Community Reinvestment Group Takes Aim at Use of Credit Overlays

Making loans for the Federal Housing Administration could become a higher-cost, but also higher-volume, business if an advocacy group succeeds in stamping out what is now a common industry practice.

At issue is what are referred to in the business as credit overlays. For the past two years most of the FHA's largest lenders set a higher minimum FICO score than the agency's threshold of 580. Many lenders refuse to even accept loan applications from borrowers with credit scores of 620 or below.

Overlays are meant to protect the lender against default risk. (Even though the loans are insured by the government, it can make the lender indemnify the FHA against losses if underwriting errors are discovered; defaulted loans are also costlier to service.) But the National Community Reinvestment Coalition says the overlays effectively discriminate against minorities and the poor by reducing their access to credit.

Last week the NCRC filed complaints with the Department of Housing and Urban Development, the FHA's parent agency, alleging that 22 lenders arbitrarily cut off access to FHA loans based on credit scores, eliminating the only remaining source of credit for borrowers who cannot afford a significant down payment. HUD announced an investigation.

Another 17 lenders were not mentioned in the complaints because they agreed to meet with the NCRC, according to David Berenbaum, the Washington organization's chief program officer; they include large aggregators like Bank of America Corp., JPMorgan Chase & Co., and Wells Fargo & Co. Some lenders already have expressed an interest in having HUD mediate a solution, Berenbaum said.

The group wants lenders to voluntarily change their policies to drop the credit overlays that were widely adopted in 2008 and 2009.

"This is a serious new form of redlining," Berenbaum said, rattling off a list of laws — the Fair Housing Act, the Equal Credit Opportunity Act and the Community Reinvestment Act — that he contends the overlays violate.

The NCRC appears to have some leverage. HUD, for one thing, seems sympathetic to its cause (Berenbaum said his group received grant money from HUD to conduct its research on the subject). Lawyers for some of the largest banks said they have expected "disparate impact" lawsuits since the Obama administration took the White House. Some said it would be hard to convince a court that the overlays provide needed protection when FHA loans are 100% insured.

On the bright side, the paltry home-purchase market could get a lift if lenders eliminate overlays.

In March, FHA Commissioner Dave Stevens told Congress that its new 580 FICO minimum "will actually open up the credit box from what has happened over 2009 via the consolidation amongst these large institutions. And it is our hope that the large institutions will actually move back to our policy, which we believe will expand the market." (Previously the FHA had no credit score requirement.)

But some lenders say that could lead to another race to the bottom. "Now they want us to go back into subprime," said Jim Coffrini, the president of Sierra Pacific Mortgage Co. Inc. in Sacramento, which received a complaint letter. A borrower with less than a 620 FICO is "five times more likely to go into default than someone over 620," he said.

At the very least, without overlays lenders likely would have to spend more time and money sifting through applications. They'd have to consider applicants with FICO scores between 580 and 620, even if they deny those consumer loans after taking a closer look at their payment histories.

Matt Hackett, an underwriting manager at Equity Now Inc., a lender based in New York that was not named in the NCRC's complaint, said smaller lenders are in a bind since most are dependent on selling loans to big banks that impose stricter overlays.

"Even if we see good loans that could be made, we can't make them," Hackett said. "What happened with FHA, is so many people abused the system that the big banks who buy from small lenders put in their own overlays to protect themselves. In an ideal world, we can do a good job figuring out if a 560 score is a good loan but no one will buy it."

Wells Fargo has a 640 FICO cutoff for loans bought from correspondent and wholesale lenders, but accepts applications at its own retail branches with FICO scores of 600, said Tom Goyda, a Wells spokesman. "The credit score requirements are there to ensure the borrowers has the ability to repay," he said. "With our retail business we have complete control over every phase of the process, and FICO scores are an appropriate way to address that in the indirect channels."

B of A also has a 640 FICO minimum for third-party originators and a 620 requirement at retail, said Jumana Bauwens, a B of A spokeswoman. A JPMorgan Chase spokesman would say only that it is meeting with the NCRC.

Berenbaum argued that because the loans are insured by the FHA, lenders do not take on any risk, and smaller lenders can bypass the large banks and sell directly to Ginnie Mae.

"A credit overlay has questionable business justification," he said. "There must be a more effective way to ensure profitable loans are made for the industry, as well as sustainable loans, that do not disqualify borrowers based on race."

Glen Corso, managing director of the Community Mortgage Banking Project, a trade group for independent lenders, said some lenders have groused that the NCRC gets funding from large banks that were excluded from the complaint list. Wells, for example, is part of the NCRC's Banker/Community Collaborative Counsel, which meets periodically to discuss common ground between nonprofits and banks.

Berenbaum chafed at the suggestion that his nonprofit was looking for funding. "To call this very serious issue a shakedown is to sidestep the serious responsible lending and civil rights issues being raised by this organization."