CONFORMING AND NON-CONFORMING LOANS

Conforming loans are defined as those loans that meet the purchase criteria of Fannie Mae and Freddie Mac as set forth in their Seller Servicer Guides. A broader definition includes the underwriting guidelines as established by the FHA (Federal Housing Administration) and VA (Veterans Administration). These two agencies of the US Government insure and guarantee mortgages that meet their own criteria, but they account for less than 5% of all new originations. For purposes of this discussion only the guidelines of Fannie Mae and Freddie Mac will be considered.

Conforming loans are recognized by many characteristics including size, term, borrower profile and property type. The guidelines for conforming loans are dynamic, meaning they change from time to time as conditions warrant. For example, in the 1980's the loan limits, meaning the largest dollar value of individual mortgages that Fannie Mae and Freddie Mac would purchase more than doubled from the low $30,000's to the high $60,000's. In the later part of the twentieth century that limit broke through $300,000 and continues to increase in response to increases in the cost of housing.

The world of conforming underwriting changed considerably with the introduction of AU (Automated Underwriting) which was introduced by Fannie Mae and Freddie Mac. Until the advent of AU lenders employed underwriters whose job was to examine loan files to see if they met the agencies’ guidelines. Now computers do that job and the guidelines for loan approval have expanded considerably. There was a time when the guidelines specified that a borrower who made a down payment of 10% would qualify if he had reasonably good credit, adequate reserves, two years of continuous employment, and his housing payment to income ratio did not exceed 25%, and his total monthly payments, including housing and revolving credit, as a percentage of monthly income did not exceed 33%. This guideline was not cast in stone and there were areas where an underwriter could use a certain amount of discretion. For example, if this same borrower had many years of continuous employment and an exemplary credit record and vast reserves, the underwriter might be willing to approve higher payment ratios. Likewise if a borrower made a down payment of 20% and had good credit and reserves, the guidelines called for the underwriter to approve payment ratios of 28% and 36%. At the same time the underwriter had the flexibility to approve higher ratios under conditions where the borrower was exceptionally strong in the area of employment, credit or reserves. In this scenario the human aspect of underwriting could not be ignored. In spite of guidelines that were meant to offer flexibility in the determination of whether a loan was considered investment quality, many loan applications that met the conforming guidelines were not approved by underwriters, and many loans that did not meet the guidelines were approved. All too often the concept of whether or not a loan was a conforming loan was subject to human error or whim.

Many of the guidelines that underwriters in the past were supposed to follow have changed since the advent of AU. Years of research and many millions of dollars of software development have resulted in more flexible underwriting criteria and a more scientific approach to loan approvals. Today an underwriter, loan processor or loan officer can enter a loan application into Fannie Mae’s underwriting engine called Desktop Underwriter (DU) or Desktop Originator (DO), or into Freddie Mac’s Loan Prospector (LP) and receive an underwriting determination within a few minutes. Vast data banks with credit profiles and property values are accessed through AU.

Through the years of research done by Fannie Mae and Freddie Mac in developing Automated Underwriting many of the past notions of what constitutes risk in a loan have been dispelled. For example, in the past the guidelines called for two years of verified employment, preferably in the same job, but at least in the same line of work. Since that time it has been discovered that job tenure is a weak indicator of risk in a loan, so under LP or DU an underwriter might expect a result that calls for income verification in the form of a previous year’s W-2 or 1099, or a recent pay stub from an employer. Far less frequent is the requirement for two year’s of full income tax returns, and almost never does a DU or LP result ask for business returns as was the case prior to the introduction of AU.

Emerging as the two most important elements of loan quality are credit scores and home equity. A borrower who is meticulous about his credit obligations resulting in high FICO or BEACON scores, in concert with the ability to make a sizeable down payment, is considered the strongest kind of borrower and approval for conforming financing is assured.

Guidelines for property have changed very little on account of AU, however, the requirements for appraisals has been dramatically affected. In purchase transactions the requirement for full appraisals with interior inspections remains the norm and is often handled differently than with refinance transactions. The underwriting engines use data banks of property values to set a range within which it is reasonable to expect a property value to fall. In fact, Fannie Mae and Freddie Mac’s influence is so pervasive within the residential real estate community that a property submitted to AU has a strong likelihood of having been financed through one of those agencies some time in the past. Houseboats, condo hotels and time share properties remain ineligible.

The four most important considerations in loan underwriting simply stated are income, assets, credit and property. When all of these elements fall into their proper place the loan will qualify as a conforming loan and receive the designation ‘investment quality’. Fannie Mae and Freddie Mac pool investment quality mortgages into securities called Mortgage Backed Securities which are bought and sold by investors of every kind. These high quality securities end up in pension plans, mutual funds, international portfolios and just about anywhere investments are made.

Securities backed by Fannie Mae and Freddie Mac are attractive for several reasons. The behavioral characteristics of conforming loans have proven over the years to have very low default rates which translates into a high level of performance. Additionally, Fannie Mae and Freddie Mac are two of the largest financial institutions in the world and their guarantee leaves little fear of loss of capital when investing in these securities. In fact, the quality of agency guaranteed Mortgage Backed Securities ranks second only to Treasury Securities which are backed by the full faith and credit of the United States Government. The lesson to remember here is that securities with strong backing will be more liquid and receive more favorable pricing in the investment market.

This brings up the issue of non-conforming loans. Loans can be non-conforming for many reasons and, as such, securities backed by this type of loan will be priced less favorably than Fannie Mae or Freddie Mac conforming Mortgage Backed Securities. Since the securities backed by non-conforming loans receive less favorable pricing, this inferior pricing must be passed on in the form of premiums charged to the borrower. Premiums in the form of higher interest rates and fees vary according to the degree by which a loan fails to meet the conforming standard. Further, some non-conforming loans cannot be securitized which will often result in still higher premium pricing.

None of this is meant to say that non-conforming loans are not good loans or that they are risky. Take the example of a very wealthy individual who has excellent income and credit and borrows $650,000 toward the purchase of a $2,000,000 home. The investor in this loan takes virtually no risk with respect to the possibility of default. With a very strong borrower and $1,350,000 in equity ahead of the loan, it would be very difficult for the lender to lose money on account of the borrower’s failure to pay. On the other hand, this loan cannot be sold to Fannie Mae or Freddie Mac because the $650,000 loan balance exceeds their maximum loan limit. In this specific example there is still a market for the loan. Many institutional investors form their own securities and market them as alternatives to agency Mortgage Backed Securities. Since the loans in these securities are non-conforming and since they do not have the backing of one of the agencies, the securities will be less liquid and command a higher price. Some of the institutions backing these securities are very substantial and their backing of a security is considered to be quite strong. The higher price of the institutional backing verses Fannie Mae backing will be passed on to the borrower. Because the borrower in this example was well qualified and the loan was of exceptional quality, the premium charged will not be so great. In the same market where a thirty year fixed rate mortgage eligible for sale to Fannie Mae might be priced at 7.5%, this high quality non-conforming loan might carry a rate of 8% to 8.25%, or a premium of .50% to .75%.

The greater degree by which a loan deviates from the conforming standards, usually the higher the premium. In the example above, the only aspect of the loan that kept it from being agency eligible was its size. Other than that it was an excellent loan. But what about loans that are ineligible because the borrower is credit impaired? Or consider a loan where the borrower cannot verify his income or source of down payment. These situations are a bit further from the conforming standards and the premium a borrower will pay will be greater. There are issues of mortgage backed securities comprised of pools of loans of this type, but investors want a more significant premium in return for the risk they take. Default rates are generally higher for less than “A” credit borrowers and the collection efforts associated with this type of lending are much more extensive. In the market described above where a Fannie Mae fixed rate mortgage might be priced at 7.50%, a borrower who falls into this latter category may have to pay an interest rate of 9% or more.

There is another class of loans for which the secondary market is not well organized and for which there is very little liquidity. Loans to foreign nationals and to corporations, both domestic and foreign, and loans on condo hotel and time share units are generally ineligible for purchase by Fannie Mae and Freddie Mac, and have not been well accepted in the Mortgage Backed Securities of traditional institutional investors. Due to this illiquidity, the market for loans of this type is limited to institutions that are willing to hold them as whole loans in their own investment portfolios. Often it is the local commercial bank that makes this type of loan and their motivation and philosophy of lending is much different than it would be for an institutional investor. For one thing, most commercial banks that are regulated by the Office of the Comptroller of the Currency (OCC), or Savings Banks that are regulated by the Office of Thrift Supervision (OTS) are, in general, limited with respect to the maximum term for which they can lock in a rate. Therefore, fixed rate financing would probably not be offered. Further, such a bank would be inclined to look for other areas of safety in the loan itself, such as lower loan-to-value ratios and additional personal guarantees.

Loans of this type are from time to time sold between banks, but the pricing is not very competitive and the market is limited. For all these reasons, loans that fit into this category can expect to carry a much greater premium for financing. Since these loans are most often limited to adjustable rate financing, a comparison to Fannie Mae adjustable rate financing would be appropriate. Where the market rate for a Fannie Mae conforming five year ARM might be 5.0%, a foreign national or corporate borrower could expect to pay a rate of 7.0% for the same loan.

In general, the farther from the conforming norm a loan is, the less liquid is the market for that loan. The most liquidity in the mortgage market comes from Fannie Mae and Freddie Mac Mortgage Backed Securities which are populated by conforming loans and these loans command the best prices. Conversely, the farther from the conforming norm a loan is, the higher the price will be.

Licensed and Regulated by:

 Pennsylvania Department of Banking    Pennsylvania Department of Insurance    Pennsylvania Real Estate Commission