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posted: 10/19/2013 12:08 AM

Why will some lenders accept borrowers that other lenders reject?

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Some mortgage applicants will be accepted by every lender and others will be rejected by every lender. However, there is a group of "marginal applicants" who will be rejected by some lenders and accepted by others.

During the period 1920-34, before the development of secondary markets and mortgage insurance, the risk associated with every mortgage loan was entirely borne by the lender making the loan. The number of marginal applicants was sizable in that period because each lender had its own underwriting requirements, which varied widely, depending on their business model. Those focusing on generating large loan volume would have more liberal requirements, but would also charge higher rates to cover the larger losses resulting from that policy. The rates charged by more selective lenders would tend to be lower.

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The mortgage professor of that era, if there had been one, would have advised borrowers who could meet the requirements of a selective lender to patronize such a lender. Borrowers with strong credentials who unwittingly placed themselves in the hands of a volume-oriented lender with liberal requirements, would usually overpay.

Flash forward to the market structure that existed in 2000 and lasted until the financial crisis of 2007-8. By then the federal government had become a major player, setting the underwriting standards and assuming the risk of loss over a sizable segment of that market. Nonetheless, a sizable chunk of the market remained private, and was divided into "prime" and "subprime" components.

The mortgage professor of that era (me) warned borrowers who could meet the requirements of prime lenders to avoid subprime lenders, who would charge them subprime prices, but many fell into that trap. Much of the restrictive legislation that followed the crisis was a reaction to this and other abuses associated with the subprime market.

Now flash forward to the market structure that exists in 2013. The private subprime market is gone, and the private prime market is less than 10 percent of the total. The qualification standards today are dominated by Fannie Mae, Freddie Mac and FHA, which purchase or insure more than 90 percent of all new mortgages. Yet even with the government setting the standards, there are mortgage applicants who will be rejected by some lenders and accepted by others.

Some lenders use underwriting rules, referred to as "overlays," that are stricter than those set by the government. They may set a higher required credit score, for example, or a lower maximum ratio of loan amount to property value on some types of property, such as condominiums or four-family townhouses.

The reason is that lenders retain some risk on loans sold to or insured by the agencies. Fannie Mae and Freddie Mac keep records on the performance of loans they purchase from each loan originator. That performance record affects the price they pay the originator. FHA also maintains performance data, and if it is poor they will terminate the lender's access to the FHA program.

In addition, loan underwriting includes some judgment calls, exposing lenders to the risk that their judgment might be overruled by the relevant agency. The adequacy of property appraisals is an important example. If Fannie Mae or Freddie Mac determine that an appraisal is unsatisfactory, they will make the lender buy back the loan, while FHA will refuse to insure it.

Lenders differ in their willingness to expose themselves to these risks. Those who are most judgmental and have the most restrictive overlays want to minimize their exposure, at the cost of passing on loans that they might otherwise make. Other lenders are willing to take these risks because they can generate more volume and charge higher prices.

A good illustration is how lenders set minimum credit scores on FHA loans. FHA does not impose one, so it is left strictly to the lender. Most lenders set a minimum score of 640, but a few go to 580. They do this because they can make more money on the 580 borrower who has no place else to go, knowing that they are endangering their performance record with FHA, which could get them kicked out of the program. In an earlier article I referred to this as the "FHA subprime market."

In its essentials, therefore, the problem is the same as it was in the 1920s, and the best advice to mortgage borrowers is also the same. If you are a marginal applicant acceptable only to a small number of high-priced lenders, you might want to reconsider whether or not it wouldn't be better to wait until such time as you can improve your credentials. This is especially pertinent to applicants who are cash short and need an FHA but have credit scores below 640.

If you are in the conventional market with strong credentials, you may do better dealing with a lender who has overlays that are more restrictive than Fannie or Freddie requirements. There is no simple way to identify these lenders, but if you shop effectively on a multi-lender website, it won't matter because these lenders will emerge with the best prices.

• Contact Jack Guttentag via his website at mtgprofessor.com.

2013

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