Freddie Mac is discovering that some people with tainted credit histories may actually be prime-quality customers.
That means a revolution of sorts is brewing in the mortgage business. So far, it is quiet and behind the scenes, but the implications are far- reaching. Freddie's discovery challenges the way loan applications have been evaluated for decades.
In recent months, Freddie Mac, formally the Federal Home Loan Mortgage Corp., has been using Loan Prospector, its automated underwriting system, to evaluate loans that lenders believed were subprime, usually because of blemishes on the applicants' credit histories. Such loans often end up being made at premium rates in the B and C market.
Freddie has generated credit scores - a quantitative approach that predicts the likelihood of default - for large numbers of such loans, along with sets of rules for interpreting the numbers.
Credit scoring was pioneered by the credit card industry and is now in widespread use. Freddie is using a more detailed version of the procedure known as mortgage scoring, which includes factors specific to home loans.
Freddie's discovery: a significant portion of the suspect loans receive comfortably low scores or are qualified by rule interpretations that put them in the same quality category as prime, or A, paper.
"We expected that to happen," said Peter Maselli, a Freddie Mac vice president in charge of automated underwriting. "We haven't done enough loans to get a read" on the potential quantities of loans that may be involved. "But we think it's tremendous," he said.
Freddie Mac has begun a pilot program under which it will buy such loans. It emphasizes that the experiment does not mean it is moving into the subprime market, only that it is rescuing prime loans in the B and C slag pile.
Should the experiment prove successful, it would mean that lenders could approve thousands of applications that they had previously rejected. And thousands of borrowers would benefit from the far lower interest rates on conventional loans.
Mr. Maselli says the rescued loans are occurring across the board, without regard to size of loan, income group, or other demographic factors.
He said many borrowers with minor blemishes on their credit histories have offsetting factors that qualify them for top ratings.
"A lot of first-time homebuyers who normally fall into the A-minus and B categories will have high debt-to-income ratios," he added. "They may have student loans or car payments, and we have a lot of flexibility" in making exceptions, he said.
Mr. Maselli acknowledged that lenders would have to go through a learning period to make full use of their expanded lending capability. He said agency guidelines had been conservative up to now and lenders would need to understand the flexibility offered by automated underwriting through Freddie Mac's Loan Prospector system.
On the downside, some loans that looked like A paper may be downgraded because of the automated underwriting system. But Mr. Maselli said he believes they will be far outnumbered by the upgrades.
That's good news for borrowers and conventional lenders.
For lenders that specialize in B and C loans, however, the news could be very bad. Conventional lenders could siphon off the best loans and leave subprime lenders with fewer customers and reduced credit quality.
"Freddie Mac throughout its history has focused on bringing efficiencies into the secondary market," Mr. Maselli said. "Now we're focused more on helping our lenders originate better loans, in being able to attract a larger number of quality borrowers."
