Secrets of the automated mortgage
underwriting system are revealed at last
By Michael D. Larson • Bankrate.com

Borrowers may think the mortgage industry is an "evil empire." But just like Ronald Reagan's onetime enemy, the business seems to have realized some glasnost is in order.

Companies that design automated underwriting systems -- which lenders use to evaluate roughly three out of four mortgages today -- have started releasing more details than ever before about how they work. Fannie Mae opened its Desktop Underwriter system to scrutiny Jan. 14 by sharing a list of all the factors that DU reviews. Observers now know the system considers whether someone is getting a fixed rate or adjustable rate mortgage, for instance, and whether a borrower is buying a duplex, renting out one of the units and using the income to support the loan payment. (For a more detailed look at the system's inner workings, see the accompanying Bankrate.com story.)

The move comes just two months after the Department of Housing and Urban Development said it will make its automated underwriting system for Federal Housing Administration loans transparent when it comes out later this year. While it doesn't go as far as it could, this policy of openness should help demystify the lending process for prospective and rejected borrowers alike.

"Anything that gets out to consumers what is looked at, it's a good thing," says Joe May, a loan officer with Home Security Mortgage Corp. in Fredericksburg, Va. "Everyone wants to know what's going to be on the test, what it's going to be graded on and the more people know about the process, the better it is for consumers and the entire mortgage industry."

Lenders have used automated underwriting systems for years, but the trend accelerated in the late 1990s. The percentage of companies with a computerized loan approval process in place soared to 75 last year from 25 percent in 1996, according to Jeff Lebowitz, a principal at the industry research firm Mortech, LLC of Silver Spring, Md.

Speeds up the process
Most experts agree that's helped lenders approve loans faster while saving consumers money on underwriting costs. But it's also shifted a lot of the responsibility for lending decisions to the secondary marketing agencies Fannie Mae and Freddie Mac.

Consider that together their two automated underwriting systems account for 95 percent of the market. While those systems technically don't approve or deny mortgages, they reply to applications submitted by lenders with either an "approve" or "accept" (the language depends on whether Fannie Mae or Freddie Mac did the evaluation), a "refer," or a "refer with caution."

The first response means the reviewing agency will probably agree to buy the loan from the lender. The second means the agency wants manual underwriting performed on it. The third means the agency probably won't buy the mortgage unless there are extenuating circumstances.

Since lenders often follow those guidelines to a "T," somebody who's referred may not get a loan. If the borrower does, it may be at a higher interest rate. That's because the lender has to either hold that loan in its own portfolio or sell it to a private company that costs more to do business with than the agencies.

Given this setup, it's only natural consumers would want to know how to get the best rating. But until now, the agencies haven't been willing to share exactly how their systems work. Nor have they given people a road map to success.

Freddie Mac has provided some information about its Loan Prospector system to consumers via the company's Internet site for a few years, but many details have been left out. Other information is available exclusively to lenders.

Fannie Mae, on the other hand, has talked in general terms about its DU system to many audiences, but refused to share specifics with anyone. In interviews last fall, for instance, company officials wouldn't discuss exactly how borrowers are evaluated or how much lenders pay to use the system. They also wouldn't provide examples of the responses, called advice or findings, that DU spits back to lenders.

HUD wants consumers to know
Those stances prompted HUD to lambaste the agencies in mid-November. HUD also promised to make its own automated underwriting system, which will start processing loans sometime in late spring or early summer, transparent. Consumers will be made aware of the government agency's underwriting methodology and anyone who's rejected for an FHA loan will be told exactly why.

"Buying a home is the most expensive, most complicated and most intimidating financial transaction most Americans ever make. Some people who could qualify for mortgages don't apply because they fear the process is too hard and fear they'll be turned down," HUD Secretary Andrew Cuomo said. The agency's approach, he added, should help change that this year.

"In effect, FHA's new automated underwriting system will be like a glass box, exposed to the light of day and public scrutiny."

Whether on its own or in response to HUD's pressure, Fannie Mae revised its own stance on automated underwriting technology last month. During a speech before the National Association of Home Builders, Chief Executive Officer Franklin Raines fired off a list of the things DU considers. He also pledged to improve the system so that it tells lenders more about why a borrower's application was referred rather than approved.

"I'm going to open the book on Fannie Mae's automated underwriting system," Raines said. "You want to know what's in Desktop Underwriter, how it works and what criteria it uses? OK. Here it is."

What Fannie Mae looks at
In addition to an overall list of the variables that the system uses, Fannie Mae spelled out what it considers to be the most important things about a transaction -- equity, credit history and liquid reserves.

A loan looks better, for example, if the borrower has more invested in the transaction via a higher down payment. The system also likes borrowers who have managed their finances well and have a fair amount of money left over in the bank after closing because that cash could be tapped for a payment or two, if necessary. (For a more detailed look at the system's inner workings, see the accompanying Bankrate.com story.)

Still, Fannie Mae didn't explain how the system weights each of the DU variables. It also didn't provide consumers a way to take their data and compute how they would rate on their own.

There are other details missing as well. Fannie Mae says its system overrides an otherwise approvable application in a couple of cases, such as when a borrower has a total debt to income ratio that's "unusually high." But a company spokeswoman refused to say how high is too high. The only thing consumers do know is that the old 36 percent guideline -- which said people shouldn't get a mortgage if overall debt payments would swallow more than 36 percent of gross monthly income after closing -- no longer applies.

It's good for people who pay their bills
Agency supporters argue that rigid black-and-white standards serve no purpose because automated underwriting systems allow strength in one part of a borrower's application to compensate for weakness in another. A strong record of paying bills on time might make up for a low down payment, they point out.

"The good side about automated underwriting is it has some leeway," says Randy Johnson, a Newport Beach, Calif. mortgage broker who wrote How to Save Thousands of Dollars on Your Home Mortgage. "People who pay their bills are going to get their loans approved, by and large.

"You don't have a human underwriter coming in and saying, 'You've only been employed 23 months, not 24 months', 'Your ratios are 40.1 and my limit is 40', or 'Show me the seasoning of three months of bank statements on that account for the down payment', or 'Write me a letter of explanation on the credit,' " he adds. "It allows people who are interested in helping their clients get past that issue."

Officials from the secondary marketing agencies also say that lenders should be a part of the explaining process when it comes to automated underwriting methods. Giving borrowers the keys to the city without someone to show them around would be foolish.

"We are a company that, by and large, speaks with lenders who then speak with customers," says Freddie Mac spokesman Douglas Robinson. "The lenders have our guidelines."

Not everyone agrees, however.

Wei Chao, a 37-year old research scientist at Iowa State University, is in the process of shopping for his first house in Ames. While he understands the concept behind automated underwriting and some of what the systems look at, he says he wishes he knew more.

"I believe it would make our lives a lot easier if they let us know what things in the files (are) actually hurting us," Chao says during an e-mail interview. "It shouldn't be a black box."

"I give my confidential financial information to them," he adds. "It's fair they let me know how they have come to the decision to say no."