How Lender-Mandated Credit Overlays Undermine the Mission of the GSEs

Imagine that you're a borrower with a credit score of 580 or worst yet no credit at all.  You have what the Lenders call alternative credit (rent, utilities, cable & phone bill and etc.).  You are employed with a qualified debt to income ratio and have saved a down payment of at least 3.5% and maybe some of your closing cost. On paper, you seem like a perfect candidate for an FHA loan. However, your lender denies your loan application because of your low FICO score or because you do not have a FICO score.  Even though you have met the U.S. government's requirements for getting an FHA loan, your lender declines to approve your loan because of their credit overlays.  This scenario is being played out every single day at all the major banks, credit unions and many mortgage banks.  Who is in charge of the guidelines and parameters by which banks can lend?  Are the additional credit requirements legal or discriminatory based on federal law?  I believe that credit overlays are discriminatory and possibly illegal.

What Is a Credit Overlay?

Lender credit overlay requirements demand that borrowers have higher credit scores than what the federal government requires. In other words, bank requirements for credit scores exceed what a government-sponsored enterprise (GSE) like Freddie Mac or Fannie Mae or HUD mandates for mortgage loans. While some lenders defend their right to focus on a credit score as evidence that a borrower can repay a mortgage, HUD challenges banks to examine the totality of a borrower's qualifications beyond just the credit score.

Credit overlays charged by lenders often disqualify borrowers from receiving mortgages. The National Community Reinvestment Coalition has filed a complaint with HUD alleging that at least 22 lenders that administer FHA loans violate the terms of the Community Reinvestment Act, the Fair Housing Act and the Equal Credit Opportunity Act. Critics allege that credit overlays disproportionately deny African-American and Latino borrowers access to FHA mortgages.

How Borrowers Can Fight Back?

Some organizations, like e21 (Economic Policies for the 21st Century) have demanded that Freddie Mac and Fannie Mae transition from GSEs into private organizations. In this new role, the two mortgage backers would purchase conforming mortgages and then bundle them into securities that would become eligible for government backing. As GSEs, Freddie Mac and Fannie Mae have pursued private profit while backed by the full faith and credit of the U.S. government. GSE standing allowed Freddie Mac and Fannie Mae to take excessive risks.

On one hand, Freddie Mac and Fannie Mae pump secondary liquidity into the mortgage market, making it possible for many Americans to receive home loans. On the other hand, Freddie Mac and Fannie Mae receive minimal government scrutiny, and they fail to deliver benefits to American families that need the most help. Instead of imposing strict credit score requirements, lenders that work with Freddie and Fannie should consider the factors that contribute to lower credit scores. Lenders should also consider other factors including debt-to-income ratios and future job stability.  Recent changes in the HUD guidelines are a step in the right direction, but will lenders adopt these changes in their underwriting guidelines?   Lenders need to decide if they want to be intermediaries of the GSEs & HUD and if they are prepared to have the reserves necessary for delinquencies, repurchases and foreclosure.  It is a part of the business that is never going away and not every Lender is prepared or able to manage the risk.  Lenders that are prepared should get all the business and those who are not should consider getting out of the business of securitized lending and relying on government guarantees and liquidity.

 There is private equity market waiting for lenders who want to make up their own rules.  It is called Private Banking or Private Equity and is already a business channel in most banks.   It is not fair to American people for banks to change rules mandated by congress and the GSEs.  If a bank changes the rules, the bank should not be able to leverage the good faith and credit of the American taxpayer who pays for the guarantees and the GSEs that create the liquidity and the secondary market.  Either makes loans according the guidelines set forth by FNMA, FHLMC, HUD, and GINNIE MAE or move into the private banking and equity market where you belong and make up your own rules.

It is clear to me that credit overlays that include fico scores are just as unreliable as the credit ratings by Standard and Poor’s, Fitch and other credit rating agencies.  A closer examination of the risky loans that banks and the secondary market originated because of a high fico scores and were sold in the bond market because of Triple A ratings by Credit Agencies should give us all reason to pause.  These ratings represent an opinion that was baseless and blew up the secondary market.  At least it was human error and fraud. Why hasn’t FICO been hauled in before congress and ordered to open up the black box and tell the American people why their FICO is worth more than the paper it is written on?   Why should the entire US Lending and Banking system rely on it when it has failed us so miserably in the past?   No one is asking the question.   We need to go back to the basics when FICOs didn't exist and rating agencies actually reviewed most of the loans that made up the bonds instead of getting paid for Triple A ratings.  The corruption, zero oversight, greed and fraud that existed during this time between the rating agencies, banks and investment banks was on a level of a third world country being ran by drug and gang lords in three piece suits.  A new kind of gangster that no one thought was possible emerged.  This is now common knowledge and nothing has been done about it.  No one has gone to jail over this incredible secondary market Ponzi scheme where nothing was real except the families in the homes foreclosed on.  This was truly gangster activity at the highest levels of business and it is how real gangster's roll.  Real gangsters rarely see the inside of a jail cell.  

Whitepaper Coming Soon

To learn more about credit overlays and how they undermine the government's mission to enable low and middle-income Americans to purchase housing, read the whitepaper I am writing that will help real estate and lending professionals address this issue with their representatives in congress and mortgage banking executives.  The whitepaper will be release in the next two weeks.