The Real Housing Fix: Common-Sense Lending

It will take years before we can truly assess how far out of whack the real estate market was at the pinnacle of the housing boom last decade. That's important to remember when assessing the current dismal state of the U.S. housing market.

Lax lending standards that in 2005 allowed almost anyone to get a mortgage have been tightened considerably in the past couple of years -- so much so that many housing experts believe the tougher standards are what's blocking a sustained housing recovery.

The often-used analogy is that of a pendulum that swung a long way in one direction and has now inevitably swung a nearly equal distance in the opposite direction. Of course, no one questions why the new standards emerged. They are a direct response to a lending-era dominated by no income/no asset mortgages, otherwise known as no doc or liar loans.

The dilemma now is how to find a comfortable middle-ground.

Specifically, what's needed are lending standards that balance the need for accountability and responsibility while at the same time fulfilling the important function that mortgages have served for decades -- making homeownership an affordable option for millions of Americans.

Nothing less than the health of the U.S. economy depends on it.

(New Home Sales Slip in June)

The U.S. has a national priority of homeownership, said Ron Phipps, president of the National Association of Realtors. But it has to be sustainable. That should be the preface to the conversation about homeownership in the U.S.

The mortgage industry has taken important strides toward that goal of sustainability, reining in its practices in an effort to ensure that borrowers can actually repay their loans.

Theres a movement afoot that would establish a national set of mortgage servicing standards designed to reduce costs to lenders and consumers alike, and also make the process more transparent and less cumbersome and confusing.

The Mortgage Bankers Association supports the effort, arguing that consumers and lenders would benefit from a uniform set of standards that would cut down on paperwork and reduce legal expenses for both borrowers and lenders by significantly streamlining the process.

We at MBA believe that a consolidated national servicing standard, if developed in a cooperative manner, could stimulate much needed reform of a residential mortgage loan servicing system that has admittedly failed a great number of consumers during the recent foreclosure crisis, MBA President David Stevens said during testimony earlier this month before Congress.

Meanwhile, the Federal Reserve recently introduced a proposal that would require mortgage lenders to verify borrowers incomes and outstanding debt before approving a home loan. The idea is similar to the MBA supported measures: that is, create safeguards so that consumers borrow within their means and lenders make responsible loans.

The Fed is currently seeking public comment on the plan.

But while one half of the equation is making strides toward a solution as lenders address the folly of giving loans to people who cant repay them, the other half of the equation is still in flux.

That part of the solution will require a flexibility that allows otherwise qualified borrowers to obtain mortgages even it their finances -- monthly income, credit history, outstanding debt, etc. -- dont precisely fit the rigid lending restrictions now in place.

Phipps praised the new industry policies targeting the terrible underwriting practices of the past decade that contributed to the real estate meltdown and subsequent financial crisis.  He warned, however, that punishing homeowners with overly stringent requirements is unnecessary and harmful.

The NAR believes U.S. home sales could potentially jump 15% -- an estimated 750,000 sales in 2010 -- if lending standards were relaxed just a bit.

Industry experts are virtually unanimous in their belief that uniform standards for underwriters would benefit the mortgage industry (and ultimately the housing market), but uniform standards for borrowers do not.

In fact, thats already proving to be true.

Patty Raymo, chief operating officer at Mortgage Master, a large Massachusetts-based residential mortgage lender, said stringent uniform lending standards, for the most part set by secondary market investors rather than the actual lenders, are excluding many qualified home buyers.

Raymo cited the tough guidelines used by automated underwriting engines to determine if a borrower is qualified. Lenders plug a potential borrowers financial data into these engines, and the software removes any human element of the decision making process.

In todays world you can either get a loan or you cant. Theres no gray area, said Raymo. The pendulum has definitely swung.

Consider, for example, debt ratio standards now required by the automated underwriting engines. Currently, a potential borrowers debt ratio cant exceed 45% of their gross monthly income. If the debt ratio falls outside of that box, in the parlance of the mortgage industry, the borrowers application is automatically rejected.

In the past, common sense lending allowed a lending officer to review a file and formulate their own decision. That process went awry during the housing boom, but now it has become overly restrictive.

Its probably the most frustrating its been since Ive been in the business. You see a loan that makes sense but it cant get done because it doesnt fit into the box. The automated underwriting engine probably  wouldnt allow it, so you cant do it. It would be nice if we get back to a point where we were able to make a decision outside that box, said Raymo.

The reason those boxes are so inflexible is that the secondary market for mortgages comprised of the big Wall Street investment banks -- Citigroup (NYSE:C), Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) among them -- are still healing from the collapse of the subprime mortgage market and remain extremely skittish toward risk.

The big banks have made it clear to the lenders on the front lines of the mortgage industry -- Mortgage Master, for example -- that if a loan doesnt pass their muster they wont buy it. Consequently, if the big Wall Street banks wont buy a loan the lenders wont approve it.

Raymo said she expects the big banks will eventually become less risk averse.

Eventually they will loosen up and there will be a balance but its going to take some time because everyone is still digging out from the mess that occurred, she said.