Which of the following will eventually be made obsolete by the march of mortgage technology?
Prequalification of borrowers.
Underwriting ratios.
Rate sheets.
The correct answer, according to various industry pundits, may be all of the above. The home loan business is moving rapidly, if somewhat blindly, toward risk-based pricing that would radically change the loan underwriting process. This could eliminate prequalifications, underwriting ratios, and rate sheets.
And by extending pricing efficiencies to those loans previously regarded as of lower quality, the experts speculate, risk pricing could also have a significant impact on the Department of Housing and Urban Development's FHA program.
Behind this phenomenon is the development of automated underwriting and mortgage scores. The scores use elaborate mathematical formulas to reduce credit and loan information to a single number, and the scores have proved highly predictive of default rates. Freddie Mac, Fannie Mae, the mortgage insurers, and some vendors have all developed mortgage scoring models.
Previously, underwriting was done manually and resulted simply in a yes- no-maybe decision. While automated underwriting systems are presently being used in the same fashion, they differ significantly in not disqualifying borrowers on the basis of a single knockout factor. And because they detect subtle gradations in loan quality, they translate naturally into the engines for risk-based pricing of loans.
One of the believers in the future of risk-based pricing is Leland C. Brendsel, chairman of Freddie Mac, who says the industry will switch to the system within about three years. Speaking at the annual convention of the Mortgage Bankers Association last year, he said, "By the year 2000, I predict that 100% of our mortgage purchases will be priced according to projected costs." He also said pilot testing of risk-based pricing was beginning and would be offered to all of Freddie's lenders using its Loan Prospector this year.
Fannie Mae says it has long been pricing according to risk, and management of this risk is one of its core skills. Frank Demarais, vice president for product development, said, "We are focused on A quality business, on bringing as many people as possible into the A category. We are working to define and identify loans that we consider eligible." Mr. Demarais believes automated underwriting will allow Fannie to identify many more A-quality lenders than was previously the case.
Scott Cooley, president of Contour Software Inc., Campbell, Calif., is among the true believers in risk-based pricing. As Mr. Cooley sees it, the ideal model for a risk-based pricing system would look something like this:
The originator gets a mortgage score for a borrower from an open automated-undewriting system that does not tie the loan to a specific lender. The originator then sends the loan details and score electronically to many wholesalers. The wholesalers evaluate the loan instantly by computer and send back interest-rate quotes to the originator.
Such a model eliminates rate sheets, prequalifications, and any up-front underwriting.
"Once the score is available, Wall Street understands the risk profile of that consumer," Mr. Cooley said. Interest quotes could be returned by a conduit or by Fannie Mae or Freddie Mac. Mr. Cooley notes, however, that a change in Fannie's and Freddie's practices would be required because their present automated underwriting system ties a loan to a particular lender.
The development of such systems is by no means pie in the sky. Residential Funding Corp., Minneapolis, has developed a system capable of returning risk-based prices at the loan level. But the company points out that because of gaps in the infrastructure, the information cannot always be routed all the way back to the originator. It is working on a software solution.
The impact on the Department of Housing and Urban Development's FHA program is more hypothetical. Overall, observers say, HUD is making loans at below-market rates and thus is not very vulnerable to competition. They point out that it has stayed in business through thick and thin, adapting steadily if slowly to market changes, and has considerable political support.
But some say about a third of FHA loans would qualify for purchase by Freddie Mac and possibly Fannie Mae if evaluated by their automated underwriting systems. A movement toward risk-based pricing could push the agencies' purchases farther down the risk scale and make the two even more competitive with HUD.
Market pressures could lead to a revamping of the FHA program to incorporate risk-based pricing, observers say. Indeed, Freddie Mac has developed for HUD an automated underwriting system to approve FHA loans in minutes rather than the days it takes to do manually.
While this will significantly improve HUD's effectiveness, there is no free lunch. The good deed to HUD also provided Freddie with a wealth of information about FHA borrowers. This data could give Freddie a leg up in a drive to compete head on with the FHA program. Any additional competitiveness on the part of Freddie and Fannie could offset an increase in the FHA loan limits that is being pushed by the Clinton Administration.
