Lender Choice Set to Transform Credit Allocation
Analysts say the “lender choice” policy, which lets banks send either a FICO® or VantageScore® 4.0 credit score to Fannie Mae or Freddie Mac, could reshape how mortgage credit is spread among investors.
Potential for adverse selection
When lenders can pick the higher of two scores, they may steer the best‑rated borrowers toward the government‑sponsored enterprises (GSEs). If the GSEs do not adjust their pricing, the result could be a rise in credit risk on the loans they purchase. A series of studies, including one by the analyst who prepared this report, warn that such adverse selection would pressure the agencies to respond.
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How loan‑level price adjustments work
GSEs typically use loan‑level price adjustments (LLPAs) to compensate for risk. In past cycles they raised LLPAs on investor‑property and second‑home loans, shifting the cost burden to private investors. A new best‑execution pricing model suggests a similar pattern could repeat if the agencies raise LLPAs to match the risk from lender choice.
The best‑execution analysis looks at all revenue and cost components a lender faces when originating and servicing a mortgage. Options include selling to a GSE, placing the loan in a Ginnie Mae securitization, issuing a private‑label security, or retaining the loan in a portfolio. The highest “all‑in” price determines the preferred path, and the LLPA assigned by the GSE becomes a key factor linking lender choice to credit allocation.
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What the shift means for credit investors
Absent other policy changes, the analysis suggests a material reduction in the volume of loans sold to the GSEs. The study does not factor in non‑pricing considerations such as operational differences or policy preferences, which could soften the projected outflow. Nonetheless, the trend mirrors what happened when LLPAs rose on second homes and investor properties.
FHA‑backed securities appear poised to capture a larger slice of lower‑credit‑score loans, while private‑label investors will likely claim the highest‑quality mortgages. The GSEs, facing higher LLPAs, could see a narrowing of their market share, prompting a reallocation of credit risk toward the FHA and private sectors.
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One analyst cautioned that the lender‑choice rule is “one of the biggest policy changes to mortgage underwriting in years,” and that the full implications remain uncertain.
For background on the credit scoring systems mentioned, see the FICO score article on Wikipedia.
