Mortgage lending standards remain prudently restrictive though 2013

realtors, homebuilders and others who profit on real estate transactions hold the false belief that lenders are holding back the market with tight lending standards. It’s an easy position to hold for those who have no risk of loss when loans go bad. The reality is that lenders are not willing to make bad loans anymore because if the do, they will lose money — which is how it should be. Lenders are supposed to be the adults looking over real estate transactions. After all, it’s mostly their money being used to fund the purchase. During the housing bubble lenders abandoned lending standards entirely because they weren’t held accountable when loans went bad. Now, with buy-back provisions in most securitzation agreements, lenders are very cautious about making bad loans, as they should be.

Earlier this year, I posted that Credit availability will get even tighter in 2013. I followed up with evidence in Mortgage lending standards continue to tighten. Despite the whining from realtors and others who don’t care about bad loans, tight underwriting is a good thing because tighter mortgage standards for GSEs will encourage private lending.

Oftentimes, rising prices prompts lenders to lower their standards because they have less risk of capital loss. This becomes a cycle as looser credit qualifies more borrowers which drives prices even higher which gives lenders confidence to reduce standards further. This keeps going until lending standards are so loose that many borrowers default which prompts a sudden and violent restriction in standards known as a credit crunch.

For lenders that hold their bad loans, lower risk from rising prices makes a tangible difference to their balance sheets. However, for originate-to-sell lenders, rising prices doesn’t effect them much. The GSEs who insure nearly all loan pools today will go after the lender for costs and fees through their buy-back agreements. Thus, bad loans severely impact originate-to-sell lenders whether prices are rising or not. This is one of the main reasons loan standards are not getting any looser despite the turn in the market.

In the long run prudently restrictive lending standards are a great thing. If borrowers are consistently making their payments, there are fewer foreclosures, and the housing market is more stable. The cycle of loosening standards leading to a credit crunch does not need to recur. If the underwriting standards in place today remain as prudent as they are now, the chances of a future credit crunch and catastrophic decline in prices is minimal.

Mortgage lending standards stay tight: Fed survey

May 06, 2013|Greg Robb, MarketWatch

WASHINGTON (MarketWatch) — In a possible threat to the nascent housing recovery, banks remain unwilling to loosen mortgage standards, a new survey of officers released by the Federal Reserve on Monday showed.

Tight lending standards are not a threat to a recovery. They are the foundation for a recovery. The dramatic language reflects the desire of realtors and loanowers to see standards loosen again to drive more sales volume and higher prices.

Cash buyers and investors have been driving the housing recovery so far. If it is going to persist, it will need to include more buyers with mortgages, economists say.

Last fall, Federal Reserve Chairman Ben Bernanke said that mortgage lending standards appeared to be “overly tight.”

Bernanke knows that standards are not overly tight, but he has to give lip service to those who want to see them loosened.

Bernanke said the surveys showed that lenders began tightening mortgage credit standards in 2007 and have not eased standards significantly since.

In the latest senior loan survey , released on Monday, only a few American banks reported that they eased standards on prime residential mortgages over the past three months.

A large majority of the loan officers said that the “risk-adjusted profitability of the residential mortgage business relative to other possible uses of funds” was an important factor restraining residential real estate loans.

Let’s decode that and consider what it means.

Investors are piling into government-backed mortgages because they don’t have any other good places to park their money. 3.5% returns over a typical 7-10 year holding period is not very good. Plus, there is a very real possibility that these loans may last much longer than 10 years because if interest rates rise, these people won’t refinance. A wise investor would not want to be stuck in a 30-year loan yielding 3.5%, particularly considering the future inflation likely to come from years of 0% interest rates.

So what happens when the economy improves, and there are better risk-adjusted returns in the market? Investors won’t fund these loans. If better opportunities start appearing, investors will demand better returns in order to be compensated for the risks. That will drive up mortgage interest rates.

If loan officers are already stating they aren’t pleased with the returns they are getting, it won’t take much for mortgage rates to rise. Eventually, all the money being printed at the federal reserve will stimulate the economy. When it does, look for mortgage rates to begin to rise.

Fear of “putback risk,” the risk that the insurers and mortgage buyers would force them to buy back bad loans, was another important factor.

This is the lynchpin holding the system together. Lenders must behave as if they are holding the paper themselves. They have risk of loss if the loan goes bad. This is a great thing because it makes lenders accountable. Without the fear of buy-backs, lenders would underwrite the same kind of crap they defecated on the market during the bubble.

A number of smaller banks indicated that they were even less likely now to approve a mortgage loan with a FICO score of 620, depending on the down payment.

Some more banks were likely to approve a mortgage application with excellent credit — a FICO score of 720 — and a 20% down payment.

About a third of bank loan officers indicated that they were less likely to approve mortgages insured by the Federal Housing Administration with FICO scores of 580 or 620. …

Interesting that subprime standards are getting even tighter. This is the fear of buy-backs at work. The default rate at 620 is about 15%. Originate-to-sell lenders simply can’t afford those kind of buy-back rates, so they are less likely to underwrite those loans.

Lending standards only appear tight through the lens of the housing bubble. Looking back to times when lenders were accountable for their own loans, lending standards are right where they should be. As long as standards remain tight, the housing market will be more stable. Let’s hope standards remain tight for a very long time.