Why some banks don't want to take a chance on some borrowers

For at least a year, the Obama administration has been pushing lenders to make mortgages more widely available to responsible people looking to buy homes.

"Now that we've made it harder for reckless buyers to buy homes that they can't afford, let's make it a little bit easier for qualified buyers to buy the homes they can afford," President Barack Obama said last August in a speech at an Arizona high school, adding that too many qualified families are getting rejected by banks.

But the hurdles remain tough. The Mortgage Bankers Association said that access to credit is running at roughly one quarter of the pre-housing bubble rate of 2004.

The administration has been meeting with key stakeholders, including David Stevens, the MBA's chief executive, throughout the year to understand why the situation isn't improving. Stevens says he told administration officials that many potential buyers are getting shut out of the market because lenders don't want to take a chance on them.

In an interview with The Washington Post, Stevens explained why. A major stumbling block for potential borrowers, he said: "Credit overlays."

This interview was edited for length and clarity.

Dina Elboghdady: What are credit overlays?

David Stevens: In order for lenders to sell mortgages to Fannie Mae, Freddie Mac or the Federal Housing Administration, the mortgages have to meet minimum standards for some key variables: the credit score, the amount of debt the borrower has relative to his or her income and the documentation. But lenders are applying standards that are more conservative than what is required, and those are the credit overlays. For instance, FHA allows credit scores that can be as low as 500, but most lenders insist on a minimum of 620 or 640 because they think it's risky to do anything under that. They'll demand a higher credit score on a loan because data shows that higher scores perform better.

(Note: Fannie, Freddie and FHA do not make loans. FHA insures lenders against losses should the loans go bad. Fannie and Freddie buy loans, package them into securities and sell them to investors. For a fee, they insure the loans and pay investors should the loans default.)

DE: Why are the lenders doing that?

DS: There are a variety of reasons for overlays that include both regulatory and legal risk. Lenders are putting policies in place for self-protection. All you have to do is read the headlines about the massive legal settlements against the largest lenders for loans they made that went into default. There's been very aggressive enforcement in response to the housing bust, to bad mortgage programs that should have never been created, and to lenders who did the wrong thing, many of whom are now out of business. And there's no end in sight. Lenders are saying we're going to have clear lines so our decisions can never be questioned when a loan defaults. Lenders feel like there really have to be zero errors now. They also don't want to risk having to buy back loans that have minor, nonmaterial errors.

DE: Aren't the lawsuits more about holding lenders accountable for fraud rather than minor errors?

DS: I'm not passing judgment at all on the lawsuits themselves, and the big ones have fairly aggressive claims in them. But there are others that don't make the headlines. We have cases where lenders hired third-party appraisers, and followed all the requirements for ordering an appraisal. The borrowers made their payments for five, seven or even 10 years before defaulting. The investor who purchased the loan then said: "We don't think the appraisal was done right." Is there some point at which you should sunset the risk? If a borrower defaults in the first year or two, that probably means they got into the wrong program or the lender made a mistake. But if they default many years later, that probably reflects changes in their lives and changes in the economy. It's less likely to be the result of the manufacturing of the mortgage years earlier. The regulator that oversees Fannie and Freddie has made some minor policy changes in this area.

DE: Why shouldn't there be a zero-tolerance policy for errors?

DS: The average loan file today is somewhere between 300 to 500 pages, depending on the state and the loan product. There's a lot of human intervention involved in putting that loan file together. The likelihood of a minor defect is almost 100 percent, like getting the middle initial wrong on the application versus the title.

DE: Almost a quarter of the banks surveyed by the Federal Reserve in July said they've loosened standards for prime mortgages, the most since the 2007 housing bust. Last week, Fannie Mae's chief executive said that credit overlays are easing. Are you also seeing signs of that?

DS: We're seeing credit standards ease most for wealthier borrowers with big down payments rather than for marginal first-time borrowers with less wealth and lower down payments.