Banks Tighten Lending Despite Receiving TARP Funds

I received another wave of emails last week from my investors announcing an increase to their minimum credit score requirement on government loans to a 600 FICO. Unlike small product differences amongst my investors, I refer to this sort of a change as a "mass exodus" as the flee of investors from certain loan products affects mortgages offered industry-wide. See below my description of a "mass exodus".

Recognizing this market shift, I called a Broker I work with who has a client (587 FICO) writing an offer to build a home. I explained I could easily write a prequalification letter for the client; however, the loan available for her today may not be around four months from now when the house is complete; and if it is, the lending requirements may be tougher to meet. Therefore, it may be smarter (and easier) to buy an existing home sooner.

His first question to me was, "Why aren't investors buying these loans if they're within FHA's underwriting guidelines?" And to that question, I offered my "mass exodus" answer.

Now, I'm not saying its impossible to buy a home if you have a FICO below a 600; however, these loan programs will become increasingly scarce and difficult to qualify for in the near future. Therefore, if you're sitting on the sidelines, now may be the time to move.

Banks Admit to Tighter Lending

The Federal Reserve noticed this tightening in its January 2009 Senior Loan Officer Opinion Survey of Bank Lending Practices. The survey found residential lending requirements have actually tightened over the last three months despite receiving plenty of taxpayer funds to stimulate lending.

Of the banks surveyed, 47.1% of banks indicated a tightening of prime loan lending standards; 48% indicated a tightening of non-traditional lending standards; and 50% indicated a tightening of subprime lending standards. Interestingly, not one bank indicated an ease in their credit standards on residential mortgage loans, or loans to large or mid-sized commercial or industrial firms.

Banks are not only hoarding TARP funds to pad their balance sheets, but also because lending during a recession is riskier as people and businesses find it harder to meet financial obligations. JP Morgan Chase economist Michael Feroli stated, "Most banks are tightening not just because of balance sheet constraints, but because credits are going to be less solid during this environment."

So What's a Bank Supposed to Do?

Sounds like banks are in a Catch 22 -- they're supposed to ease credit to stimulate the economy, but doing so could mean lending unwisely. Surely, Washington was smart enough to see this coming, right? New Treasury Secretary, Timothy Geitner, plans to unveil an overhaul of the financial bailout next week. I look forward to more accountability with how our taxpayer funds are being allocated (I've been pretty impressed with Citi's transparency); I'm just a little concerned that a bigger push for more lending could flood the market with more false liquidity. In my opinion, that's what happened post 9/11, which combined with Wall Street's irresponsibility, caused the bubble that's bursting today.

But hey, that's just my humble opinion. One thing is for sure, the more we evaluate how we're supposed to stimulate lending during these tough times, the more we realize there's no easy answer. All you can do as a player in real estate is see the writing on the wall of where the industry is headed, and shift how you do business accordingly.

Nicole's "Mass Exodus" Scenario

1. We start off with a good number of investors purchasing these "less attractive" loans on the secondary market.

2. For whatever reason (including risk), investors decide this pool of loans is no longer attractive and halt purchases of these loans on the secondary market.

3. The number of investors left to purchase these loans decreases.

4. The "lone ranger" investors begin absorbing all the market's risk as Loan Originators send them all these loans.

5. Investors realize absorbing all the market's risk isn't good way to manage their portfolios' risk, and they halt purchases of these loans as well.

6. With nobody buying these "less attractive" loans on the secondary market, originations stop.