Whoa! Where are the Brakes?

For many years the mortgage industry has acted as a brake on the housing sales business. There are usually more buyers than properties and someone needed to weed out those who would not be able to make the payments. That was us.

Traditional underwriting standards were established at S&Ls in the early days before that segment imploded. They were then incorporated into the guidelines established by FannieMae, FreddieMac, and other industry leaders. These guidelines theoretically kept the unworthy from joining the Homeowner Club.

Most particularly, the underwriting focused on income and expense, creditworthiness, and equity. Let’s talk about those.

Underwriters first calculate the ratio of the borrowers’ income to his housing expense. Then they calculate the ratio of income to total expenses, housing expense plus bills such as car payments and credit card payments. Traditionally the first ratio could not exceed 28% and the second was not to exceed 36%. Many, many homebuyers have been turned down because their ratios were higher than that.

Second, they look at a borrower’s credit history in order to see if the borrowers have handled other obligations in a satisfactory manner. We didn’t have credit scoring back then so it was a little more subjective, but the objective was to weed out the flakes.

Finally, lenders are concerned about equity in the property. The KNOW that they are going to end up foreclosing on between 1 and 2 percent of the homes they lend on, and they want to be sure that there is adequate collateral so they can get their money back. To do loans over 80% LTV, lenders also require Private Mortgage Insurance, PMI, which inserts a higher level of underwriting and caution into the process.

Many of the traditional standards were modified significantly when FannieMae and FreddieMac introduced their automated underwriting systems. These systems routinely approve loans where the total expense ratio is 50%, sometimes even higher. They will also approve loans for people with modestly damaged credit and those with little or no down payment.

That doesn't bother me. It was a good move because I have always felt that the traditional criteria were too restrictive. By that I mean that there were people who didn’t meet those criteria but who were perfectly capable of making all the payments on time. They should have been approved back then and if they were trying today, they would get approved.

Most interestingly, there does not seem to have been any negative repercussions from this, meaning that the number of loans going into foreclosure is a little higher but like by tenths of one percent, not a cause for alarm. That said, there may well be cases where people did get over their heads, but because the market values improved enough, they were able to sell before the lender took their home away from them.

Today, it’s even looser. There are lenders who will approve ANYBODY with a 680 credit score and not much other documentation, and they get A-paper rates. I also get flyers daily from lenders saying that they will do 100% financing to people with people with 580 credit scores, pretty flakey. They don’t need to document the source of income either, but the rates are higher, of course. I think that this means that practically anyone can buy a home these days! Doesn’t it seem like that to you?

So where are the brakes?

I’m not sure, but I think that there are people being put into houses that they really can’t afford. I’m working on one right now where an aggressive real estate combined forces with a lender who was there only to help the agent get a commission. The result is that the buyer feels way over his head. We’re going to re-fi the owner into an interest loan which at least makes living there affordable until he can sell it. He’ll keep the home for two years and one day so his likely big gain in value will not be taxable, and then go buy a home in which he will be more comfortable.

In the next article, we’ll talk about some of the real dangers of deals being proposed and, I’m sure, executed daily.

Be careful out there!