A Time article entitled Fed to Curb Shady Home-Lending Practices claims that the Fed seeks to ”bar lenders from making loans without proof of a borrower’s income.” Is this really necessary? Fed economist William Emmons concluded in a recent study that intervention makes housing market conditions more volatile and artificially keeps the market from correcting itself. Self-correction generally happens sooner and is therefore less extreme. If left to itself the mortgage financing market will determine what loans lose money and which borrowers are most likely to successfully repay mortgages. Fix the accountability problem and you fix the “shady” lending problem. Lenders who will bear the consequenses of their decisions are unlikely to lend to someone who can’t repay the loan.
But we’ve heard that a million times so I’m not going there. I just have a practical question: how do you define “proof of income?” Does the Fed mean that those whose income doesn’t fall within Fannie or Freddie’s definition of “proof” are out of luck? For example, I had a self-employed client (a developer) whose business operated on weird cycles. He would experience huge outgo, often generating a loss or a tiny income at best for a year or two, followed by ginormous profits. His income averaged in the mid-six figures and he had the assets to back it up. I documented this with several years’ tax returns and a letter from his CPA. However, underwriters required that we take the lowest year’s income (happened to be the most recent) when calculating ratios; naturally negative income isn’t going to get you approved. So we went with stated income financing and all was well.
I feel that the proof we offered should have been adequate, and I hope that the Fed will allow alternative ways of documenting income, such as bank statements showing cash flow, or a statement from an accountant explaining why this year’s income is more representative of the true picture because it isn’t offset by start-up costs. In other words, I hope in the name of reform we don’t lose common sense. Too much of that has disappeared already.
Hi Gina,
Great post and I agree. With all the recent problems it seems that the pendulum has swung a little too far. Let’s hope that the reforms that are being discussed are carefully thought through as not to hinder markets from doing what they do well being efficient.
I’d far rather see self-employed who cannot qualify using conservative adjusted income from tax returns go into stated income programs. They are high risk and they should be priced accordingly.
As someone who has loaned MY OWN money to homebuyers (unlike a lot of those institutions who are in trouble) I am much more comfortable with a stated income borrower who is putting 25-30% down, has good credit and the assets to support the income than an FHA borrower with 3% down, no reserves, and a 580 credit score. It’s when you layer risk you get in trouble. I notice the recent foreclosure stats divide bad loans into “prime” or “subprime.” To date I haven’t seen foreclosure stats on stated income loans that were not subprime. Prime lenders require assets to support the income stated and decent credit and a significant down payment. I’d bet (in fact I have, literally, when I’ve loaned out my money for this kind of purchase) that those mortgages very seldom go sideways.
It’s the lender’s prerogative to set their underwriting standards. Underwriting self-employed such as you have described is outside of normal due diligence and should be pooled separately so the ultimate lender can bid and set price based upon their own tolerance for risk. Pooling loans to self-employed with other more cookie-cutter type transactions requires conservative underwriting or the level of risk is not reliably categorized.
Diane, I have NEVER said that stated income borrowers should be considered the same as vanilla borrowers; only that if a new law says you can’t do them (that you have to prove income) there should be other provisions for “proving” income. Saying out of hand that stated income shouldn’t be legal is short-sighted and does lenders and borrowers a disservice.
In addition, Fannie Mae’s stricter guidelines haven’t saved it from trouble, and FHA’s insurance has failed to cover its losses (making us the taxpayers ultimately liable for one and potentially liable for the other. So we all have a stake in this, as borrowers, industry pros, and as taxpayers). I feel (and when the stats become available I’m sure they will bear this out) that the borrower’s assets and equity are a far better indicator of who pays and who goes than income, stated or othrwise.
When people have more to lose they find the money, and when they have less they become more cavalier about paying. As an analyst for Experian, I found our models showed consistently it was “willingness” to pay that was a better indicator of a consumer’s performance on loans than “ability to pay.” And we had very extensive data to back that up.
I would say willingness and ability go hand in hand. They always have. The law, I presume, would only impact federally related mortgage lending and so those who choose to hide their income can find lending from private sources or even resort to the old fashioned community bank style lending in which other assets such as CDs are used to secure the debt in addition to the real estate.
We must restore faith in federally related mortgage lending. There are some core and time tested principals in traditional underwriting that work yet were abandoned wholesale in the quest for high volume and easy credit.
Some markets have lived with this mind-set since the 80s and it will require a full paradigm shift in thinking, but I hope that we’ll find an equilibrium of good judgment combined with standards in due diligence that can be fairly predicted and audited. Using a routine method for calculating the income for self-employed individuals has to be part of that kind of due diligence. Those that can’t make that kind of a cut will just have to find another way to borrow.
Due diligence, especially that sitting underneath a security pool must be predictable and auditors have to be able to pick up any file and come to roughly the same conclusion as the original underwriter.
My big fear moving on is that there will be a move to automate the thought process. The over-reliance on FICO right now scares me.
Pricing according to a FICO score scares me.
We are fully capable as an industry of creating a trained class of qualified underwriters using humans with experience. Backed by a fully expert quality control program – manned by professional underwriters performing due diligence, unfettered by conflicts of interest, this kind of system does work. It did before it was crushed by automation. If we have learned anything from this debacle, it’s that you can’t replace the good judgment of a qualified human underwriter who is committed to following specific guidelines and who has authority with oversight to use judgment in compensating factors with limits.
Loan originators would eventually get used to the new system and be able to predict underwriting outcomes.
In my view losing stated income in the normal course of business is the correct course. Having to make that choice through legislation is bizarre, but given the current climate of lending ignorance, it must be necessary. I don’t use the word ignorance in any unkind manner. I mean it in the most sincere way of stating lack of experience or training as we have had roughly 20 years of hardly any lending rules.
If anyone could come up with actual statistics that show that stated income loans (prime, with substantial down payments, assets from which you can extrapolate income, and good credit) are more likely to go sideways than the oh-so-successful Fannie, Freddie and FHA programs I’d agree with you (and eat my hat or whatever item of clothing you choose). But so far no one has come up with actual facts to support their assertions.
As a lender myself not subject to the moral hazard of being able to dump my risk off on a wholesale lender, an investor, or an insurance policy, I know which loan I’m more comfortable making. I don’t have the stats either but I do put my money where my mouth is. And I want skin in the game, not a reliance on someone’s good will or moral fiber.
Not approving loans more likely to be profitable in favor of those which we know to be problematic is not responsible underwriting and it does both borrowers and shareholders a disservice. You’re right that the shortcuts the industry is taking are harmful in the long run. My suggestion for making underwriting less cookie cutter dovetails with that.
New York Times:
“In fact, researchers say the rich are no more or less likely to walk away — “ruthlessly default” is the economic term for it — than those of more modest means. A person’s credit history is usually a better indication of how he will behave than his income. How much money a person put down on the house when he bought it also makes a difference.”
http://www.nytimes.com/2008/05/10/business/10housing.html