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CQ WEEKLY - IN FOCUS
April 17, 2006 - Page 1018

By Michael R. Crittenden, CQ Staff
Friends and family concerned about a loved one losing a battle with
substance abuse will stage an intervention to help. Federal banking
regulators are taking a similar tack with lenders and borrowers who have
become addicted to so-called exotic mortgage loans in the past several
years. But lenders are resisting a call to quit this lucrative business cold
turkey.
Previously a niche market for savvy, affluent homebuyers, exotic or
non-traditional mortgages offer borrowers lower initial monthly costs,
flexible payment options and the ability to pay nothing but interest charges
for a period of time. These loans, known by terms such as interest-only,
negative-amortization and payment-option ARM, are a far cry from the common
30-year fixed-rate loan or even standard adjustable-rate mortgages (ARMs).
Lenders have offered these non-traditional loans for years without raising
concerns. But that changed as falling interest rates drove a booming housing
market that has been marked by rapidly appreciating house prices and record
lender profits. To keep that market churning, buyers were encouraged to
purchase the most expensive property possible; to reach new customers, banks
and mortgage brokers started marketing non-traditional loans to those for
whom they were a greater risk.
Borrowers have been eager to sign up, confident they would be able to make
pricier payments down the road. Non-traditional loans have jumped from less
than 2 percent of total mortgage borrowing five years ago to a third of all
home loans last year.
The arrangement worked when houses were appreciating 20 percent a year in
some markets and the Federal Reserve was intent on holding interest rates
close to historic lows to keep the economy expanding. But non-traditional
loans pose an increased risk for both lenders and homeowners when interest
rates rise and prices start to slow down, as is the case now.
Federal financial regulators are growing worried and took a first step in
December, proposing new "guidance" to lenders that prescribes limits on who
should qualify for such loans and how much capital lenders should set aside
in case these exotic mortgages start to fail. While not expected to be final
for several months, the guidance will be used by bank examiners to ensure
that lenders are adequately monitoring the increased risk.
That risk comes from the repayment program for non-traditional loans.
Interest-only loans promise smaller payments in the early years of the loan
and significantly higher costs in the future when principal repayments take
effect and interest rates adjust. For payment-option ARMs and
negative-amortization loans, the initial payment can be even lower as
borrowers make interest-only payments that are less than the amount actually
owed, with the difference added to the loan's principal. All these loans can
put homeowners in the position of owing more than their houses are worth if
prices fail to appreciate or actually decline. And a current slowdown in
home sales is making that more likely, regulators say.
The fear is a rise in delinquencies and defaults, and the consequences for
borrowers and lenders. And that worst-case outcome looks increasingly
possible because mortgage rates have climbed a half percentage point or more
in the past six months and are headed higher; wages for most Americans have
been stagnant; and home sales are slowing and even falling in some places.
Adding to the worry, within the next 18 months mortgage market experts
expect that between $1.5 trillion and $3 trillion of debt will suddenly be
subject to higher interest rates when loans taken out the past few years
adjust.
The overall effect, said Allen Fishbein, director of housing and credit
policy at the Consumer Federation of America, could be disastrous. "At the
very least I think you are going to see significant run-ups in default and
delinquencies and foreclosures, and it is going to undercut some of the very
positive gains in recent years," Fishbein said.
Still, banks and mortgage bankers are pushing back against the guidance from
regulators, concerned that limits on these loans will stem a valuable
channel of income.
"Exotic mortgages are a way for banks to get people into homes they wouldn't
normally be able to," said Jaret Seiberg, a policy analyst at Stanford
Washington Research Group. "So anything you do to make those products less
attractive could hurt lenders."
An equally important question for regulators, and one not addressed in their
recent guidance, is what to do with millions of borrowers who already have
non-traditional loans. As those homeowners try to refinance their mortgages
before big increases in their payments take effect, they may be left with
few alternatives if regulatory guidance puts too tight a lasso around loan
innovation.
"If you finance all these people into loans that have teaser rates that can
jump by 100 percent in a few years, I don't think it's enough to say,
starting now, we expect lenders to use more cautious underwriting, and leave
borrowers out on the ledge," Fishbein said.
Suitability and Disclosure
The most significant part of the guidance from federal regulators would be a
so-called suitability requirement that calls on banks to assure themselves
that borrowers will be able to repay a loan once initial teaser interest
rates expire. A similar standard exists in the securities industry, though
banking regulators haven't said they want to extend the guidance as far as
those regulations, which allow borrowers to sue if a lender offers an
investment or loan that is judged to be inappropriate.
"Although these products can be beneficial for some borrowers, today these
products are being offered to a wider spectrum of consumers," Federal
Reserve Gov. Susan Schmidt Bies told a bankers' association on April 10.
"Some of these consumers may not understand the associated risks."
Other parts of the regulatory guidance require lenders to explain to
borrowers that they might wind up owing more than the house is worth under
certain conditions, or that monthly payments might balloon.
"These are exotic, they can be quite complex, and you need to look at the
full picture and not just the near-term attractiveness of a very small
initial payment," said Steven D. Fritts, an associate director at the
Federal Deposit Insurance Corporation.
The payment-option ARM is one type of loan that particularly concerns
regulators. Like other adjustable-rate loans, the option ARM allows lower
payments for a fixed period before the interest rate adjusts. Additionally,
however, these loans allow borrowers a choice to pay a variety of amounts on
a monthly basis, from a minimum that is less than the interest owed to the
equivalent of a 30-year fixed rate.
These loans were designed for borrowers who are already wealthy, or have a
significant potential for salary growth and receive sizable year-end
bonuses. Such buyers presumably can afford higher payments that kick in when
the loan adjusts, and the plan gives them flexibility to boost payments
after receiving bonuses.
But for other borrowers these loans may be much more difficult to repay.
Someone who can barely cover the lower initial payment is likely to be
shocked if the loan adjusts to a higher rate. Borrowers also face the
prospect that the outstanding balance on the loan will increase - possibly
without their clear understanding - if they choose to make the minimum
payment required.
Avoiding Judgments
Complaints about the regulatory effort from banking and mortgage lending
groups include fears the guidance will be "overly prescriptive" in setting
underwriting standards and semantics of disclosure rules. One group has
asked regulators to call these mortgages "alternative" rather than
"non-traditional."
Particular ire is reserved for the suggestion that banks should determine if
a borrower will be able to repay the loan after its terms change. Banks
argue that such a requirement requires them to make subjective
determinations of whether a particular mortgage is appropriate for a
borrower.
There is a concern that this could open banks up to lawsuits from borrowers
who are unable to make payments or whose applications for a loan are
rejected.
"We do not believe it is appropriate or possible for the lender to identify
or dictate the best mortgage product for individual consumers," said Diane
Casey-Landry, president of America's Community Bankers, in a March 27
comment letter to regulators.
Banking groups have also complained that the guidance applies only to banks
and savings and loans, and excludes mortgage brokers and other lenders that
fall outside the jurisdiction of federal regulators.
Banks also don't support requirements that they disclose more to borrowers.
"We find the disclosure guidelines . . . too detailed to be easily
understood by consumers," Casey-Landry said in her letter.
The Consumer Has to Fit
Regulators, who have set no schedule for making the proposed guidance final,
are reviewing comments from lenders and consumer groups and are expected to
publish the final form of the guidance later this spring.
Seiberg said the attempt by banking groups to water down the rules is
unlikely to succeed because regulators have already observed that lenders
are willing to push the envelope on these mortgages. "This is making sure
that when these products become attractive again that they are geared toward
consumers who they are appropriate for," Seiberg said.
And Fishbein said regulators and lenders alike need to help borrowers who
are already in over their heads or will be once their loans adjust to higher
interest rates. If borrowers aren't given help refinancing into more
conservative loans, he said, the economic effect could be serious.
"A wave of foreclosures would have an impact not just on the individual
households . . . but on the neighborhoods where they are located, which
could have a devastating and destabilizing effect on local economies,"
Fishbein said.