Softening the Credit Choke Hold

By all credible measures, access to credit has been constrained in recent years. The market appears to have loosened in the spring of 2015 though, followed by another modest improvement in the late summer. However, credit remains tight by historical standards and there are storm clouds on the horizon.

Starting in 2012, there was a steady decline in the average FICO on accepted FHA applications as the FHA increased its mortgage insurance fees, private mortgage insurers recapitalized and recovered, and borrowers migrated into the cheaper conventional space. However, the average FICO score for rejected applications in both the conventional and FHA spaces, 725 and 668 respectively, were relatively unchanged and significantly above levels on accepted applications from 2001 suggesting that overlays were limiting downward movement in these measures.

The average FICO score on rejected FHA applications began to fluctuate in the summer of 2014, but in the 4^th quarter of 2015 the average FICO scores on a rejected application fell in both the conventional and FHA space. This pattern accelerated in the spring of 2015, following overhaul of the representation and warranties framework for the GSEs, changes in FHA pricing, renewed confidence among consumers with lower credit scores, and clarification of the FHA’s defect taxonomy. Conversely, the average accepted FICO in the FHA space rose reflecting the migration of some borrowers from the GSEs to the FHA as a result of the FHA’s 50 basis point reduction in its mortgage insurance premium in January of 2015.

The reduction in the average FICO score on a rejected application is a signal of an important change. Some lenders including Wells Fargo indicated that they would reduce overlays on FHA mortgages in early 2014. The eventual decline in the average rejected FICO suggests that this did in fact occur, but it was not widely signaled to consumers, consumers were constrained in other ways, or that there were only a limited number of lenders willing to make these loans until later in 2014. More recently, though, lenders have indicated concern about the FHA’s proposed changes to its certification policy and Wells Fargo along with a number of other lenders indicated that they would reinstitute overlays on FHA loans. The average FICO on a rejected application rose from 627 to 630 from September to October. This measure can be volatile and the FHA’s policy would not explain why the average FICO on rejected conventional applications rose as well, so time will tell whether the reemergence of overlays will have a persistent impact. Regardless of recent trends, the average FICO on an accepted application remains nearly 40 points higher on conventional loans and 20 points higher on FHA mortgages.

Credit scores are not the only dimension for overlays though. Loan-to-value ratios or down payments can also be used to limited access to credit, but as evidenced by the chart above low down payment loans were available at the FHA. The steady rise in the average LTV on accepted conventional loans from 2011 to 2013 reflects the renewed health and return of private mortgage insurers as well as excessive pricing by the FHA.

The average front-end debt to income ratio (DTI) climbed through the middle of 2013 for both conventional and FHA accepted applications as mortgage rates jumped following the taper tantrum. International instability drove rates lower in early 2015 and caused the average front end DTI in both channels to moderate, but this pattern was reversed by mid-summer. Meanwhile, the average for rejected FHA applications fell sharply and remains below its average from 2011 to 2014, a sign that the FHA’s 50 basis point reduction improved affordability for the marginal borrower.

The average back-end DTI ratio on an accepted FHA or conventional loan has changed little in the last four years at roughly 41 percent and 36 percent, respectively. This pattern suggests that despite the GSEs having an exemption on the back-end DTI requirements of the Ability to Repay (ATR) rule while in conservatorship, the bulk of originations are observing the 43 percent back-end DTI restriction. The same is true in the FHA space. However, the average back-end ratio on a rejected application has climbed to 50 percent in October of 2015 from 47 percent in the summer of 2014.

The recent trend of overlay relief suggests that mortgage originators and investors have become more comfortable with regulatory and legal risks in the post-Great Recession paradigm. However, overlays on credit scores remain historically high, while the current environment does not resemble the extreme risk taking behavior from 2001 to 2005. Lenders and insurers regularly impose compensating factors on borrowers who have risky elements in their credit profile. Furthermore, regulators have imposed significant increases in capital requirements and lenders price risk appropriately. While not complete, signs point to significant strides in healing the mortgage market.