Friday, March 01, 2013

Close Up On REO Deals: Understanding the Underwriting Process for REO Loans is Essential

As the housing crisis hit in 2008, the Housing Economic Recovery Act made the Federal Housing Finance Authority (FHFA) the exclusive supervisory regulator of the government-sponsored enterprises. Since then, in the eyes of many mortgage professionals, the industry has begun to over-correct itself and has created more conservative underwriting guidelines across the board.

In today’s market, if an originator cannot provide a detailed paper trail for every angle of a loan — from income, source of downpayment and accountability of payments — any conventional loan has a strong chance of being denied. The underwriting process is not that different when it comes to real-estate owned (REO) properties, but mortgage professionals should know that lenders have different approaches when it comes to regulatory changes and safeguarding against risk.

For instance, an important issue related to the underwriting of loans on REO properties is their time frame. Many lenders take weeks to underwrite and approve a loan, and if an underwriter determines that a buyer does not qualify, a property can get tied up in limbo for lengthy stretches of time. That noted, the listing agent on an REO property is tasked with providing the lender with frequent and reliable feedback regarding the transaction. To this end, REO listing agents often establish relationships with lenders that can pre-approve buyers quickly, provide the involved parties with daily communication on the transaction and have the ability to close REO loans in just a few weeks.

Just like more conventional mortgages, all Federal Housing Administration (FHA) REO loans are underwritten according to standard FHA guidelines. Even so, the FHA has risk parameters that are different from many lenders, and that’s where originators’ frustration can come into play.

In dealing with REO transactions, underwriters will examine many of the same details that they consider for conventional loans. For instance, they’ll review every document submitted and scrutinize its income figures, appraisal report, Social Security number, date of birth and address. They’ll also make sure that the loan application is filled out in its entirety. Some additional areas covered include:

  • Monthly housing expenses and total debt obligations
  • Debt-to-income ratios
  • Funds available to close
  • Credit analyses

Many lenders even require a second underwriter to review the loan package before a final approval or denial is communicated to the borrower. The amount of verification involved depends on how risky your lender perceives the borrower to be, or how many overlays the lender employs.

When it comes to conventional and REO transactions, another important issue that brokers and originators should consider is the lender’s underwriting overlays. Every mortgage lender determines what level of risk it will allow and underwrites the borrower’s loan with these additional requirements in mind. According to the FHFA, however, there are three basic ways that loans can qualify for purchase by Fannie Mae:

  1. By meeting its manual underwriting standards;
  2. By meeting its underwriting standards, as amended by authorized variances; or
  3. By meeting the evaluation criteria in its automated underwriting system, Desktop Underwriter.

Considering that some distressed properties are purchased for investment reasons, it’s also useful for mortgage professionals to know how this affects the processing and reviewing of a deal. Fannie Mae does allow a borrower to purchase an investment property and use the proposed rental income in their qualifications. Originators should know, however, that FHA financing is rather strict on certain income details and will ask for a history to consider this income. A lender may use about 75 percent of that income against the debt, and use around 25 percent for vacancies and maintenance.

In addition, originators should know that some lenders will not allow the proposed investment property’s rental income to be used to offset the borrower’s new payment, a stipulation that may make it more difficult to close REO transactions with certain lenders. Even if the borrower doesn’t qualify at the first bank, however, that borrower still may qualify for a loan at a different lender.

With the overlays in part to blame — combined with conservative underwriting and the lingering effects of the financial crisis — there is also a threat of losing community banks in the home-lending space. This is noteworthy because these types of institutions are frequent sources of funding for REO deals, as small community banks are an important network of local, familiar faces with whom you can talk openly about your clients’ finances.

Many experts argue that regulation is starting to reach a point where its benefits are outweighed by the risks of overburdening community banks and forcing them out of home lending altogether. Although it’s true that some subprime lenders abused certain tools — such as high interest rates and balloon payments — to create volume for themselves, many small community banks continue to use those tools successfully and hold their risk on their own balance sheets. A local bank will have the knowledge of measureable credit risk by personally knowing the borrower or the deal’s intangibles. That is, even if one of your borrowers may not be the best documented applicant, they may pose less credit risk to the right network of lenders.

Working with REO transactions can be trying at times, and in fact, mortgage bankers sometimes see as much as a third of their REO buyers back out of their transactions because of loan-related challenges. Even if some standards are advantageous, others often harm the cycle, especially when it comes to small community banks and REO timelines. Continued education on regulations as they change is a must for lenders and originators alike, as loan officers should be as thoroughly trained as underwriters to properly manage, process and close loan applications in a timely manner.

*originally published in Scotsman Guide's Residential Edition | March 2013 | Read it here.


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