Apr 19, 2020

The name of the game this week:  credit overlays.  What's that, you ask?

During the Great Recession, when lenders started foreclosing on homes, the GSEs (Fannie Mae and Freddie Mac) started examining loan files to figure out why.  Soon, they began to identify deficiencies in loan files.  Maybe Bank of America didn't properly document the fact that a borrower was 30 days late on his auto loan six months prior to closing.  The GSE would then assert that Bank of America didn't do their job and require B of A buy the loan back.  And buybacks are a big problem.

Remember, after originating your home loan, mortgage companies make money by selling that loan on the secondary market.  That's how they earn capital ot make new home loans to new borrowers.  When lenders aren't able to sell those loans or they're required to buy back loans they've already sold, that's not good.

If you're a REALTOR®, think about the firm for whom you work.  What if they had to buy back houses if something went wrong a few months after the sale?  How many houses could your firm buy before they couldn't afford to be in the real estate business anymore?  In fact, some experts believe it was buybacks, not foreclosures, that caused so many mortgage companies to fail during the Great Recession.

To hedge against buybacks, many lenders instituted credit overlays.  A credit overlay is a guideline that is more strict than the guidelines established by Fannie, Freddie, and Ginnie Mae.  Maybe FHA will allow a credit score as low as 580.  Wells Fargo might require 660.  Maybe Fannie Mae will approve a debt-to-income ratio as high as 50%.  Some lenders won't allow debt ratios above 45%.

Credit overlays were really common during and after the Great Recession.  Then, Fannie and Freddie made big changes to their representation and warranty relief on income, asset, and collateral data.  Representations and Warranties assure lenders that a mortgage sold to Fannie or Freddie satisfies their underwriting and documentation requirements.  Once lenders were assured they wouldn't be forced to repuchase loans, they began to loosen guidelines again.

Enter the Coronavirus.  As I mentioned a few weeks ago, another thing that cause a loan to be unsaleable are first payment defaults.  Remember, mortgage payments are made in arrears.  Let's say a consumer closed on his new mortgage loan on April 14th.  His first payment won't be due until June 1st.  If that consumer loses his job on May 15th, he may decide he can't make his first payment and contact his lender to request forbearance.  That lender then has an unsaleable loan on their hands.

So lenders are getting really picky about the types of borrowers they'll fund loans for right now.  They don't want to be caught with their pants down if a borrower suddenly finds himself unemployed and unable to make his payments.

These are a few of the (more concerning) overlays I've heard discussed in the last few days:

  • No credit scores below 700
  • Down payment must be 20% or more
  • Rental income may not be used to qualify unless a borrower has six months of reserves for each financed property.
  • Self-employed borrowers must have twelve months of reserves AND be able to document current deposits into a business bank account consistent with normal income.

I think all lenders are getting more strict about employment verification.  It's no longer sufficient to prove a self-employed borrower has a business license and filed his last tax returns.  We now have to show that they are currently working and are earning an income that is similar to that earned in previous months/years.

We'll usually see the big banks tighten the reigns first.  The big banks can afford to be conservative.  They have multiple lines of revenue.  They can afford to lose half their mortgage business because they have additional channels for making money.

If you're a consumer who wants to purchase a home or refinance an existing mortgage, it's more important than ever to shop around.  Align yourself with a loan officer who understands how the market (and interest rates) are behaving and why.  And work with a lender with a demonstrated ability to close home loans in your market.

We are very fortunate that the company I work for, New American Funding, has not announced significant credit overlays.  But I am constantly monitoring the market for guideline changes and program announcements.

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