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Suitability, Now More Than Ever

posted by Kathleen Engel and Patricia McCoy

In the old days, when lenders had to hold their home mortgages in portfolio, they cared about whether loan applicants could repay their loans.   True, there were serious problems, including credit rationing, redlining, and race discrimination, but one thing was for sure:  traditional underwriters took default risks seriously.  As a result, more borrowers were able to pay their loans.

Over the past two decades, securitization and outsourcing have revolutionized the lending industry.     Investment banks can slice and dice even the wildest credit risks and diversify those risks among investors worldwide.  Increasingly, lenders can even move their unrated or “B” tranches off their balance sheets by re-securitizing these tranches as collateralized debt obligations.  When lenders can collect upfront fees and pass off lemon loans and their retained risk to the secondary market, why should sound underwriting take top priority?

Outsourcing dealt a further blow to underwriting.  Many lenders outsource customer recruitment to mortgage brokers and collection to specialized servicers.  Incredibly, lenders even outsource underwriting to contract underwriters who process loan applications for a flat fee per loan.  This unbundling of functions promotes finger-pointing, not good underwriting.   The upshot has been a surge in loans with no regard for the borrowers’ ability to repay, including numerous low-doc/no-doc loans, subprime loans, FHA loans, and adjustable-rate and exotic mortgages underwritten solely to teaser rates. 

Several years ago, after watching loan underwriting collapse in inner-city Cleveland, we argued that lenders should only make home mortgages that are suitable for the borrowers.  Today, the problem of lax underwriting is worse than ever.  Subprime default rates are going through the roof (see today's New York Times business section) and default rates for nontraditional mortgages are not far behind.  Lenders have done little to address irresponsible underwriting practices.  In fact, underwriting problems are spilling over into the prime market due to imprudent adjustable-rate loans.

Four years after we first proposed a suitability standard, two things are clear.  First, the lending industry is not prepared to clean up its act.   Second, lax underwriting is not limited to the subprime market, but is spreading to prime loans too.  As a society, if we care about keeping people in their homes and preserving many families’ single largest asset, then it’s time to make suitability for all mortgages the law of the land.   

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