Mortgage Lending Creativity Is Increasing Risk 


BLOG VIEW: The mortgage market is shifting. The fact that pundits have been warning that lenders would see significant changes in their businesses in 2022 has done little to prepare them or make the shocks that come with these changes any easier. Experts had been predicting that interest rates would be rising as early as late 2020. Now that it’s here, the impacts are landing.

After years of sub-4% interest rates, Freddie Mac said in Mid-April that it expected to see rates rise to 4.6% by year’s end and then rise to 5.0% – and beyond in 2023. Then, just two weeks later, Freddie’s average rate for a 30-year-fixed-rate mortgage hit 5%. As one would expect, purchase applications fell, according to the Mortgage Bankers Association, down 8% for the week of April 25 and 17% from this time last year.

Lenders are reacting to this in a number of ways, some of which are serving to add risk to their businesses.

Bracing for the Impact of Higher Rates

As rates rise, traditional loans from Fannie Mae and Freddie Mac are beginning to look far less affordable to many consumers. That’s true, but it’s only part of the problem. Housing in general is far less affordable right now. In January, the Nation Association of Realtor’s Housing Affordability Index fell, largely due to an increase in the monthly payment of 3.4% and only a modest increase in family income (0.5%).

“The income required to afford a mortgage, or the qualifying income, is the income needed so that mortgage payments on a 30-year fixed mortgage loan with 20% down payment account for 25% of family income,” according to the NAR. That’s too high for many and so we’re seeing fewer purchase applications.

High construction costs have pushed new homes well beyond the reach of many prospective buyers. This month, the National Association Home Builders said the share of adults planning to purchase a home within a year fell for a third straight quarter to 13%.

While purchase applications are down, there is still a great deal of unmet demand in the market, both for new homes and new home financing. One thing we’re seeing more borrowers do is turn to cash-out refinances in order to make alterations to a home they already own. Even with rates rising, this can make more sense for some borrowers than a second mortgage.

That’s not to say home equity second mortgages are being ignored. With inflation pushing up rates and no end in sight to the Fed’s actions to slow down inflation, some borrowers are opting for a HELOC, either to make changes to their home or just to take some of their equity for other purposes.

And we’re also seeing more interest in adjustable-rate mortgages. ARMs have fallen out of favor in the recent past, despite offering lower interest rates than fixed-rate mortgages, but that’s changing. It could be because the pandemic’s work from home protocols made it easier for people to move or that it’s just easier to work remotely now, but more consumers are accepting the fact that they may not be in their homes that long. A 7- or 10-year ARM could save them a lot of money if they are going to move anyway.

Getting Creative and Increasing Risk

While embracing any of the above options will be a change for lenders who have spent most of the last few years writing rate and term refis, most will easily make the pivot and find that these programs can shore up some of the business they will lose to rising interest rates.

It’s when the lender gets really creative that things can become risky.

For example, we are now seeing some lenders embracing asset depletion models. These have been around for years and have traditionally been transactions offered to individuals with investment portfolios who can apply some of those assets as collateral on a loan.

Now we are beginning to see some investors use the asset depletion model where they are using equity in other properties, they own to make additional real estate investments. We believe this is happening because the GSEs have dialed back their investor loans.

This is an interesting approach and there is nothing, on the surface, to say that this is not a good idea for both the lender and the investor. But it does require careful oversight and good due diligence. Mistakes and missteps here can have grave consequences for all parties involved.

As rates rise and the market tightens, we expect to see more examples of lenders getting creative to keep business coming into their shops. While this is exactly what they should be doing, they must exercise care and practice excellent due diligence. This may be a challenge for many who don’t have the trained staff in house to provide adequate quality control.

Fortunately, there are third parties who have both the experience and the trained staff to support lenders as they stretch their businesses into enterprises who can weather the storms ahead and succeed through this part of the cycle.

John Hutchison is chief operating officer at Infinity IPS. He has more than 25 years of experience in the financial markets including managing such areas as due diligence, deal and transaction management, compliance, fraud, originations, collections, loss mitigation, foreclosure, and bankruptcy.

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