WORD ON THE STREET: Some buyers who would like to purchase a home are unable to do so because they are unable to obtain a mortgage. According to the Federal Reserve's quarterly senior loan officer opinion survey on bank lending practices, underwriting standards for residential mortgages tightened steadily from 2007 to 2009, and they do not appear to have eased much since then.
This tightening of credit standards is apparent in the credit scores of borrowers who obtain mortgages. For newly originated mortgages, the median credit score of prime borrowers rose from about 700 in 2006 to more than 760 in 2009, where it remains today.
Moreover, a large swath of borrowers who likely had access to credit a few years ago appear to be essentially excluded from the mortgage market under current prevailing standards. Indeed, in an indication of the minimum credit score required to obtain credit, the credit scores of borrowers in the bottom 10% of those who obtained credit have risen from around 625 in 2006 to approximately 690 today.
Tight mortgage underwriting standards make obtaining mortgage credit particularly more difficult for first-time home buyers. Because first-time home buyers tend to be younger than other home buyers, they also tend to have lower credit scores and fewer financial assets that can be used for down payments.
As a result, tight lending standards would be expected to constrain their demand by more than it would for other home buyers. Indeed, research by Federal Reserve staff finds that first-time home buying during the past two years has been quite weak by historical standards and that this weakness has been particularly pronounced among borrowers with lower credit scores.
So why is access to mortgage credit so tight? Lenders may have tightened credit standards partly as a correction for the lax and problematic lending standards that prevailed in the years leading up to the peak in house prices. And, given the significant consequences that those lax lending standards had for many households, communities, financial institutions and the economy, some tightening of credit standards is warranted.
But it seems likely that other factors are at work as well. Constraints on lenders' capacity to process loan applications have reportedly been part of the story. Since the crisis hit, some lenders have closed their doors, and others have cut back substantially on staff.
In addition, a shift to full documentation of income and assets, along with a heightened concern that underwriting mistakes could cause lenders to be forced to repurchase seriously delinquent loans, has lengthened the time required to originate each mortgage.
According to Home Mortgage Disclosure Act data, the median time that elapsed between mortgage application and closing increased from about four weeks in 2008 to around six weeks in 2010. Moreover, empirical evidence suggests that lenders might be nearly as capacity-constrained now as during the 2003 refinance boom, even though current mortgage volume is only about one-third of the volume in 2003.
But capacity constraints alone are an unsatisfying answer to the question of why access to credit is so tight. It seems reasonable to suppose that if lenders were eager to originate mortgages, they would have an incentive to invest in staff and systems to alleviate these constraints. I believe uncertainty about the future on the part of lenders is inhibiting these investments.
The problem of uncertainty
Just as uncertainty about job prospects or house prices has likely discouraged some potential buyers from purchasing homes, it is likely that uncertainty has also affected mortgage lenders. Uncertainty surrounds several key aspects of mortgage lending: the strength of the economic recovery and the trajectory of future house prices; the costs and liabilities associated with originating and servicing mortgage loans; the regulatory environment; and the future structure of the mortgage market, including that of Fannie Mae and Freddie Mac and of private-label securitization.
I think the effects of these uncertainties have an important bearing on the future strength of the housing market and would like to discuss each in a bit more detail.
Turning first to macroeconomic uncertainty, borrowers are more likely to default when they lose their jobs or when their houses decline in value. So long as unemployment remains elevated and further house-price declines remain possible, lenders will be cautious in setting their requirements for credit – and rightfully so. But these factors should ease as the economic recovery gains steam and the trajectory for house prices appears more certain.
Although house-price declines have moderated notably, the continuing effects on house prices of the large number of underwater mortgages and of the mortgages still in the foreclosure pipeline remain unclear. Even professional forecasters diverge widely in their views about the future path of house prices: In one recent survey, house-price forecasts for 2012 ranged from a decline of 8% to an increase of 5%.
Uncertainty about house prices and the high volume of distressed sales make the job of residential appraisers and lenders more difficult. In the current market, appraisers may tend to have a more conservative view of a home's market value, and as long as house prices continue to decline, lenders may lean toward more conservative underwriting. Taken together, these factors could discourage – or even disrupt – sales that might otherwise happen smoothly.
While macroeconomic uncertainty is likely an important contributing factor to tight mortgage credit conditions, we also observe that lenders have tended to be conservative in making some mortgages that are guaranteed by government-sponsored enterprises (GSEs) – loans in which lenders do not bear the credit risk in the event of borrower default – which suggests that issues other than macroeconomic risk are affecting lending decisions. Indeed, analysis by Federal Reserve staff suggests that only about half of lenders currently offer mortgages to borrowers whose credit metrics fall into the lower range of GSE purchase parameters.
In the April survey, lenders were asked targeted questions about the likelihood, compared with 2006, that they would originate mortgages with specific credit profiles. Responses confirmed that lenders today are less likely – and often much less likely – to originate loans to GSE borrowers with credit scores of 620, even when borrowers were making down payments of 20%. In fact, the only category of borrower to have experienced no net reduction in reported credit availability was the category with the highest credit profile asked about in the survey – those with down payments of 20% and credit scores of 720.
Lenders that responded in the April survey that they were less likely to originate loans were asked to identify the reasons why. About 80% of the respondents reported greater borrower difficulty in obtaining affordable private mortgage insurance, a less favorable economic outlook, or the outlook for home prices as being at least somewhat important.
But policy concerns played a role as well. In an indication that delinquency risk is now considered in addition to the risk of credit loss, more than half of the respondents cited risks associated with loans becoming delinquent as being at least somewhat important – in particular, higher servicing costs of past-due loans or the risk that the GSEs would require banks to repurchase delinquent loans, known as putback risk.
The ability of the GSEs to put back loans when lenders have misrepresented their riskiness helps protect taxpayers from losses; however, if lenders perceive that minor errors can result in significant losses from putback loans, they may respond by being more conservative in originating those loans.
Additional regulatory uncertainty arises from the Dodd-Frank Act requirement for two important regulatory rulemakings that could significantly influence mortgage underwriting as well as the cost and availability of mortgage credit.
First, the Consumer Financial Protection Bureau is required to issue rules that will set requirements for establishing a borrower's ability to repay a mortgage. These rules would include a definition of a ‘qualified mortgage’ (QM). Mortgages that meet the definition would be presumed to meet the standards regarding the ability of the borrower to repay. These rules are important because violation of the standards could subject lenders to penalties and, in some cases, impede their ability to collect on defaulted mortgages.
In the second rulemaking, several regulators, including the Federal Reserve, are charged with establishing a definition for the ‘qualified residential mortgage’ (QRM), a subset of QM that would be exempt from risk-retention requirements in mortgage loan securitizations. Without commenting on the specifics of any of these individual regulatory rules under consideration, I think it is important to note that potentially each of them – servicing requirements, capital requirements and underwriting requirements – will affect the costs and liabilities associated with mortgage lending and, thus, the attractiveness of the mortgage lending business.
The road forward
We have had a severe financial crisis, with both housing and housing finance playing a central role, and recovery is not likely to be quick or easy. But I do believe there are some things that can help. So, if I were to write a prescription for housing recovery, I would include the following items.
Most important to the health of the housing market is the strength of the economic recovery – the labor market, in particular. Potential homeowners are unwilling to buy if they are uncertain about their income prospects. And credit standards will remain tight as long as lenders are concerned about borrowers' ability to repay.
In addition, I think efforts under way to reduce the flow of foreclosed homes and distressed sales in the market will help to stabilize home prices. Mortgage loan modifications, short sales and deeds-in-lieu of foreclosure all act to reduce the number of homes in the foreclosure pipeline.
Recent price signals – higher rental rates and falling rental vacancies, combined with low home prices and elevated single-family home vacancies – indicate that by reallocating some of the foreclosed home inventory to rental property, investors could help balance supply and demand in both the rental and the owner-occupied markets.
Neighborhood stabilization efforts can help alleviate some of the costs to neighborhoods of foreclosure and allow local decisions regarding low-value and dilapidated properties. Many borrowers are current on their payments but are still unable to refinance to take advantage of low interest rates. Recent changes to the Home Affordable Refinance Program will allow more of these borrowers to refinance and lower their payments, thus reducing the likelihood that they will become delinquent.
But perhaps the most important solution that I am suggesting today is that policymakers move forward with the difficult decisions that will affect the future of the mortgage market. To be sure, important issues need to be addressed, and hard questions remain to be answered.
It will not be easy to decide what to do about the GSEs, or how best to promote a robust secondary market, or what form crucial regulations should ultimately take. And it is unlikely that anyone will fully agree with the final decisions that are made. Nevertheless, until these tough decisions are made, uncertainties will continue to hinder access to credit, the evolution of the mortgage finance system and the ultimate recovery of the housing market.
I don't want to diminish the importance of any individual policy decision, but I do believe that the most important prescription for the housing market is for these decisions to be made and the path for the future of housing finance to be set.
Elizabeth A. Duke is a governor of the Federal Reserve System. This article was adapted and edited from a recent speech delivered May 15 at the National Association of Realtors Midyear Legislative Meetings and Trade Expo in Washington, D.C. The original text is online.