Tight Credit Woes

Story first appeared in USATODAY.


Adele and Josue Montoya missed the housing bubble and bust.

Still, the first-time home shoppers are in a situation not unlike that faced by millions of Americans in the years preceding the start of the housing collapse in 2006.

Then, as now, home prices were rising rapidly in the Sacramento area where they live. Investors chasing fat profits on rising prices were a big part of the U.S. housing market, just as they are now. Buyers, such as the Montoyas, thought prices would go up further.

One thing is very different: It's far harder to get a home loan.

To pre-qualify for a home loan, the Montoyas had to submit reams of documents to show that they could actually afford it. That often didn't happen in the loose-lending days leading up to the housing bust, which helped drive Lehman Bros. into bankruptcy five years ago.

What's more, new lending rules have been put in place to guard against the worst lending abuses that fueled the housing bubble, the mortgage industry says. But critics say the rules aren't shaping up to be tough enough.

"We've created this false sense that we've made mortgages low risk," says Edward Pinto, resident fellow at the American Enterprise Institute. "But as time goes on and the push for looser lending occurs ... the same thing could happen again."

In the housing bubble from 2000 to 2006, U.S. home prices rose by an inflation-adjusted 76%, based on Case-Shiller data. The bubble was fed by low interest rates, easy credit, scant regulation, toxic mortgages and, some economists argue, a false belief that home prices couldn't fall.

Trillions of dollars in risky mortgages became embedded in the U.S. financial system as the loans were packaged, turned into securities and sold to investors. Lehman bet on rising property prices, too.

The change in lending standards since the bust is hard to miss.

In 2006, 16% of new home loans were subprime, meaning they went to borrowers with credit scores below 620. Last year, just 0.2% of new home loans were subprime, according to mortgage tracker Lender Processing Services.

By 2006, loans issued with little or no documentation of borrowers' finances made up more than one in four mortgages, says the Center for Responsible Lending. As the recession hit, and home prices tanked, many of those borrowers found they couldn't afford their home loans anymore. All told, an estimated 7 million homes have been lost to foreclosure or short sale in the housing bust, says market researcher RealtyTrac.

The change isn't a bad thing, says Adele Montoya, 38. She works as an office supervisor. Her husband works as a produce supervisor in a grocery chain. The couple wants to know they can afford whatever loan they get.

"I don't want any surprises down the road," she says.

Signs of easing

Lending standards "remain tight" but have eased slightly in recent quarters, says Jonathan Corr, CEO of mortgage tracker Ellie Mae.

In August, the average FICO score for a closed home loan was 734, down from 748 for all of last year, show data to be released next week by Ellie Mae. The top FICO score is 850. The average down payment was 18%, vs. 21% last year.

Corr says lenders appear to be easing standards, given rising home prices and higher interest rates, which cut into refinance volumes, leaving lenders to look for more business from home purchases.

Rising home prices also reduce the risk of loan defaults. After falling more than 30% from their 2006 peak, U.S. home prices were up 12.1% in June over 12 months, Case-Shiller says. They're still about 23% off their 2006 peak.

As the bust recedes, look for further easing in mortgage lending as the housing industry tries to drum up business, says Anthony Sanders, real estate finance professor at George Mason University.

"There's a lot of money in weak credit standards," he says.

Reducing lending risks

There are some new safeguards, however.

"We are in an entirely different universe than the unregulated period" before the bubble, says David Stevens, CEO of the Mortgage Bankers Association.

One big change is that, starting in January, lenders must make home loans that meet new federal qualified mortgage standards or face greater liability from borrower lawsuits, should the loans go sour.

Some of the risky loans that fed the housing bubble are outside the new standards. Those include interest-only loans and loans that push borrowers' debt above 43% of their income.

Lenders could still make those loans. But borrowers could sue to recoup losses or stop foreclosures if they went into default.

The standards put a "set of documented rules" around what lenders are doing today, Corr says.

If loans are resold to investors, thereby shifting risk, other rules will come into play.Those are still being developed by six federal agencies, including the Federal Reserve and the Securities and Exchange Commission.

The current proposal is for those loans to meet the same standards dictated by the qualified mortgage rule.

In 2011, regulators had proposed a 20% down payment for loans sold to investors, or lenders would have to retain 5% of the risk.

Last month, the 20% down payment condition was dropped amid opposition from the real estate industry and consumer groups. They argued it would hurt the housing market, including first-time buyers.

The typical American family would have to direct every penny of savings for 16 years to a housing down payment if 20% was required, said the Coalition for Sensible Housing Policy, which includes real estate, banking and consumer groups. They also argue that low-down-payment loans work as long as lenders make sure consumers can afford their loans.

Sanders says higher down payments guard against mortgage defaults. Even before the new rule gets out the door, "it's being weakened," he says.

Echos of past bubbles

Loose lending standards weren't the only factor driving the bubble.

An even bigger factor may have been the widespread expectation that home prices would only go up, says Harvard economics professor Edward Glaeser.

The same optimism has long fueled real estate bubbles in America, including the frontier land boom of the 1790s, the Alabama land boom in 1820, the skyscraper craze of the 1920s and the Southern California housing boom in the 1990s, he says.

"It's the same American instinct to gamble on land," Glaeser says, noting that even George Washington was a big land speculator.

What's more, the U.S. tax code still encourages home ownership through the mortgage interest deduction, Glaeser notes.The government also now backs more home loans than ever, about 85% of new loans through Freddie Mac, Fannie Mae and the Federal Housing Administration. While reducing the government's role in the home loan business is being discussed, reforms are likely years away.

The biggest impediment to another housing bubble might be that "a whole generation of buyers have seen that housing can go down," says Discover Home Loans economist Cameron Findlay.

The U.S. homeownership rate has fallen from a record high of 69.2% in 2004 to 65% and could drop to 63.5%, he says.

Even the Montoyas have decided to hold off on buying in the frenzied Sacramento market, where prices were up almost 27% in July year-over-year. They expect new home construction to add to the supply of homes for sale, increasing their chances.

"We're just going to wait," Adele Montoya says.