Feds Re-Impose Loan Standards They Helped Undermine

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When President Obama announces Washington’s new plan to help troubled mortgage-holders today, the betting is that the program will include a loan-modification effort that reduces the size of a besieged homeowner’s debt. One goal would be to cut the size of loans and perhaps also their interest rate so that a mortgage holder’s monthly payment would equal no more than 31 percent of his pre-tax income. Fannie Mae and Freddie Mac have already been experimenting with an income-to-payment ratio of 38 percent in their loan modification efforts, but Washington wants to go further, indeed probably needs to go further, if it is to stem the tide of defaults.

There is a great irony that Washington will now lead the way in imposing new, stricter standards, including a tougher income-to-payment ratio, because it was Washington, prodded by affordable housing advocates, which pushed mortgage lenders to dilute their traditional underwriting values in the first place. Federal regulators attacked those established standards as being “unintentionally biased” against low and moderate income borrowers and used a variety of laws and regulatory bodies to push often resistant lenders into programs based on these lower standards. The government and those who backed its actions assured lenders these lower standards were safer than they thought, even though there was little research to support that contention. Now that a huge chunk of the market based on these debased standards has melted down, the government is going full circle.

The movement to water down underwriting standards grew out of claims of some housing advocates and elected officials that mortgage lenders were ‘redlining,’ or avoiding, certain urban neighborhoods, and that these credit-starved areas were decaying from a lack of capital. When bankers countered that they received few credit-worthy applications based on their traditional underwriting criteria in many of these neighborhoods, regulators and housing advocates began to argue that there must be something wrong with the lending criteria, which needed to change.

One group that led the way was the Association of Community Organizations for Reform Now, or ACORN, which began protesting bank mergers and expansion requests in the mid-1980s under the Community Reinvestment Act. In 1986, ACORN threatened to oppose an acquisition by a Southern bank, Louisiana Bancshares, until the financial institution agreed to new “flexible credit and underwriting standards” for low-income borrowers, including agreeing to take into account on mortgage applications such income as public assistance and food stamps. ACORN also led a coalition of community groups that demanded industry-wide changes in lending standards for urban residents, including watering down minimum down-payment requirements. The community groups also attacked Fannie Mae as part of the problem with bank lending in certain areas because the giant, quasi government agency’s underwriters were “strictly by-the-book interpreters” of standards who turned down purchases of unconventional loans, which sent a message to banks that these loans were unsafe.

Under pressure from Washington, Fannie Mae and Freddie Mac agreed to begin purchasing mortgages under new, looser guidelines. Freddie Mac, for instance, made 28 changes to its underwriting standards, including approving low-income buyers without credit histories or with bad credit as long as they were current on rent and utilities payments--even though research had concluded that such buyers are more likely to default. Freddie Mac also said it would count income from seasonal jobs and public assistance toward income minimums, although such income (particularly seasonal work) was by definition not steady.

The giant agencies began several experimental lending programs based on watered-down standards. Freddie Mac began a program with Sears Mortgage Corporation to make mortgages to borrowers with an income-to-monthly payment ratio of 50 percent, at a time when most private mortgage companies aimed for a 28-to-33 percent ratio. The program also allowed borrowers with bad credit to win mortgage approval if they took credit counseling classes administered by local nonprofits like ACORN, although research would show that credit counseling classes have little impact on default rates.

These efforts gained the endorsement of some of our most authoritative federal institutions. Shortly after producing a controversial study in 1992 which asserted there was some evidence that lenders were intentionally avoiding minority neighborhoods, the Federal Reserve Bank of Boston produced a “guide” to equal opportunity lending in which it told mortgage makers that conventional underwriting standards were “unintentionally biased” because they didn’t take into account “the economic culture of urban, lower-income and nontraditional customers.” Among other things, the Boston Fed told lenders they should consider junking the industry's traditional “obligation ratios,” including the 28 percent income-to-payments ratio. The Fed noted in its guide that the “secondary market,” that is, those that purchased mortgages from banks, was willing to buy loans with higher ratios, thereby implying that others thought these loans a good bet, too. But at this point the secondary market for such loans consisted of Fannie Mae and Freddie Mac, which had both been cajoled into buying them by Washington.

Under pressure, these institutions accepted these new standards even though there were plenty of early warning signs as well as several decades worth of research which suggested that when banks departed too far from traditional underwriting criteria delinquencies and foreclosures rose sharply. For instance, a minority loan program put together by banks in Atlanta after a newspaper series accused local financial institutions of redlining quickly ran into predictable trouble. The program allowed loans with payments that were up to 50 percent of an applicant’s monthly income, and within a year, 10 percent of the loans were delinquent. Even worse, those who took out the loans fell deeper into other kinds of debt, defaulted on credit card payments and had goods they’d purchased on credit repossessed.

Meanwhile, a Freddie Mac program called Affordable Gold, which purchased loans from banks under looser underwriting standards, including loans which allowed a borrower to make a down payment with funds contributed from a third party like a government assistance program or a nonprofit, showed sharply higher default rates, up to four times higher than traditional underwriting standards.

Despite such evidence, over time these programs moved from the experimental stage to a large part of the marketplace because politicians in both parties made expanding the number of home owners in America a high priority, and the only way to keep doing that was to lend to people with increasingly riskier credit. Fannie Mae announced a $1 trillion commitment to purchase affordable housing loans in 1992, then in 1999 under pressure from the Clinton administration announced a new program to buy loans made to “borrowers with slightly impaired credit.” In 2005 Fannie Mae and Freddie Mac committed to another $1 trillion in affordable housing lending.

And as their loan pools grew, their credit standards deteriorated. In a recent Forbes article Peter Wallison of the American Enterprise Institute and Edward Pinto, former chief credit officer of Fannie Mae, point out that by 2001, 18 percent of Fannie Mae’s portfolio consisted of loans to people with credit scores below 680—the traditional definition of a loan to someone with riskier credit, who is also someone more likely to default.

Of course, with two huge federal agencies willing to purchase such loans, mortgage makers couldn’t churn them out fast enough, and private investors also began snapping up the loans in competition with Fannie and Freddie. Prof. Stan Liebowitz of the University of Texas uncovered a 1998 sales pitches by Bear Stearns, the leading private packager of mortgage-backed securities, in which a managing director of the firm assures banks in language remarkably similar to that used by government regulators that these loans were safer than traditionally thought and that investors were ready to buy them, if only banks would make more of them. “Do we automatically exclude or severely discount …loans with [poor credit scores]? Absolutely not,” the eager investment banker tells his audience. Bear Stearns, of course, was eventually sunk by such loans.

Today, housing advocates and ex-government regulators say federal programs were not the problem because many of the worst loans portfolios were created by non-bank lenders which are not even subject to the Community Reinvestment Act. But that’s an argument that ignores the much broader role that government played in watering down standards, including using pressure to force players across the industry to participate.

The Department of Housing and Urban Development under President Clinton, for instance, threatened to introduce legislation to make non-bank lenders, that is, mortgage finance companies, subject to CRA if these firms didn’t sign on to affordable lending goals. HUD even crafted an agreement with the Mortgage Bankers Association, the industry trade group, which pledged that the group’s members would aid in affordable housing goals. One of the first members of the MBA to take up the pledge was Countrywide, which pledged to introduce low-down payment loans with high income-to-payment ratios for low-income borrowers. Countrywide and its co-founder, Angelo Mozilo, ultimately became infamous as one of the first major mortgage lenders to melt down under the weight of its bad lending, but before it was notorious Countrywide was celebrated for its low-income efforts.

Today, the Obama administration acknowledges through its bailout program that those standards were unsafe. It’s a backhanded acknowledgement that comes only because bailout efforts up until now have largely failed except in cases where borrowers are given new mortgages written to reflect former underwriting standards, which in many cases can only be accomplished by simply forgiving a big chunk of the borrower’s debt. I suppose that’s about as far as we can expect government to go in admitting the mess it helped to make.

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