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Lenders Refocus on Borrower's Capacity to Pay

With the loosening of underwriting standards in recent years, lenders often made loans without paying enough attention to all of the "three C's" of underwriting, an executive from Freddie Mac said at the MBA National Mortgage Secondary Market Conference last week.

Many of the loans made in recent years were underwritten for the buyer's credit quality and collateral taken into account, but too little attention was paid to their capacity to make payments, said Patricia McClung, a vice president at Freddie Mac.

Toward that end, Freddie Mac - like many of its lender clients - has imposed some new underwriting restrictions going forward. For instance, Freddie Mac will no longer make "no income, no asset" loans going forward. Those low-documentation products, where borrowers are not asked to verify income and assets, were popular at the peak of the market, especially among buyers of investment homes.

She said it is important for lenders to underwrite for principal, interest, taxes and insurance payments that borrowers will have to make when they own a home. Too often, in recent years, loans have been underwritten for "PI" rather than "PITI," she said. Failure to take the tax and insurance burden into account is one reason some borrowers have fallen behind on their payments.

With regard to refinancing borrowers who face onerous rate resets, Ms. McClung said that Freddie Mac's data suggest that many borrowers still have comfortable debt-to-income ratios even if they are facing potentially troublesome rate resets. In that scenario, many can be refinanced into fixed-rate loans, she believes.

And she reiterated that Freddie Mac wants to find ways to serve subprime mortgage borrowers.

"We want to serve the subprime borrower. This is not about turning a subprime borrower into a prime borrower. But we do want to make them a better borrower," she said.

One tool for managing credit risk on subprime borrowers who may be refinanced into conforming loan products backed by the government-sponsored enterprises is mortgage insurance, which has made a comeback in the market as the popularity of "piggyback" seconds has declined.

To date, Freddie Mac has focused mostly on buying AAA-rated securities backed by subprime loans, but Ms. McClung said the company is heading in the direction of making whole loan purchases based on performance data gathered from its investment portfolio.

"We see value in bringing some of the prime practices to the subprime market," Ms. McClung said.

Lisa Weaver, director of business expansion and market development for Genworth Mortgage Insurance, noted that combination first and second loans dropped from 54% of the market in the first quarter of 2006 to 41% in the first quarter of 2007, providing an opportunity for mortgage insurers to pick up market share in the business of managing credit risk on low-downpayment loans.

Also, she said the penetration rate of the GSEs, which fell to a low of 39% of originations, has come back to account for 48% of loan originations today.

And in the first quarter of 2007, mortgage insurance was placed on 7.2% of new loans, up from 5.9% two years earlier.

She said lenders have a number of MI tools and other options for refinancing troubled subprime borrowers.

For those in need of a "heavy rescue," one tool is a shared-equity loan, in which a first mortgage is underwritten for the amount the borrower can qualify for and a second is underwritten to cover the balance. Typically, the second may not be paid off until the property is sold.

But these solutions may require the current investor to write off a portion of the original loan, she noted.

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