Why are banks making it so difficult for borrowers to get a mortgage? The recent letter from the Federal Reserve to Congress with suggestions on how to fix the housing market lays out important reasons why mortgage credit is tight.

The good news is that we can understand the reasons. The bad news is that self-preservation may prevent the problem from being fixed.

The Fed describes the tightness of mortgage credit conditions:

“Other data show, for instance, that less than half of lenders are currently offering mortgages to borrowers with a FICO score above 620 and a down payment of 10 percent – even though these loans are within GSE parameters. This hesitancy on the part of lenders is due in part to concerns about the high cost of servicing in the event of loan delinquency and fear that the GSEs could force the lender to repurchase the loan if the borrower defaults in the future.”

The Fed goes on to say that concerns about the high cost of mortgage servicing stem from:

• the realization of how expensive it is to resolve a nonperforming loan,
• uncertainty about what it will cost to comply with new mortgage servicing-related regulations and
• the potential change in the way Mortgage Servicing Rights (MSRs) are treated for capital requirements under Basel III (new international banking regulations).

National Mortgage News reports that it costs a servicer 75 basis points (.75 percent) or more to service a high-touch loan (a.k.a. defaulted loan) compared with the 25 basis point servicing fee it receives. It is a losing business.

What about the difficulty of getting an FHA loan? Recently the Department of Housing and Urban Development said it would like to see the FHA lenders relax their credit score minimums so that more borrowers could qualify for FHA loans. According to the Asset Securitization Report, “Lenders are telling HUD officials the agency must first change FHA’s lender/monitoring system known as Neighborhood Watch so they aren’t stigmatized for making loans to borrowers with lower credit scores.” A lender that makes loans with higher default rates will have a higher Neighborhood Watch ratio than other lenders, which could lead to audits and indemnification demands. The lenders want HUD to consider borrower credit score when evaluating them and calculating the ratio.

Don’t forget to add the risk of government and private lawsuits and judicial foreclosure proceedings to the list of concerns about making loans that are more likely to default.

If you were a lender facing all these challenges, would you make the loan? Demonization of mortgage lenders and servicers makes for great political theatrics. But it doesn’t make them want to lend more.

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