How Lenders Cut Risk on Low-Doc Loans
Shenn, Jody, American Banker
Home lenders have never cared so little about knowing for sure how much consumers earn.
For a fast-growing percentage of loans, lenders are letting applicants skip the traditional two pay stubs or other proof of steady income. Some are even relaxing demands for bank statements.
How can these lenders expect to make loans that perform? How do they guard against outright fraud, or even small misrepresentations that can hurt a lender later in the event of a default?
Most lenders start by looking at credit scores and loan-to-value ratios. They gain peace of mind by steering clear of borrowers most likely to default (or those who would cause sizable losses if they did). Whether set by the originator or by the secondary market, smart lending guidelines - and the automated engines that enforce them - are considered the most valuable defense against trouble.
Often, especially with refinancings, if the borrower has a history of repaying debts and a big stake in the house, the lender will not even charge a premium for the uncertainty associated with reduced documentation.
Nevertheless, lenders use a wide range of other checks and balances, especially when the borrower requests lower documentation.
In the alternative-A market, lenders try to ensure loan quality by actively evaluating guidelines and parsing loan data, monitoring brokers and correspondents, and making sure underwriters use "common sense" when they don't have access to pay stubs.
(Low documentation is generally a feature of alt-A lending, but it is a fuzzy category that includes many borrowers who provide pay stubs and bank statements but have other characteristics that make them ineligible for conforming loans.)
Many lenders use such methods on all types of home loans, along with automated fraud checks, models that vet home values, and pre- and post-funding sampling. But when documentation is reduced, these tools get even more emphasis, say industry insiders.
For instance, the head of U.S. Bancorp's mortgage unit says it does "two to three times" the usual amount of post-funding quality control on its alt-A loans. Flagstar Bancorp always runs automated appraisals to review home valuations on alt-A loans, but not for other products.
At other lenders, however, such quality checks are applied widely. At some, extra attention is devoted to specific loans flagged by automated systems or human suspicions.
Finding two sizable lenders with exactly the same practices when it comes to alt-A loans is difficult, but many experienced lenders pay attention to the same details.
The parties most at risk, such as mortgage insurers, appreciate the extra controls, though they typically add yet another layer of scrutiny.
"There are a group of lenders out there that know what they're doing with this product," said Paul Fischer, the executive vice president of risk management at the mortgage insurer Radian Group Inc. "The scary ones are the ones that use it as an additional menu item" without performing any additional controls.
The percentage of loans being made with little or no documentation of income or assets has exploded in recent years. Alt-A volumes are growing even though interest rates are rising. Industrywide technological and analytical advancements have made the boom possible.
This boom has created opportunities for waitresses and copy shop owners to get loans, and it has meant less hassle for numerous others. Consumers who seek such low-documentation loans range from the high-net-worth self-employed to, increasingly, immigrant and minority borrowers.
But the relaxation of standards creates the danger that borrowers will take low-doc loans - with the encouragement of brokers and lenders - only because they could not qualify if they provided full documentation.
One disturbing sign: In audits of lenders' loan files, Fitch Inc. …