The One Thing Policymakers Can Do to Loosen Credit

NEW YORK ( TheStreet) -- Mortgage credit conditions are tighter than they were even in the pre-bubble days and it is hurting the housing recovery and the economy.

In a new paper titled "Opening the Credit Box," noted Moody's Analytics economist Mark Zandi and Jim Parrott, a former White House policy adviser who is now with Urban Institute, argue that the pendulum has swung too far in the mortgage market and a balance needs to be struck between risk management and access to credit.

Tight credit conditions are most apparent in the average credit score of today's mortgage borrower.

The average score of households receiving purchase mortgage loans from government-sponsored enterprises Fannie Mae and Freddie Mac rose to a new high of 766 in June. That is 50 points over the average borrower credit score in the country. It is also 50 points higher than the average credit score on loans that were taken to purchase homes a decade ago, before the housing bubble.

Current FHA borrowers have an average credit score above 700, also about 50 points higher than in more normal times.

Meanwhile, none of the purchase borrowers this year had a credit score of less than 620, something that Zillow researchers also recently noted .

On a related note, TheStreet recently asked credit score provider FICO to share some of its data on credit score distribution. According to FICO, only 37% of the 200 million Americans that they currently score have a credit score over 750.

FICO data also traces the change in the distribution of credit scores for the average mortgage borrower since the bubble.

In October 2005, about 52% of the mortgage originations were made to borrowers with a credit score over 700. In October 2011, that ratio had jumped to 84%.

The authors say the credit box has tightened for several reasons. One, lenders have reassessed risks in the years since the crisis. They now recognize the higher costs of riskier lending -- the increased cost of servicing distressed borrowers, the reputational and legal risks associated with delinquent borrowers, to name a few.

Another reason is that banks have had a booming refinancing business, which has allowed them to be conservative on purchase business.

But the most important reason, the authors believe, is the uncertainty related to repurchase requests from Fannie Mae, Freddie Mac and the Federal Housing Administration.

These agencies generally absorb the default risk on a loan but they reserve the right to "put back" the loan on the bank if it is later determined that the bank did not follow the rules in making the loan.

The agencies arguably need to know that banks followed the rules in underwriting loans so that they can price the risk correctly.

However, they have become more aggressive in their putback requests in recent years. The problem is not the more aggressive stance, according to the authors of the paper.

"Under normal circumstances, lenders could adapt to changing regulatory conditions by improving their quality control or raising prices to reflect increased risk. The problem is that Fannie, Freddie and the FHA have stepped up their put-backs in ways that lenders cannot address adequately through better underwriting or pricing. This includes disagreements over judgment calls made by lenders or their agents; changes in circumstances occurring after the underwriting process has been completed; small mistakes that bear little relation to either the credit risk or the subsequent default; and inconsistent interpretations of the rules."

The only way lenders can manage their risk under such circumstances is to reduce the risk of default by only lending to borrowers with very low default risk.

So banks end up operating in an even tighter credit box than that envisaged by policymakers.

What can policymakers do to loosen credit? The only factor within their control is to minimize the uncertainty surrounding put-back risk.

"Fannie, Freddie and the FHA need to work with lenders to identify the sources of uncertainty," the authors wrote. "The objective needs to be creating and enforcing rules in a way that leads to better underwriting and quality control, not less lending."

The stakes are high. The authors calculate that if credit standards loosen such that the average credit score on a purchase loan drops by 50 points -- in line with normal times -- the annual pace of new and existing home sales could rise by nearly 450,000 in the four to six quarters following the change in score.

The rise in home sales in turn would support 275,000 more single-family housing starts per year, and raise house prices nearly 4%.

And given the role housing plays in the economy, U.S. GDP could grow by 0.7% and the unemployment rate could drop 0.4%.

"Normalizing credit scores will not by itself get the economy back to full employment, but it would go a long way and, at the very least, cushion the negative fallout from rising interest rates," the authors wrote.

-- Written by Shanthi Bharatwaj New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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