Are Underwriting Standards Getting Looser?

As the second half of 2018 emerged, there was evidence that mortgage lenders had begun loosening underwriting standards. Even government lending standards for some loans became less restrictive, and consumers were able to access credit easier. This activity could present greater challenges to lenders in the future.


Underwriting Standards Became Looser in 2018

When the last financial crisis hit, mortgage lenders were forced to tighten the requirements to qualify for a loan. Over the past decade, borrowers with a high debt-to-income (DTI) were considered higher risk, and many were unable to qualify for a loan. This has begun to change.

In the second quarter of 2018, the MBA's Mortgage Credit Availability Index grew over two consecutive months, with a 0.2 percent increase in June. The index was up 1.4 percent from the prior year, largely thanks to more high-balance conforming and jumbo loan products coming on the market.

On the government side, there were some policy changes related to the Department of Veterans Affairs Interest Rate Reduction Refinance Loan Program that tightened underwriting, but this was offset in other areas. Fannie Mae and Freddie Mac, two of the largest government-sponsored mortgage enterprises, have eased lending rules. Both allow lenders to finance up to 97 percent of a home's purchase price and Fannie Mae has increased its maximum DTI ratio from 45 to 50 percent.

After Fannie Mae raised this limit, the ratio of conventional conforming mortgages with a ratio above 45 soared. According to CoreLogic, these high DTI loans comprised roughly 5 to 7 percent of the total from 2012 until 2018. In the first quarter of 2018, the number of these loans skyrocketed to 20 percent. Between Q1 2017 and Q1 2018, the average DTI ratio on home loans jumped to 37 percent, an increase of 2 percentage points.


Why Underwriting Standards Could Be Shifting

While there were plenty of lessons learned from the last financial crisis, it doesn't always make sense to keep consumers locked out of loans. A higher DTI ratio can be a red flag for lenders that want to avoid risk. However, expanding access to credit can help borrowers who are creditworthy purchase in higher-priced housing markets where they might have otherwise have been shut out of homeownership.

Even so, lending standards remain much more stringent than before the last housing crisis. Gone are the days when a borrower can be approved for a loan without showing proof of employment or income. Even though higher DTI ratio loans are more common, research shows that lenders are still sticklers for a respectable credit score. The average credit score of 755 on conforming purchases remained unchanged in Q1 2018 compared to the prior year.

What Looser Standards Could Mean for Lenders

As the first half of 2018 came to a close, private credit managers had a globally combined purse of $251 billion to lend. As lenders of all types, from banks to non-banks, compete for customers, they are under pressure to write business, and many have loosened underwriting standards. There is particular pressure among private equity firms to underwrite more business, which has its risks.

Some lenders have attempted to mitigate risk by having strong covenants and liquidity tests, but these become negotiable when a borrower has many options. Banks have not only found that they are competing with each other in the mortgage space but also foreign investors and direct lenders. Loan growth among big banks was just 1 percent in 2017, but it jumped to 5.5 percent in Q2 2018.

In some commercial real estate deals, terms are based on optimistic figures instead of hard data. For example, the earnings generated by borrowers are taken as "possible" instead of "likely." When loan portfolios are more aggressive, it makes sense to evaluate these more frequently in terms of potential risk and return.