Want to send a jolt of energy through the housing market and help ignite our listless economy?
A good first step would be to clarify the rules regarding mortgage “put backs,” the requirement that lenders repurchase mortgages from Fannie Mae and Freddie Mac when there is an alleged violation of one of the representations and warranties in the loan purchase documents.
It’s no secret that fear of put backs continues to have a dampening effect on the housing market. Despite recent efforts by the Federal Housing Finance Agency to put some boundaries around put-back risk, many mortgage originators remain skittish about lending to families with less-than-pristine credit.
With average FICO scores around 750 and most downpayments at 20% or more, chances are you will have a tough time finding a bank willing to lend to you on affordable terms if you don’t meet these requirements. Put-back risk is a major reason for today’s cautious lending practices and tight mortgage credit.
Here’s why.
If a mistake in underwriting causes a mortgage default, the effects of this error are likely to manifest themselves soon after origination. Under these circumstances, requiring the lender to repurchase the loan is entirely appropriate.
Yet, under today’s rules, lenders can be subject to a put back even if the borrower has made timely payments for 35 consecutive months after the loan has been acquired by the two GSEs. In truth, a put back of a mortgage can occur up to five years after acquisition by Fannie and Freddie.
Even minor, non-material breaches of the representation and warranty framework can lead to a put back. A missed signature on one of the many mortgage settlement documents, a slight overstatement of borrower income, or the failure to disclose a small outstanding credit card debt all have the potential to require lenders to repurchase defaulted mortgages they originate.
In addition, many lenders see the current put-back process as a self-interested way for the GSEs to shift credit losses to them, even for minor underwriting mistakes that merit a less drastic penalty or for errors not directly related to the mortgage default. Absent housing finance reform, the GSEs have little motivation to change current practices.
Adding to these concerns is the fact that the rules governing put backs appear within the GSE origination and servicing guides that are subject to modification at the sole discretion of the GSEs themselves. In other words, a mortgage lending or servicing practice that may be acceptable today may not be so tomorrow.
The good news is that the put-back problem can be remedied relatively easily compared to achieving long-term reform of the housing finance system. It does not take an act of Congress nor does it require a Herculean regulatory effort. Furthermore, there is ample opportunity to give lenders a greater sense of certainty about the representation and warranty framework without damaging the financial position of Fannie and Freddie, as explained by Laurie Goodman and Jun Zhu in a recent Urban Institute paper.
On May 13, new Federal Housing Finance Agency Director, Mel Watt, will be at the Brookings Institution to make an important policy speech on the future of the two GSEs. It’s my hope that Director Watt will use this opportunity to comment on how FHFA intends to alleviate the continuing concerns around put-back risk and improve access to mortgage credit.
Here are my thoughts on what should be done:
First, recognizing that most underwriting errors will be detected soon after origination, the current three-year put-back window is too long and should be reduced.
Second, all underwriting mistakes are not equal. Only those errors that are material and directly related to a mortgage default should be considered a violation of the representations and warranties framework resulting in a put back. For non-material mistakes and servicing defects, other less severe penalties that are more proportional to the violation should be designed.
Third, the rules governing put backs should be recorded not in GSE guides but in clearly written contracts that can only be modified with the consent of all parties involved. These contracts should include a clear appeals process to facilitate timely dispute resolution.
Of course, no one wants a return to the reckless underwriting practices of the boom-and-bust period, but the pendulum has swung too far in the opposite direction.
Providing greater certainty around put-back risk will help open the mortgage spigot and allow tens of thousands of creditworthy families obtain the mortgage credit they need. A stronger, more durable economic recovery will be the result.
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