When it comes to new-fangled loan options, caveat emptor — buyer beware — is no longer enough. The government now says lenders must give equal billing to both the pros and the cons of each loan choice so that borrowers are not surprised by rising monthly payments or growing debt levels. No less important, lenders will have to toughen qualification standards — a move that could purge large number of potential buyers from the marketplace and thus dampen housing demand and pricing.
“No one should object to these new standards,” says James J. Saccacio, chief executive officer of RealtyTrac, the largest marketplace for foreclosure properties. “Government regulators are merely injecting a dose of caution and common sense into nontraditional loans, values which will reduce borrower foreclosures and lender risk.”
The government’s latest effort to rein in interest-only mortgages, option ARMs, stated loan applications and piggy-back financing comes in the form of guidance from the five federal regulators who oversee the national banking system. These agencies along with state regulators are concerned that new loan products make financing available to marginally-qualified borrowers who represent an unknown level of risk.
These borrowers, say regulators, “may not fully understand the risks of these products,” especially when combined “with other features that may compound risk. These features include simultaneous second-lien mortgages and the use of reduced documentation in evaluating an applicant’s creditworthiness.”
The five regulators include the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS) and the National Credit Union Administration (NCUA).
Since national lenders are regulated and insured by the federal government, tougher lending standards are expected to hold down future claims against the government. This is prudent, say the regulators, because the new loan formats have been “untested in a stressed environment” — meaning when sales slow and home prices decline.
So what will change? In basic terms, the most important items are:
To this point, some option ARM borrowers and those who got interest-only financing have been able to qualify on the basis of their ability to make initial payments. Now, says the government, lenders must look at the ability of borrowers to repay mortgage debt on the basis of each loan’s “fully indexed” rate and as if the loan was being fully amortized.
The fully indexed rate, say regulators, “equals the index rate prevailing at origination plus the margin that will apply after the expiration of an introductory interest rate.”
As an example, suppose a $300,000 interest-only loan has a 6 percent “start rate” that’s good for five years. The cost for principal and interest during the first 60 months of the loan term is $1,500. Then, assuming the loan rate can go up a maximum of 2 percent at the first rate adjustment change, the mortgage would have a fully-indexed rate of 8 percent. However, since only 25 years remain on the loan term the new monthly payment for principal and interest will be $2,315.
Some lenders argued that the new guideline was unnecessary because many borrowers sell or refinance before the end of the start period. Also, it was argued that some lenders already qualify borrowers on the basis of the fully-indexed rate.
The regulators disagreed saying that many borrowers would hold loans long enough for fully-indexed rates to kick-in, raising lender and borrower risk. Lenders, said the government, “should maintain qualification standards that include a credible analysis of a borrower’s capacity to repay the full amount of credit that may be extended.”
“If lenders now qualify borrowers on the basis of the fully-indexed rate then the rule would merely adopt a common industry practice and not be a burden,” says RealtyTrac’s Saccacio. “At the same time the rule would force all lenders to use the same general standard so that no federally-regulated lender would have a competitive advantage.”
The regulators say that lenders should “recognize the potential impact of payment shock, especially for borrowers with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low credit scores.” In practice borrowers who might once have qualified for financing on the basis of a loan’s “start” rate will now have to meet a tougher qualification test. For many borrowers it will only be possible to get a smaller loan amount; for others it will mean not enough financial power to buy in today’s market.
Many loans are now structured to allow “negative amortization.” This expression means the monthly payment is insufficient to pay off loan interest. The monthly interest not paid is added to the mortgage debt.
For instance, a $200,000 option ARM might have a 1.25 percent initial rate but a 6.75 percent fully-indexed rate. With this loan the borrower during the first five years of the loan term can make monthly payments to pay off the loan in 30 or 15 years, or he can make interest-only payments, or he can pay a minimum of just $666.50 a month — a payment that produces $630.70 in negative amortization each month. If our borrower makes only minimum payments then after a year the loan balance will increase by nearly $8,000.
For many borrowers — and for many lenders — the growing loan balance produced by negative amortization is not an issue if the property is sold at a profit or refinanced before higher payments kick-in. However, property values do not always rise and sometimes homes must be sold quickly because of a job change or for other reasons. The result, say regulators, is that borrowers should be expected “to demonstrate the capacity to repay the full loan amount that may be advanced. This includes the initial loan amount plus any balance increase that may accrue from the negative amortization provision.”
With stated-income loan applications, a borrower is asked how much he earns — and then the loan is processed, generally without checking the income claim. Not surprisingly, many worry that the income claimed is not accurate thus raising lender risk and the probability of default and foreclosure.
When asked if new guidelines were need for stated-income loan applications, the regulators found that many “community and consumer organizations, financial institutions, and industry associations, suggested that reduced documentation loans should not be offered to subprime borrowers. Some questioned whether stated income loans are appropriate under any circumstances, when used with nontraditional mortgage products, or when used for wage earners who can readily provide standard documentation of their wages. Others argued that simultaneous second-lien loans should be paired with nontraditional mortgage loans only when borrowers will continue to have substantial equity in the property.”
In the end, the regulators decided that stated-income applications could be continued — provided that lenders maintained “strong quality control and risk mitigation factors.”
“The final guidance,” said the regulators, “also cautions that institutions generally should be able to readily document income for wage earners through means such as W-2 statements, pay stubs or tax returns.”
Reading between the lines, the regulators are saying that lenders should audit more stated-income loans (which means they will check income claims more frequently for quality control purposes) and that lenders should also look for other ways to reduce risk, such as tougher loan qualification standards or more down.
One of the problems with non-traditional loans is that the terms are often complex. The regulators decided that “transaction-specific” disclosures were not required — that is, individual statements showing the best and worst case scenarios for a particular loan, a specific loan amount and a give interest rate.
Instead, the regulators decided that lenders should focus on providing more extensive information to borrowers during the pre-application shopping phase and in monthly statements after the loan closes. While the regulators did not require the use of standardized disclosure information, model language has been proposed in the federal register and may be adopted in the next few months.
One of the ways that borrowers reduce down payment needs is to get one loan for as much as 80 percent of the purchase price and then a “simultaneous second” or a “piggy back” loan for much or all of the balance.
Such arrangements, say regulators, are fraught with risk and more exacting loan standards should be required. The regulator’s comments are unusually straight-forward:
“Institutions that originate or purchase mortgage loans that combine nontraditional features, such as interest only loans with reduced documentation or a simultaneous second-lien loan, face increased risk. When features are layered, an institution should demonstrate that mitigating factors support the underwriting decision and the borrower’s repayment capacity. Mitigating factors could include higher credit scores, lower LTV (loan-to-value) and DTI (debt-to-income) ratios, significant liquid assets, mortgage insurance or other credit enhancements. While higher pricing is often used to address elevated risk levels, it does not replace the need for sound underwriting.”
What Does It All Mean?
Future visits to lenders are plainly going to be more exacting than in the past few years, especially for those who seek interest-only mortgages or option ARMs, who want to financing with little or nothing done and who prefer stated-income loan applications.
“Are these new guidelines really a problem?” asks Saccacio. “Shouldn’t borrowers be able to document income claims, especially when paying little down or buying with high-risk loans? Shouldn’t lenders want such documentation to cut foreclosure rates? The new regulations generally look like a step in the right direction for both borrowers and lenders.”
Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 90 newspapers.