Mortgage Lending Standards Could Ease Further, As a Result of Rule Change

Lately, we’ve been writing a lot about easing credit standards within the mortgage industry. After being criticized for imposing overly strict criteria on borrowers since the housing crash, lenders now appear to be relaxing their standards. And a new development within the secondary mortgage market could relax those standards even further.

A recently announced rule change that would otherwise go unnoticed by home buyers and borrowers may actually lead to easier mortgage lending standards in the U.S. Freddie Mac and Fannie Mae, the two government-controlled corporations or “enterprises” that buy and sell home loans, are revising their rules for mortgage put-backs.

A put-back occurs when a lender has to repurchase loans it sold to Fannie or Freddie, due to faulty origination or underwriting practices. In other words, it’s when a bank has to take back a bad loan — at their own expense.

FHFA Revises ‘Buy-Back’ Rules

Mel Watt
Mel Watt, director of FHFA

According to Mel Watt, director of the Federal Housing Finance Agency or FHFA (which oversees Freddie Mac and Fannie Mae), the two enterprises “are going to relax the payment history requirement for granting representation and warranty relief by allowing two delinquent payments in the first 36 months after acquisition.”

He is referring to a rule that requires lenders to buy back loans they’ve sold into the secondary mortgage market, if those loans are determined to be fraudulent or defective in some way. This is known as a buy-back or put-back request.

Under the previous rule, a loan would be exempted from such a request once the borrower reached three full years of payments with no delinquencies. The revised rule, scheduled to take effect in July 2014, will allow up to two delinquencies (missed payments) to occur within that three-year period.

FHFA is essentially relaxing the standards for mortgage buy-back requests, and thereby expanding the pool of loans that could be exempt from such a request. Translation: federal regulators are easing one of the biggest concerns among mortgage lenders — that they will have to buy back their loans.

Relaxed Mortgage Lending Standards on the Horizon?

So what does this have to do with mortgage lending standards for actual borrowers? How could a rule change that primarily applies to lenders affect a borrower’s ability to qualify for a home loan? To answer this question, we must look at the relationship between the primary and secondary mortgage markets. In short, the relaxing of rules and standards within the secondary market typically “trickles down” to borrowers in the primary market.

Home loans originate in the primary mortgage market. This market consists of the lenders who generate the loans (banks, credit unions, etc.) and the borrowers who apply for them. If I apply for a loan with Wells Fargo, Bank of America, or a local bank or credit union, I am participating in the primary market.

The secondary market, on the other hand, is where mortgage-backed securities (MBS) are bought and sold. It is made up of the three “players” shown in the center of the diagram below — (1) lenders, (2) Fannie Mae and Freddie Mac, and (3) the investors who purchase MBS assets through Wall Street and other channels.

mortgage securitization diagram
Overview of the mortgage securitization process. Source: SEC

When mortgage standards are relaxed in the secondary market (center of diagram), it tends to have a similar easing effect in the primary market where loans are originated. In other words, it could result in easier and broader access to credit for borrowers.

Granted, this rule change won’t be a panacea for all credit woes. Many would-be borrowers will continue to be stymied by selective mortgage lending standards and criteria. Some consumers carry too much debt in relation to their income. Some have bad credit resulting from unpaid debts in the past. Others have a combination of these problems.

For the most part, mortgage lending is limited to well-qualified borrowers with a history of responsible credit usage. Still, we could see a slight relaxing of standards once the new rules take effect in July. It’s too early to tell.

What Are Lenders Looking for These Days?

We don’t yet know if and how this rule change will affect mortgage lending standards for borrowers. Lenders might lower their minimum credit-score requirements or raise their debt-to-income limits, among other things. But we do know what they are looking for right now, in terms of borrower credentials and risk factors.

Generally speaking, mortgage shoppers need a credit score of 600 or higher to qualify for a home loan. They also need to have a manageable level of debt, which is measured through the debt-to-income ratio (DTI). These days, many lenders are limiting borrowers to a DTI of 43% or below to comply with new government rules and guidelines.

But none of this is set in stone. There are exceptions to these and other mortgage lending standards, particularly for borrowers with a history of making payments on time. And we could very well see an easing of those standards going forward.