qualify for mortgages, according to recently released research.

Millions of people considered unscoreable by conventional standards have credit profiles nearly identical to those with access to mainstream credit, the report claims. …

The white paper demonstrates that many unscoreable consumers “are not outliers at all, but rather creditworthy, whose access to credit is unduly restricted” by the reliance on a conventional scoring model, Burns said.

Let’s assume for a moment this study is correct and access to credit is unduly restricted. Wouldn’t some lender who wants to increase their business without assuming more risk act on this information? Shouldn’t private lenders work to take market share away from the GSEs but utilizing information such as this?

The fact that private lenders aren’t doing this shows how confident they are with this analysis.

The study analyzed a random sample of 5 million consumers representative of the U.S. population. It compared those with credit files that met the conditions required to obtain a conventional score with people who were excluded from conventional scoring because of the status of their credit files, but whose files were sufficient to obtain a VantageScore.

The study found that when additional demographic and financial information was used in conjunction with the Vantage model, those with thin or no credit files were “as creditworthy” as those with scoreable files.

Those who scored above 620 using the VantageScore “exhibited profiles of sufficient quality to justify mortgage loans on par with those of conventionally scoreable consumers,” Burns said.

The research also showed that unscoreable consumers are often assessed as high risk, despite the possibility that they have strong financial foundations but are simply conservative users of credit. …

The assumption that unscoreable consumers are too high risk to qualify for credit or don’t need it “is false,” said Sarah Davies, senior vice president of analytics at VantageScore. She called the study a “wake-up call” for lenders the need to choose their scoring model carefully “to ensure they see all creditworthy potential borrowers.”

Bankers make money by making loans. When loan production hit 20-year lows in 2014, some reduction of standards was inevitable if they want to remain in business.

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The competition for new business is prompting some lenders to offer toxic loan products again — at a high price. From an email a reader forwarded me…

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Perhaps we shouldn’t take this loosening credit idea too far.