In his analysis of current mortgage
credit tightening for the Joint Center on Housing Studies excerpted here earlier,
Don Layton included a special section on lender overlays. The former Freddie
Mac CEO focused specifically on how those overlays may be affected by the borrower
forbearance mandated by the CAREs Act
for borrowers impacted financially by the COVIC-19 pandemic.
During and after the 2008 housing
crisis mortgage intermediaries (originators) added their own underwriting requirements
to those required by the GSEs, FHA, and the VA. These overlays were designed to
counter “representation and warranty risk,” – i.e., the possibility they would
be required to buy back and possibly absorb default losses from loans they sold
to the government agencies that lacked characteristics required for a sale to
Layton says it took years of work
to eliminate these overlays on GSE loans. Restructuring the processes to reduce
representation and warranty risk demonstrated how large and costly each step in
the origination process could be.
Those overlays appear to be back
and have made the GSEs and FHA/VA appear to be more procyclical than they, on
their own accord, actually are. Housing finance policy is therefore focusing on
these overlays to see if credit tightening can be reduced without overt or
covert cost to the taxpayer.
As a general matter, mortgage
originating intermediaries are currently processing record volumes of
refinancing and those that are also servicers are under some liquidity pressure,
largely due to the COVID-19 forbearance requirement. These factors lead to some
bias toward overlays.
The current forbearance policy was developed by the
Federal Housing Finance Agency (FHFA) for the GSEs after hurricanes hit Texas,
Florida, and Puerto Rico in 2017. It was designed to address the temporary
dislocation of a natural disaster and was motivated by a desire to minimize
credit losses on existing mortgages
over a limited period.
When the current round of forbearance was mandated it
seemed reasonable, especially because the pandemic disruption was assumed to be
rather short term. While hurrying to provide help, however, the idea it wasn’t fully
thought through and it allowed forbearances to apply to new loans as well as
Layton says a loan in forbearance is simply not worth
100 cents on the dollar. Revenue is lost during the forbearance period and the
risk of no recovery is too great. This has created two problems.
“in transit,” already closed and in the hands of intermediaries when
forbearance was announced, immediately dropped in value when borrowers
requested a plan. Since agencies will not normally buy loans in forbearance as
it is a form of default, this caused a loss to intermediaries and more stress
on their liquidity.
The second subset,
which Layton calls “quick-forbearance” loans are those that go into forbearance
between closing and sale or becoming insured. They also drop in value and drain
Both types of loans
are hot potatoes that no one, intermediaries or government agencies, wants to
get stuck with and thus have become probably the largest and most concrete
source of overlays, focused on avoiding the riskier loans most likely to become
quick-forbearances Layton points that, at first these loans may have been in
process when the pandemic hit, but by now in-transit or quick-forbearance loans
may belong to borrowers who are “gaming” the system.
FHFA, both in response to industry
complaints and in hopes of reducing overlays has waved the GSE prohibition on taking loans in forbearance,
easing the liquidity problem, but has pushed the loss in value fully onto the
intermediary. Now the industry is lobbying Congress to force the agencies to
take both the liquidity and earnings burdens off their hands.
It is unclear whether their
proposal applies only to in-transit loans or to quick forbearance loans as
well. If it applies only to the former, there would not be an incentive impact
for new loans, and thus it would not be relevant to overlays. If it also
applies to the latter, it could create an incentive for gaming the system.
Layton calls the industry’s position completely self-serving but not
necessarily wrong. It also comes at a time when the intermediaries are
processing huge loan volumes and profitability seems to be at record high
Layton says this
is a situation where a proper policy response can reduce overlays to a minimum without
requiring unnecessary subsidies from taxpayers. He suggests the following for in-transit
loans in forbearance:
in-transit period should be defined in some reasonable way and that definition used across all four
GSEs and FHA/VA should affirm they will purchase the loans to provide liquidity
to mortgage intermediaries.
it comes to the loss of market value, everyone can accurately say “it is not my
fault, someone else should pay.” Therefore,
loss should be split with intermediaries and agencies each absorbing about
half. This policy would require the FHFA to cut in half its pricing discount,
and the FHA to turn its 20 percent indemnification into a 50-50 loss-sharing
(i.e., not a first loss) vehicle.
Layton suggests the same affirmation of liquidity as above,
and these other policy changes for quick-forbearance loans,
the same consistent end date for both FHFA’s the GSEs’ and willingness to
purchase loans in forbearance. The date should be tied to termination of the
current declared state of national emergency, so it isn’t subject to constant
industry proposal for all loss of value to be absorbed by the mortgage agencies
is not reasonable and will allow abusive actors to exploit the situation while transferring
wealth from the taxpayer to the private sector. Absent legislation that
corrects the CARES Act there is no way to help in the (likely rare)
circumstance when the quick forbearance is legitimate while not encouraging
potentially massive gaming.
suggests leaving the economic loss for all refinancing (including those with
cash-outs) with the mortgage intermediary. For purchase mortgages the four
agencies would take on two-third to three-quarters of the loss. His rationale
is that the social benefit of a borrower getting a new mortgage is small
compared to that of enabling a homeowner to purchase a new property. Reducing
the purchase mortgage burden should substantially reduce purchase money
mortgage overlays and targets the reduction to achieve the most policy and
economic bang for the buck. It also reduces the incentive to intentionally
originate quick-forbearance loans.
eventual legislative fix to the CARES Act should specify that forbearance post-closing
could be granted only to new mortgages that had been current in their monthly
payments for at least three or four months. That period is long enough that all
such mortgages should have left the hands of the intermediaries for their
permanent home with one of the four mortgage agencies. This change should
eliminate virtually all overlays.