Banks will be accused of employing discriminatory credit standards when making mortgages in a series of fair housing complaints that a national consumer coalition plans to file beginning next week.
The National Community Reinvestment Coalition plans to challenge the widespread practice of requiring borrowers asking for FHA-backed loans to have higher FICO scores than the minimum required by the FHA, according to a report from Ken Harney at New Times.
The FHA requires a minimum FICO score of 500. Borrowers with down-payments as low as 3.5 percent must have a score of at least 580. Borrowers with scores between 500 and 580 must put a minimum of 10 percent down.
Several banks require higher rates. At the start of 2009, many banks moved their minimum FICO score for an FHA backed loan up to 620. Wells Fargo and Bank of America recently raised their required score to 640. FICO scores run from 300 to 850, with higher scores supposedly indicating a lower risk of future defaults.
The NCRC says that the higher FICO requirements disproportionately discriminate against African-American and Latino borrowers, many of whom have credit scores above the 580 threshold set by FHA but below the higher minimums set by banks.
It argues that because the FHA insures the loans, there is "no legitimate business justification" for rejecting applicants on the basis of FICO scores that are acceptable to FHA.
The irony is that until October, the FHA did not set a minimum FICO score. The FICO requirement was put in place in an attempt to reduce the risk the FHA was taking on as it has greatly expanded its balance sheet to fill the gap created in lending to risky borrowers by the collapse of the subprime mortgage market.
Now what was intended to be a floor that applied only to a government program is being flipped over and turned into a ceiling for private lenders. If things go as planned by the NCRC, banks will be forced to make loans to risky borrowers to avoid charges of discrimination. Remember this the next time someone like Barry Ritholtz tells you that the government never forces banks to make bad loans.
Note also that the NCRC is just wrong when it claims that the is “no legitimate business justification” for rejecting applicants for mortgages that the government would insure. Does it think banks aren’t lending to these borrowers out of spite?
What is really happening here is that banks are setting higher standards with an eye to the secondary market. Insured loans that default result in prepayments. Those prepayments introduce an extra level of uncertainty into the cash flows mortgage backed securities are supposed to produce. Although the mortgage securitization market is still on life-support, banks anticipate a revival and lend with an eye to selling loans into securitization pools.
Generally, prepayment risk is driven by the risk of lower interest rates in the future. Banks have gotten pretty good at modeling prepayment risk arising from falling interest rates. Right now that risk is not too great on new mortgages because interest rates are at historic lows.
But insurance introduces a new kind of prepayment risk—one that is essentially default risk plus insurance. Banks, it seems, are attempting to reduce this prepayment risk by raising the minimum FICO scores.
They probably never anticipated that having the FHA adopt a minimum standard would wind up with a national campaign to brand them as racists for not treating the minimum as a maximum.
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