Regulators Recommend Subprime Changes

The federal financial regulatory agencies seek comment on a proposed Statement on Subprime Mortgage Lending issued Friday. The agencies seek to address certain risks and emerging issues specifically related to lending practices in hybrid subprime adjustable-rate mortgages that may cause borrowers payment shock down the road and ultimately foreclosure.

“The proposal addresses concerns that subprime borrowers may not fully understand the risks and consequences of obtaining these products, and that the products may pose an elevated credit risk to financial institutions,” according to an announcement by the agencies, which consist of the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the National Credit Union Administration.

Subprime ARM products causing concern include loans with short-term fixed introductory or “teaser” rates, such as 2/28 ARMs; very high or unlimited rate caps; substantial prepayment penalties as well as penalties that extend beyond the initial interest rate adjustment period; and loans approved with stated income, according to the statement. ARMs in which borrowers were provided inadequate information relative to product costs, terms, features and risks, were also cited.

The statement specified that an institution’s analysis of a borrower’s repayment capacity should include an evaluation of a borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.

“The structural evolution of subprime mortgage lending in recent years has introduced some products that are intended at their outset to be temporary credit accommodations in anticipation of early sale or refinancing, rather than longer-term amortizing accounts,” the agencies said. “Such loans typically involve terms that exceed the borrower’s ability to service the debt without refinancing or selling the property.”

Motivations for these arrangements may include “financing in anticipation of the borrower’s intended temporary residency,expected future earnings growth, or need for a period of ‘credit repair,'” the agencies said. “This fundamental shift in the purpose and actual repayment expectations of such loan programs” provides reason for insight and commentary.

An announcement by 15 different consumer advocacy groups and other organizations applauded the agencies’ move, highlighting that “exploding” subprime ARMs, those with a fixed teaser rate for the first two or three years, comprise three out of four loans in the subprime market and have been linked to an “alarming” increase in foreclosures.

The agencies’ effort “is an important step toward a return to sensible lending,” stated Martin Eakes, chief executive of the Center for Responsible Lending, in the announcement. “Subprime loans comprise only 13 percent of outstanding mortgages, but they contribute over 60 percent of foreclosures.”

Maude Hurd, president of the Association of Consumer Organization for Reform Now, stated that “the steering of subprime borrowers into ARMs is one of the biggest predatory practices today” and that it “all too common” for families to lose their homes through hybrid subprime ARMs.

The Mortgage Bankers Association issued an announcement in which it noted that products such as 2/28s, 3/27s, and other ARMs allow flexible options to help more borrowers own a home, especially those in high-cost areas.

“We are concerned that the proposed statement, if adopted as proposed, may restrict credit to many consumers in high-cost areas and deny credit to many deserving low-income, minority, and first-time homebuyers,” MBA Chairman John M. Robbins said in an announcement.

“It is important to avoid an overreaction to an evolving marketplace or current economic conditions,” he added. “Overly prescriptive measures run the risk of eliminating valuable financial options that help consumers and support homeownership.”

The federal banking and credit union regulators additionally recommended that, on subprime loans relying on reduced documentation and other forms of risk layering, institutions should demonstrate effective mitigating factors that support the underwriting decision and the borrower’s repayment capacity.

“When underwriting higher risk loans, stated income and reduced documentation should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity,” the agencies wrote. “For many borrowers, institutions should be able to readily document income using recent W-2 statements, pay stubs or tax returns. A higher interest rate is not considered an acceptable mitigating factor.”

The underwriting and marketing of mortgage loans should also provide information that enables borrowers to “understand material terms, costs, and risks of loan products at a time that will help the consumer select products and choose among payment options … not just upon submission of an application or at consummation of the loan,” according to the agencies’ proposals.

The regulators said borrowers should be informed of payment shock, prepayment penalties, balloon payments, the cost of reduced documentation loans, and the requirement to pay taxes and insurance, if not escrowed. If there is potential for payment increases, institutions should explain how the new payment will be calculated and when the teaser rate expires. Consumers should be informed how prepayment penalties will be calculated and when they may be imposed, whether a pricing premium is attached to a reduced documentation or stated income loan and that cost for taxes and insurance can be substantial.

The agencies emphasized that prepayment penalties to be structured in a way that they do not extend beyond the initial reset period and for borrowers to be provided a sufficient timeframe immediately prior to the reset date to refinance without penalty.

“Subprime lenders have had strong incentives to market harmful “exploding” ARMs, with devastating results for vulnerable consumers,” said Ed Mierzwinski, a director of U.S. PIRG, in the consumer group announcement. “We commend the regulators for a proposal that will help straighten out an industry that has lost sight of the basic underwriting practices that lead to both sustainable profits and sustainable homeownership.”

The agencies stated the qualification standards are likely to result in fewer borrowers qualifying for subprime hybrids, with no guarantee that they’ll qualify for alternative loans in the same amount. Amongst the areas, the regulators were particularly interested in obtaining feedback on was whether subprime hybrids always present inappropriate risks to institutions and consumers, or the extent to which they can be appropriate under some circumstances.

The commentary period will expire within 60 days. If the proposed statement is adopted, it would complement the 2006 Interagency Guidance on Nontraditional Mortgage Product Risks, which did not specifically address the risks of subprime ARMs.