The new face of mortgage lending is now being revealed on Capitol Hill. Bills passed by the House and Senate are being merged and it seems plausible if not likely that we'll soon have mortgage reform.
So what's the big deal? How will the market for foreclosures, REOs and short sales be impacted? How will getting a mortgage change?
The answer is that we will soon see a mortgage marketplace which largely resembles the 1990s, a calmer financial time when most loans were conventional, VA or FHA products. Borrowers will be better qualified and loans will be better documented. The result will be fewer foreclosures, more liability for lenders when things go wrong and greater price stability in the housing sector.
A conference committee on Capitol Hill is now trying to mesh two similar but different reform measures from the House and Senate. So far it appears that a number of important new concepts will be in the final legislation, including several changes which will substantially change the way mortgages are originated. Here's what's happening — and what it means.
Lenders will have little liability under the new rules when they originate “qualified” mortgages. These are fully documented, self-amortizing loans with points and fees limited to not more than 3 percent of the mortgage amount.
Translation: Conventional, FHA and VA loans will easily fit within the definition of a “qualified” mortgage. Negative amortizing loans such as option ARMs will be defined as non-qualifying mortgages. While the House wanted a 2 percent limit on fees and points, it looks like the 3 percent cap favored by the Senate will be in the final bill.
Ability to Repay
It used to be that mortgages were largely supplied by so-called “spread” lenders; that is, local banks and S&Ls making loans in the communities they served, loans which were held by originators for their entire term. If something went wrong the originating lender could face a large loss.
Today loans are originated, bundled together and re-sold within mortgage-backed securities to investors, meaning that loan originators rarely suffer when loans go bad.
Under the proposed bill lenders would be unable to originate a mortgage “unless the creditor, based on verified and documented information, determines that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan, according to its terms, and all applicable taxes, insurance, and assessments.”
The new standard also provides that the ability-to-repay rule applies “if the creditor knows, or has reason to know, that one or more loans secured by the same real property or dwelling will be made to the same consumer.”
Translation: This language creates a life-of-the-loan liability for mortgage originators. The ability-to-repay language gives mortgage security investors and mortgage insurance companies a way to go after lenders for losses when loans fail because of underwriting fraud or misrepresentation. As a result, look for underwriting audits to be common whenever a borrower defaults. The legislation will also make no-doc loan applications rare and exotic financial creatures because without verified and documented information lenders will want to avoid the new liability they represent.
A large number of foreclosures are associated with the use of “nontraditional” ARM products, loans for which borrowers were often qualified on the basis of their ability to pay monthly costs during starter periods. No more. The new rules require lenders to determine “the consumer’s ability to repay using the maximum rate permitted under the loan during the first five years following consummation and a payment schedule that fully amortizes the loan and taking into account current obligations and all applicable taxes, insurance, and assessments.”
Translation: Option ARMs and the widespread use of interest-only loans are finished. Moreover, such loans and similar financial products will not be back as long as the legislation remains in place.
Net tangible benefit
Something called loan flipping occurs when a borrower is repeatedly sold refinances with little if any benefit while the lender gets big fees and charges. The new legislation effectively prohibits loan flipping by requiring that borrowers get a clear benefit when they refinance.
Translation: The net-tangible-benefit rule involves loan flipping but can be read as going much further. If the net tangible benefit standard goes through it will be groundbreaking legislation, the first time federally regulated lenders have been forced to act in the borrower's interest. The net tangible benefit standard will effectively restrict lenders to loans “suitable” for individual borrowers. The “suitability” concept has long been fought by the lending industry because it could create massive borrower claims if inappropriate loans can be shown to be the cause of foreclosure.
Prepayment penalties under the new rules will be allowed for “qualified” mortgage but limited to three years. The maximum prepayment penalty will be 3 percent in year one, 2 percent in year two and 1 percent in year three. In effect, the case for declining prepayment penalties outlined here in 2007 has been written into the proposed legislation.
Prepayment penalties will be banned for non-qualifying mortgages, still another way to discourage toxic loans.
Translation Prepayment penalties are currently prohibited with FHA and VA loans and as a matter of practice conventional financing rarely involves a prepayment penalty. Ban prepayment penalties from non-qualifying mortgages and the result is that they will largely disappear from the marketplace.
If the reforms above make it into the final legislation — and there's a good chance the all of the reforms mentioned here will be included — the result will be a markedly changed mortgage origination system.
One reason for likely success is that Congress is forcing big national lenders and their mortgage subsidiaries to adopt the origination standards commonly used by community banks, S&Ls and credit unions — politically potent institutions which will be virtually untouched by the new mortgage rules.
In terms of foreclosures, as new loans are issued and old ones are refinanced under the new standards, the number of foreclosures will decline. This will happen because marginal borrowers who cannot document income and employment will be declined by lenders, and because toxic loan products will be too risky to originate.
“If the proposed mortgage lending changes now in the final stages of development are enacted the result will be a far stronger housing market. There will be fewer foreclosures and that will mean less pressure to push down prices,” says James J. Saccacio, chief executive officer of RealtyTrac.
“Had these rules been in place in 2004 or 2005,” he continued, “we would not have had a mortgage meltdown. There would have been few toxic mortgages to fail because there would only be a handful of such loans outstanding. Borrowers would have been required to document their income and employment and those that couldn't would not get financing. Better loans would have meant stronger mortgage-backed securities. Better mortgage-backed securities would have resulted in far fewer insurance claims. Everyone would have been ahead.”
Peter G. Miller is syndicated in more than 100 newspapers and operates the real estate information site, OurBroker.com.