In a delayed knee-jerk reaction to the mortgage meltdown and sub-prime lending crisis of 2008, lenders offering access to Federal Housing Administration (FHA) -insured loans are tightening their standards above and beyond those required by the federal agency.

The FHA instituted minimum Fair Isaac Corporation (FICO) scores for the first time in October of 2010. According to the FHA, borrowers shopping for conforming loans must have a minimum FICO score of 500 while those who have a score of 580 or higher are eligible for the maximum financing benefits available. [For more information on FHA home loan regulations, see the July 2010 first tuesday article, The true costs of a default-insured mortgage.]

However, the minimums required by the FHA are much lower than those required by the underwriting standards of most lenders today. Many lenders set a minimum FICO score of 620 for their FHA-insured loans as early as 2009. While 620 remained the magic number for the Big Three (Bank of America, Wells Fargo and JPMorgan Chase) for quite some time, now the major players on the mortgage-backed bond (MBB) market will not purchase an FHA loan from the originator unless the borrower has a minimum FICO score of 640.

Considering there are roughly 6.3 million people in the United States with a credit score between 620 and 640, the 20-point increase in minimum FICO scores will exclude as much as 15% of FHA borrowers. Given the continuing decline in consumer credit scores resulting from ongoing foreclosures and a still-high unemployment rate, these increased restrictions will affect those hit hardest by the recession.

first tuesday take: Once again, the California real estate market, and the health of the economy as a whole, are being held hostage by Wall Street. Note that this is not the government, not FHA. The MBB market is apparently still reeling from the near-death blow it sustained in 2008 and the present onslaught of litigation over their having to now buy back the bad loans they previously originated and sold, which is not helping them make a loan to the prospective homebuyer with a less-than-average credit score.

We are entering a phase in this economic recovery where wage-earners are slowly beginning to accrue wealth once again – at least in California, with the exception of temporary and part-time employees (government employees). After cutting their debt-to-income (DTI) ratio in half via strategic default or bankruptcy filing, the individual who was previously held prisoner by their underwater home is now newly solvent and looking for a good value on the real estate market. [For more information on strategic default and homeowner solvency, see the September 2010 first tuesday article, The LTV tipping point: when negative equity owners strategically default.]

Unfortunately, blame for the reckless and short-sighted lending practices during the Millennium Boom is being artfully sloughed-off by the Big Three and conveniently attributed to consumer irresponsibility. Rather than restructuring underwriting methods in such a way that would create sustainable and logical lending practices that are appropriate to the current economic milieu, the Big Three are falling back on their trusty (read: outdated and over-emphasized) tool: the FICO score. [For more information on the overemphasis on FICO scores in determining creditworthiness, see the June 2010 first tuesday article, The FICO score delusion.]

Under the guise of increased lender responsibility and consumer protection, the big banks are penalizing recently foreclosed-on homeowners by raising the arbitrary bar for creditworthiness. Certainly the FICO score can be a useful tool for determining a borrower’s ability to pay back a loan. But with a growing contingent of prospective homebuyers who have increasing purchasing power and dwindling credit scores, the overemphasis on the credit score simply does not work in our recovering economy.

In spite of their proven allegiance to the banking industry (read: massive bailouts), Congress has clearly rebuffed lender arguments that the consumer was responsible for the mortgage crisis.

After a century’s worth of efforts and many defeats at the hands of big business, Congress successfully instituted the Consumer Protection Agency this year. To drive home the point they are no longer willing to let public policy be controlled by private banks, Congress granted the Federal Reserve Bank (the Fed) control of regulating rogue mortgage lenders who still seem unwilling to bend to the government’s regulatory will.

Hopefully, as a new paradigm focused on responsible lending and sustainable homeownership takes shape, real estate agents, brokers and lenders will follow suit.

Re: “Home Buying Gets Tougher as Lenders Restrict FHA Loans” from Bloomberg News