Economists' Outlook

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FED: Demand Up, But Lending Remains Tight

The Federal Reserve released its quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) yesterday. Lenders experienced increased demand for mortgages in the 2nd quarter of 2012, but lenders’ standards remained tight even for prime loans. In addition, this survey included special questions on the HARP 2.0 program, which suggest that despite the recent changes to HARP 2.0, banks remain pensive about taking on risk and that big-banks dominate HARP 2.0 refinances raising costs to the consumer.

As depicted on the right side of the chart below, the share of respondents who tightened lending standards surged in 2006 through 2009. There was a modest bit of easing in late 2011, but that was from a very tight level and that moderation was absorbed in the subsequent quarter. Roughly 94% of respondents in the 2nd quarter said that credit standards had not changed, while 3.3% reported an easing and 3.2% indicated a tightening. The tightening trend was more pronounced outside of large banks.

While lending standards have not eased, the demand for new loans rose sharply in the 2nd quarter. 47.5% of all respondents indicated a moderately stronger demand for prime residential mortgages, while 9.8% saw a substantially stronger pattern. A larger share of small and mid-sized banks, 18.5%, reported a substantially stronger increase in demand for prime mortgages.

Demand for non-traditional residential mortgages surged in the 2nd quarter with 40.7% of all respondents indicating an increase. This pattern is likely explained by the surge in high LTV and low-documentation refinances brought on by the changes to the HARP program, which were put in place in March. Private modifications have also been on the rise in the wake of the robo-signing resolution.

The survey included special questions regarding the HARP 2.0 program that are enlightening. Respondents indicated that HARP 2.0 refinances were a substantial part of their refinance activity with 26.7% of respondents indicating that HARP 2.0 accounted for 30% to 50% of their refinance activity and another 30.0% indicating that it made up 10% to 30% of their refinance business in the 2nd quarter. This pattern was stronger for large banks than others. The difference in HARP 2.0 activity may reflect the difficulty that small and mid-sized banks have in dealing with the legal costs associated with loans that the GSEs deem unfit and force banks to repurchase.

Banks are imposing tougher standards on HARP 2.0 loans than prescribed by the program and it is limiting their participation in these refinances. Nearly half of all respondents indicated that they limited high LTV HARP 2.0 refinances to some degree despite the fact that they are allowed under HARP 2.0. This was a concern for only 41.4% of large banks while 60% of other banks were impacted. Likewise, 50% of small and mid-sized banks required higher FICO scores to some degree than those required by the HARP 2.0 program, compared to 35.5% for large banks. Documentation is also an issue as 67.7% of small to mid-sized banks required additional documentation to perform a HARP refinance than required under HARP 2.0 compared with just 28.6% of large banks. This is a surprise as the changes to HARP 2.0 should have helped to ameliorate banks’ concerns about representations and warrants in the original loans. Clearly, the forced repurchases or the threat of such has had an impact on the behavior of banks and a disproportionate one on small banks.

Finally, the ownership of servicing rights appears to have a major impact on banks’ decision to refinance loans. Under HARP 2.0, a bank that currently owns or services a loan can refinance with no additional requirements for underwriting because the representations and warranties of the original loan are waived since the GSEs already own the risk. However, a different bank cannot refinance the loans without performing additional due diligence because the representations are not waived. In short, the new servicer would face additional costs to perform the due diligence and would not be free from the representations and warranties made on the new loan in the same way that existing servicers would. The net effect it to reduce competition for the HARP 2.0 refinance business allowing the same-servicers, which tend to be small group of large banks, to raise rates on HARP 2.0 refinances. Respondents to the Fed’s survey were asked whether or not their “bank offers HARP 2.0 refinances only on mortgages that my bank already owns or services.” As depicted in the chart below, for large banks the same-servicer issue impacted 71.4% of respondents’ choice to refinance loans, while it impacted the behavior of 90% of the small and mid-sized banks surveyed.

Finally, survey respondents were asked where their current lending standards for FHA and conforming loans ranked relative to the range of their own standards, tightest to loosest, during the period from 2005 to the present. The majority of respondents indicated that their current lending was near the middle of the range of lending standards over this period, but 30% felt that their current standards were near the tightest that they had been over this period or significantly tighter than the middle-range of this period. Lending for jumbo loans [1] was even tighter with nearly 42% of respondents indicating that standards in the 2nd quarter were near the tightest that they had been since 2005 or significantly above the middle of the range established over this period. The tighter standards at banks for jumbo loans relative to conforming coupled with pensive behavior from investors in mortgage backed securities has driven the historically wide current spread between jumbo and conforming loan rates. Though down from the peak near 200 basis points in 2008 and 2009, the spread between jumbo and conforming rates of 55 basis points in July was nearly triple the historic average.

Tight lending standards come as no surprise to most real estate practitioners. However, the fact that a majority of banks are imposing tighter standards than required on HARP 2.0 refinances despite having the risk of repurchases reduced suggests that lenders are very concerned about the current regulatory and legal environment. This pensive behavior is heightened in the non-conforming space. Given the current drive toward a mortgage finance system with a limited government role and expanded private financing, such a transition may be difficult.

[1]Due to the way the question was asked, the responses to this question may include loans financed by the FHA as the FHA limit is above that of the GSEs for certain markets.

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