A new report from two Federal Reserve economists says lenders have been applying strict underwriting conditions to keep borrowers who can’t afford a large down payment out of the Federally guaranteed program that is designed to make it possible first time and mid to lower income applicants become homeowners.

The report sets down in black and white what has been rumored for months:  that the steep declining in FHA loans in recent months is due in part by a concerted effort by FHA lenders to reduce their exposure and improve profitability by rejecting applications by applying tough underwriting standards.

Federal Reserve economists Jordan Rappaport and Paul Willen found that from early 2007 to mid-2010 the median FICO score on a conforming mortgage increased by almost 50 points as lenders raised standards for conventional loans.  Lower income borrowers who could not meet those standards turned to the FHA program.  The median FICO score for the combination of conforming and FHA-guaranteed mortgages increased only 10 points.

But rather than cutting off access to mortgage credit for a subset of households, lenders tightened credit for all households through strict underwriting procedures.

“Lenders required conservative appraisals, meticulous documentation and the curing of even the slightest questions of title.  To the extent that these standards constitute sound lending practices, adhering to them is a positive development.  But the level of vigilance suggests that regulatory uncertainty may also be playing a role,” the Fed economists said.

“Lenders fear that departures from the evolving standards will result in considerable costs, including the forced buyback of loans sold to Fannie and Freddie and the rescinding of FHA mortgage guarantees.  The associated uncertainty has caused lenders to act as if strict interpretations of possible restrictive future standards will apply,” they said.

Weak income growth, increases in student debt, and rising home prices are each putting downward pressure on purchase demand.  Clarifying what constitutes approved lending may help to overcome these challenges, they concluded.