Mortgage finance companies Fannie Mae and Freddie Mac have announced their intention to get tougher on mortgage lenders going forward. Will this no-nonsense approach help or hurt borrowers?
Fannie Mae and Freddie Mac are government-sponsored entities that buy loans made by banks and other mortgage lenders. By buying those loans, Fannie and Freddie put money back into the lending system, which allows more loans to be made - a process known as adding liquidity to the system.
The catch is that if lenders make bad loans, Fannie and Freddie can get caught holding the bag - which ultimately means the US taxpayer foots the bill, since both organizations are backed by US government guarantees. Having gotten burned by too many bad loans during the mortgage crisis and its aftermath, Fannie and Freddie are now demanding higher standards from lenders who want to sell them loans.
The "Zero Defects" Approach
According to the National Mortgage News, quality control executives from both Fannie and Freddie laid out their plans for better loan quality monitoring at a risk management conference in September. Steve Spies, a vice president at Fannie Mae, referred to this tougher monitoring as a "zero defects" approach.
"Zero defects" is a management approach historically associated with manufacturing. The underlying concept is that it is cheaper to prevent mistakes than to correct them, so everyone involved in the production process must take measures to eliminate errors. According to the National Mortgage News, applying this concept to the mortgage underwriting process puts more pressure on lenders to provide complete documentation, and increases monitoring and double-checking by Fannie and Freddie when they buy loans from lenders.
The Argument for Lower Mortgage Rates
It could be argued that this zero defects approach will ultimately help keep mortgage rates down. Low mortgage rates are partly a function of how confident the lender is about getting repaid. The tighter the lending standards, the more confidence lenders and finance companies like Fannie and Freddie should have in making new loans or buying existing ones. That means that they can build less of a risk premium into the mortgage rate.
The Argument for Higher Mortgage Rates
On the other hand, quality control doesn't come without a cost. Lending guidelines from Fannie and Freddie already top 1,000 pages. Between them, those two companies involve some 750 employees in quality control efforts. All of this not only creates costs for Fannie and Freddie, but it increases compliance costs for lenders. The more cost is built into the lending system, the higher mortgage rates and fees have to go to pay for those costs.
Tighter standards not only can mean higher mortgage rates, but they also make it more difficult to qualify for a home loan. This means that even well-qualified borrowers can expect to have to provide more documentation to get their mortgage applications approved.
How Rates Themselves Affect Quality Control
As noted above, quality control standards could have a positive or negative impact on mortgage rates. Conversely, mortgage rates themselves affect quality control. When 30-year fixed mortgage rates were below 4 percent, there wasn't much incentive for lenders to relax their standards to approve loans. However, as mortgage rates rise, the incentive to make loans increases - and those incentives can lead lenders to make mortgage approvals easier.
Thus, the new quality control standards may prove especially timely if mortgage rates continue the upward trend of recent months.
A High Stakes Business
Manufacturers pursue quality control measures because they recognize that a little investment upfront can save money in the long run. The same can be true of mortgage lending. Fannie and Freddie play a crucial role in the mortgage market, so ensuring their continued viability will help make sure mortgages remain widely available.
It is, after all, a high-stakes business. Since the beginning of 2009, Fannie Mae has provided $3.7 trillion in liquidity to mortgage lenders, and Freddie Mac has provided $2 trillion. With the mortgage system so dependent on these entities, and with the US taxpayer ultimately on the hook, a heightened awareness of quality control seems more than appropriate - it seems long overdue.