Schafer: Wells Fargo returns to subprime lending: Good or bad?

No need to read past the headline "Wells Fargo edges back into subprime" to suspect that this can't be healthy for the economy.

It was less than a decade ago that NegAm (negative amortization) loans were so popular, when the payment wasn't even meant to cover the interest on the mortgage and the homeowner's hole just got deeper. Also hot were "stated income" loans, better known as "liar's loans."

It was a cascade of defaults in this kind of junk that almost brought down the financial system. And now Wells Fargo, the nation's top home lender and Minnesota's biggest bank, is reaching down to subprime credit scores of 600 to grab a few more dollars of loan origination revenue, suggesting that it hasn't learned a thing.

The reality, however, is quite different. The small change in underwriting standards it has made is the kind of change that makes the market for residential housing finance a little healthier and modestly expands access to credit, a proven driver of economic growth.

As Paul Miller, a financial services industry analyst with Virginia-based FBR Capital Markets, put it, "I think Wells is trying to be a good citizen here" by signaling a change in credit underwriting practice to the industry.

Today there basically is no subprime mortgage lending market: Only 0.3 percent of home loan originations as of last fall. Julie Gugin of the nonprofit Minnesota Homeownership Center said, "If done properly, the idea of a lower credit score would be a good thing."

It wasn't that long ago, of course that "subprime" and "good citizen" would never have been used together. Many of the go-go lenders in the subprime boom were nonbank "mortgage originators," but Wells Fargo Home Mortgage showed up on the lists of top 10 players, too.

What it is doing is dropping its underwriting standard only for what it called "FHA purchase loans," from a FICO score from 640 to 600, with 640 being the break between a "prime" borrower and a subprime borrower.

The new mortgage has to be for buying a home rather than refinancing one, a distinction worth noting because of the abuse of refis during the mid-decade subprime gold rush.

The more important distinction is that it's only for loans with a ­Federal Housing Administration guarantee, and here we are once again reminded of just how much the residential housing credit market is tied up with government ­policy.

It helps to understand that in the home mortgage market banks like Wells Fargo really don't act as banks. They "originate" the loan, working with the customer on the application and approval process. Then the bank, after closing on a mortgage, sells it, likely into a pool backing some sort of mortgage bond placed with an institutional investor.

The other big player in the mortgage market, standing between the borrower and the institutional money manager, is the government, in the form of the FHA as well as the so-called government-sponsored enterprises like Fannie Mae and Freddie Mac.

"Fannie Mae kept all the good loans, and if a loan failed they would push it back to the bank," Miller said. "Listen, Bank of America paid over $40 billion for loans they sold to Fannie and Freddie. That's a lot."

A Wells Fargo spokesman explained that dropping the cutoff to a credit score of 600 wasn't exactly done in concert with the FHA. Wells Fargo continues to have a bit higher credit score standard than the FHA, and Wells Fargo does face some additional risk if its FHA loan production generates a disproportionate share of bad loans.

Wells Fargo also is far from alone in moving down: Enough mortgage bankers have been lowering their credit score cutoff to make the FHA's average FICO scores fall to 685 in the fourth quarter from over 700 a year earlier, Miller said.

The term FICO comes from Fair Isaac Corp., an early innovator in creating tools to help figure out who is going to pay back their loans. There's a reason to track a credit score, of course, as subprime FICO score borrowers do default at significantly higher rates than do prime borrowers.

According to a recent report by VantageScore Solutions, a FICO competitor, the rate at which 620-score borrowers got more than 90 days past due on payments has been consistently 2 or 3 times that of 680-score borrowers.

One of the things Miller has written about is the regulatory requirement of "perfect files," by which he means complete, not files on perfect credit borrowers. He thinks it's difficult for sprawling companies to deliver them and that's a factor in the declining market share collectively of the five largest players in the business. Wells Fargo is one of them, well off its peak share, now about 19 percent.

Then there are the new regulations, including the Consumer Financial Protection Bureau's rule requiring mortgage lenders to consider consumers' ability to repay home loans before they actually make a loan.

This one is worth pausing to consider for a second: you mean there had to be a rule? It's like Major League Baseball's commissioner announcing new rules before opening day requiring the pitchers to throw the ball and the batters to, after careful consideration, swing at the ball.

The upshot is that obtaining a mortgage loan remains a hassle, if not a challenge. But it's a 30-year personal loan, and it should be difficult to get.

Wells Fargo hasn't made it easy. For those with less-than-great credit, all it's done is make it possible.