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Recent refinances appear safer credit bets than purchase originations, AEI says

Refinance loans in recent booms have generally been less likely to default than their home-purchase counterparts, but greater numbers of cash-out and government refinances are worrisome trends, a policy institute has concluded.

Since November 2012, a period that saw a refinancing boom in 2013 and also a significant pickup this year, refinance loans have tended to have higher average FICO scores and placed lower debt burdens on borrowers than loans used to purchase homes, according to the American Enterprise Institute’s International Center on Housing Risk.

On Monday, the conservative-leaning policy institute released its risk rating of 9.7 million refinance loans purchased or guaranteed by Fannie Mae and Freddie Mac, and the government’s Federal Housing Administration (FHA) and United States Department of Agriculture (USDA) loan programs. The Institute has previously risk-rated 8.1 million purchase loans.

Codirector Stephen Oliner said refinances are riskier when put side by side with an identical purchase loan. That’s because the evaluation of a property’s value in a home-purchase deal is more rigorous, he said, and it is easier to “game” the appraisal of the value when no sale is involved.

However, lenders and the agencies have been accounting for this extra risk in the recent era of refinances, the loan data suggests.

“To some degree, the lenders and the guarantee agencies are acting on the information of the riskiness of refis, and imposing tighter underwriting criteria,” Oliner said during a briefing with reporters. “That has been true for most of the period back to late 2012.”

 In December, for example, the median FICO score for a noncash-out refinance loans was 746, which was 22 points higher than FICO’s for purchase loans, the Institute reported. The mortgage debt on the home and the debt burden on the borrower also was significantly lower in refinances than purchase loans.

Oliner cited one main reason for this. The government-sponsored enterprises Fannie Mae and Freddie Mac, which have tougher underwriting guidelines than the government programs, dominate the refinance market. The GSEs’ refinance market share has ranged from 70 to 85 percent and is now at about 75 percent, whereas Fannie and Freddie’s purchase share ranges from 55 to 60 percent.

Worrisome trends

Although the risk levels of refinance loans are running lower, Oliner highlighted some areas of concern. He said FHA-to-FHA refinances, which tend to be riskier deals, have risen steeply since the agency cut the annual insurance premium early last year. Asked by Scotsman Guide News what impact a further reduction in the insurance premium might have, Oliner indicated that the FHA and the government-sponsored enterprises might continue to try one up each other to attract business.  

"It wouldn’t be all surprising if FHA cuts the premium again," Oliner said. "Basically, the net effect will be that we will ratchet up the degree of leverage. Loans will get riskier, and there is no force that prevents this from happening because the agencies are operating in their own, narrow self interests, which is not good public policy." 

During his presentation, Oliner also said the share of cash-out refinances has risen from 20 percent to 40 percent since late 2012 as homes have built equity.

Cash-out refinances have had lower average risk than the noncash-out refinances because Fannie Mae and Freddie Mac have an even greater dominance of the cash-out refi market, the Institute concluded. Cash-out refinances ultimately present more systematic risk to the market as the volume of refinances drops off, however.

“When volume drops, like it did in the second half of 2015, you see that the risk index rises,” Oliner said. “The only borrowers left in the refi market are people who need the money, either because they need to cut their monthly payment or because they need cash.” 



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