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Mortgage Credit

In the wake of the Subprime Mortgage Crisis that led us to the Great Recession of 2009 it is not surprising that government responded by tightening up the lending standards and creating new disclosure rules for lenders when dealing with borrowers.  No one can deny that too many unqualified borrowers were granted loans that led to great dislocations for both those individuals as well as for the economy as a whole.

What can be disputed, however, is whether the reforms enacted were appropriate and will lead to the desired outcome, which should be to reduce the origination of loans that will ultimately cause systemic losses without inadvertently creating guidelines that will depress lending in situations that will not lead to lender loss.  The propensity of the focus by regulators has been on the equation of income to housing expense, which is to say income as a qualifier for a mortgage.  In this construct, a person with what might appear to be a reasonably steady job can borrow fairly readily as long as his/her total debt to income ratio does not exceed 43%.  When I began my career in the mortgage industry in 1982 this was a guideline number and was targeted at 36%.

The problem is not in the absolute number but in mandating that it be used as a hard-and-fast limitation.  Today that is the case, as any loan application that fails to meet the new standard is tarnished.  There are guidelines a loan must meet to gain the desirable standard of being a “Qualifying Mortgage,” which includes the aforementioned 43% maximum total debt-to income ratio.  And then a loan must also meet the new “Ability to Repay” standards that lenders must meet to avoid lender liability.  In this measurement, a lender must determine that a borrower has sufficient means, with a special focus on documentable income, to repay his/her loan.  If a lender makes a loan and the ATR standard is deemed to not have been met, then a lender will likely have liability in the event of a default/foreclosure/loss scenario.  This latter aspect affects both unregulated lenders as well as banks, which helps insure that those not meeting these standards will have an awfully hard time finding a loan.

The main miss here is the emphasis on the income/debt ratio rather than the money a borrower has tied up in his/her home as reflected in the Loan-to-Value (LTV) ratio.  History has shown quite conclusively that a higher amount of borrower equity is the single greatest risk mitigation against lender loss, and yet in today’s construct it is given little to no weight.  A borrower with a job and W-2 income and a steady monthly income stream can borrow at 80% or even 90%, or in an FHA program up to 97% of the value of his/her property, while someone without the ability to demonstrate this W-2 income would find his/her application shunned by traditional lenders even at 50% LTV.  The reason for this is that the government has specifically excluded the sale of one’s home as a reasonable means of demonstrating the ability to repay their loan.  This flies directly in the face of all common sense.  First, nearly all loans are repaid either through a home sale or a refinancing.  Almost none are paid off over the life a loan with monthly mortgage payments.  Second, a borrower with 50% equity in a home will do everything he/she can to protect that equity, and will move to sell the home well within the foreclosure time frame in order to do so.  A borrower with 2%-20% equity in a home will not be quite as motivated, or may not find a buyer at a satisfactory price to get any of their equity out before the foreclosure clock ticks down.  The bottom line is that a low, and especially ultra-low LTV loan will perform far better that a higher one, and the perception of a steady income from a job does little or nothing to offset that.

Finally, emphasizing W-2 income is directly at odds with the reality of today’s employment and economic situation, in which technology threatens to continue to displace jobs that were previously thought to have been steady, thus rendering W-2 income highly unpredictable.  By favorably allocating credit to those who are in jobs that might be either lost in future downsizing/right-sizing, or diminished in import and thus less likely to produce suitable incomes, and at the same time denying credit to entrepreneurs, professional investors, retirees, immigrants, and others who cannot meet today’s income documentation standards, even when they have the financial means to make significant downpayments, is both contrary to lenders’ best interests as well as to those of the broader U.S. economy.

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