Last month, the American Bankers Association released the results of a survey of mortgage lenders that found nearly 80% of banks today are making it more difficult for consumers to obtain a home loan.
For many potential borrowers, this trend could mean not qualifying for a mortgage and not being able to purchase a home. However, if we take a step back and look at the bigger picture, we should all be glad that banks are proceeding with extra caution right now.
As the credit cycle turns
Much like the cycle of expansion and contraction we see in the economy, the lending business has also moved through history in fits of boom and bust.
When the economy is strong, banker's natural tendency is to lend more money to more borrowers. A rising tide lifts all boats, after all.
When the economy does eventually contract in a recession, the tide ebbs and many banks find themselves overextended to borrowers without the financial strength to repay their loans.
The best banks are able to anticipate this and limit their growth in the good times to just those borrowers capable of surviving the inevitable changes in the economic cycle. Other banks fail to do this and find themselves with steep credit losses and, in the worst cases, failing altogether.
Right now the U.S. economy is in the midst of a more than six-year economic expansion. Tighter lending standards today, in the middle of the expansion, will protect banks from the day when the tide ebbs, the economy shrinks, and boom turns to bust.
But don't give the banks too much credit
Given the banking industry's centuries-old tradition of boom and bust, most recently highlighted by the sub-prime mortgage fiasco, it shouldn't come as a surprise that this change isn't being intentionally implemented by banks. In fact, banks wish they could make more loans to many more borrowers.
The limiting factor is a new regulation adopted by the Consumer Financial Protection Bureau that, through a system of penalties and increased liabilities, limits banks to only make "qualified loans." To be considered qualified, a borrower and loan must meet certain criteria including a minimum debt-to-income ratio, fully documented income verification, no teaser rates or gimmicks, market rates and fees, and no interest-only payment options, among a slew of other criteria.
On the surface these requirements may seem stringent, however they are fundamental and prudent underwriting practices that the best banks practice anyway. The regulations do not inhibit borrowers with the cash flow, credit history, and repayment ability from securing their mortgage. Instead, the regulations prevent banks from giving excessive debt to borrowers who can't afford to pay it back.
In other words, it forces irresponsible banks from taking advantage of their customers like we all witnessed in the financial crisis.
The key is balance
Much like a well diversified stock portfolio, banks must balance the need for strong returns, in the form of profit, with prudent risk management for the future. In stock investing that means not having all of your eggs in one basket. For banks, that means putting credit risk management and sound underwriting policies at the core of the institution's culture.
Banks must operate profitably, and they must grow, yes.
But in the long term neither of those two things can happen sustainably without putting credit quality first. Tighter lending standards today, whether implemented willfully or as a result of the qualified mortgage regulations, shows that banks are doing just that.
This commitment to credit risk management protects the banking system. It protects bank shareholders. And perhaps most importantly, it protects consumers from taking on debts that they cannot afford to repay.
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