Thursday, May 23, 2024

August 2007 Legal Briefs

Background on Subprime Mortgages

Interagency Guidance on Subprime Mortgages

  1. Statement’s Coverage
  2. What is “Subprime”?
  3. Substantial Risk Factors
  4. Balloon Payments?
  5. Consumer Protection Principles
  6. Underwriting Standards
  7. Control Systems 

Background on Subprime Mortgages

The federal financial institution regulatory agencies have issued an interagency “Statement on Subprime Mortgage Lending,” effective July 10 (summarized later in this article).  Subprime lending has been getting a lot of attention from Congress and regulators, with many changes likely in the near future.

News articles explain almost daily how subprime mortgages are affecting borrowers, lenders, real estate prices, homebuilding activities, the credit markets in general, and even the stock market.  

The regulators’ main concern is with mortgages that contain special provisions that are harmful or otherwise inappropriate in subprime borrowers’ circumstances.

In the last few years, mortgage brokers have emphasized various “exotic” subprime mortgages (described below) that provide for artificially low monthly payments during the first two years or so.  Particularly in high-priced real estate markets, these mortgages have been originated for borrowers who otherwise can’t afford to purchase a home.

When a mortgage broker qualifies a subprime borrower for a loan based only on that borrower’s ability to pay the artificially-low beginning payments, it’s easier for that borrower to be approved.  The bad news is that every mortgage with special low payments up front has a “reset” date when the required payment amount increases dramatically.

When a mortgage broker (who wants to collect fees for closing a loan) does not adequately consider the subprime borrower’s ability to make the greatly-increased monthly payments after the mortgage “resets,” that borrower can find himself trapped in a situation where he could lose his home and his equity, and also further damage his credit. This scenario will become more common as millions of subprime mortgages originated in 2005 and 2006 approach their payment “reset” date.

 I will discuss some of these issues in more detail, as background for the interagency statement outlined later.

1. ARMs vs. Fixed-Rate Mortgages

Many homeowners (and certainly those with limited income) are better off with a fixed-rate, fully amortizing mortgage—unless they do not plan to own their home for very long.  The interest rate on a fixed-rate loan usually is somewhat higher than the beginning interest rate on an adjustable-rate mortgage (“ARM”)—and as a result the beginning payment on an ARM is somewhat lower.

Some borrowers choose an ARM because they believe they cannot “afford” the payments on a fixed-rate loan; but selecting an ARM for that reason can be especially foolish:  If the borrower cannot pay more than the initial payment amount on the ARM, what will he do when that ARM’s interest rate adjusts (perhaps many times over the life of the loan)?

With an ARM (in contrast to a fixed-rate mortgage) the homeowner bears the risk that interest rates will change. (Sometimes the ARM limits how much the interest rate can increase at any one adjustment date, or imposes a cap on the maximum interest-rate increase over the life of the loan.  If so, the borrower and the lender are actually dividing between themselves the risk that market interest rates will change.)  A fixed-rate loan has a somewhat higher rate of interest, at least in the beginning, because the borrower is paying the lender something extra to absorb all of the risk that market interest rates may increase during the life of the loan. 

Generally, a homeowner with a tight budget needs certainty that the monthly payments will not change, even more than he needs a somewhat lower payment at the beginning.  A mortgage payment that can change substantially over time is a major financial risk for the subprime borrower.

2.  “Low-Initial-Payment” Mortgages

In parts of the country that have experienced rapidly-escalating real estate prices (until recent months) it has been difficult to qualify for a mortgage to purchase even a smaller home.  But consumers making high rental payments would rather make a mortgage payment; realtors want to sell homes; and mortgage brokers want to earn fees for closing loans.  Even in overpriced real estate markets there is strong motivation to find a way to qualify a borrower for a loan (including a subprime borrower).  A borrower may be steered into an ARM with low initial payments but other features inappropriate to his financial situation.

Several types of low-payment mortgages originally designed for borrowers in other circumstances have been marketed instead to subprime borrowers—especially since 2005.  Following are three types:

a. “Interest-only” ARMs.  For the first five to seven years, payments on these mortgages are “interest-only.”  (At the end of the interest-only period, the borrower still owes as much principal as in the beginning.) The principal is amortized over the remaining term of the mortgage–23 to 25 years.)

When the principal begins amortizing at the end of the “interest-only” period, the required monthly payment can increase substantially.  Monthly payments can also change throughout the life of the mortgage (including during the interest-only period) due to changes in market interest rates. 

b. Payment-Option ARMs.  These mortgages allow the borrower to choose among several payment options for the first few years of the loan (the option period).  Each month, the borrower can select any of the following payment options:  (1) a payment of principal and interest (the normal payment required to amortize the loan); (2) an interest-only payment, which pays all accruing interest, with no reduction of principal; or (3) a minimum payment, which is less than the amount of interest accruing each month.  In any month that the borrower chooses the minimum payment, the total balance outstanding on the mortgage increases by the amount of interest not paid. 

If the borrower gets into a regular habit of making only the minimum payment (less than the amount of interest actually accruing), the mortgage’s outstanding balance can increase rapidly—perhaps even to an amount higher than the resale value of the home.  All payment-option mortgages have a cap or “trigger”:  If the amount owed on the mortgage increases at any time beyond a pre-set limit (such as 110% or 125% of the original principal balance), the option period ends sooner than scheduled.  The loan then converts to a series of payments that fully amortize the amount owed. There certainly can be “payment shock” when a payment-option loan converts to “full payments,” if the borrower previously was making only the minimum payments.

A payment-option mortgage is not “bad” in itself, but can turn bad depending on what the borrower does with it.  Like any other reverse-amortization mortgage, the borrower can always pay more than the minimum payment, and can avoid reverse amortization by making large enough payments.  But if he chooses to pay only the required minimum payment, the balance owed will increase, and eventually he may dig a hole that he cannot escape.

The payment-option mortgage may be a trap for someone whose regular income is small and who also does not receive “extra” cash flow at various times during the year that can be used to pay down the mortgage in a lump sum. 

This product requires a borrower to have considerable self-discipline.  He must carefully budget his payments (perhaps varying amounts during the year) so that a certain aggregate total of payments is reached.  He should understand what his income sources and amounts will be during the year—scheduling payments that are tied to that income.  His plan may fail unless he also has the determination to make those payments, instead of just the “minimum” payment each month.

Unexpected financial hardships (loss of a job, or major medical bills) may be the cause of past credit problems, and may not be a predictor of future credit problems.  But in most other cases a subprime borrower is someone who has demonstrated in the past a lack of skills in managing his finances—whether that means (1) he doesn’t like or understand financial matters, (2) he tends to spend more money than his income, or (3) he is motivated by “immediate rewards” more than by building up his home equity.  Depending on the individual, it can be strategically unwise to allow a subprime borrower to pick between three payment options each month:  If he is required to grind out a certain payment amount each month (one choice only), he may actually be able to do it; but if he has an option to slide into the lowest possible payment each month (one of three choices), he may choose that instead, and get himself into trouble as time passes.

(c)  “2/28” ARMs.  A “2/28” mortgage offers a cheaper (fixed) interest rate for the first two years.  The initial interest rate is artificially low, so the first two years’ payments on a “2/28” are substantially smaller than the payments on a 30-year, fixed-rate, fully amortizing mortgage.  At the end of the first two years, the “2/28” switches to a fully-indexed variable market-based rate for the remaining 28 years of the mortgage.  The jump in interest rate at the end of the first two years is often 3% to 6%, and may cause a very large increase in the mortgage payment.  A subprime borrower who does not have enough income to make the “reset payments” at the end of the first two years may end up selling the house (if possible), refinancing the mortgage (perhaps with substantial closing costs) or going into foreclosure.  These mortgages also may have a prepayment penalty, to prevent the borrower from bailing out of the mortgage too soon after the interest rate is reset—allowing the lender to collect interest at a more normal rate for a period of time after the reset date.  

The “2/28” mortgage is a product marketed widely (especially since 2005) to subprime borrowers in more expensive real estate markets.  Partially in response to the interagency statement (discussed later), some larger banks around the country have announced their intention to discontinue offering “2/28” subprime mortgages.

3. Mortgage Suitability

The mortgages described above have recently been marketed very broadly to subprime borrowers, especially in overpriced real estate markets where there is a need to “shoehorn” marginally qualified buyers into some kind of mortgage.  The terms of these mortgages often mesh very poorly with the subprime borrower’s financial situation, except for the lower payments in the first years.  The typical subprime borrower may have no solid prospect of rapidly increasing income, and can have considerable difficulty making the sharply increased payments that such mortgages require after only a few years.

It’s important for a borrower to have a mortgage that matches his anticipated income stream, if possible.  (A subprime borrower automatically starts with fewer available loan options, and sometimes there may be no available mortgage that fits his circumstances well.)

There are limited situations where an ARM, with lower payments at first, although providing for higher payments later, can be a pretty good fit for the particular borrower.  Following are some examples: (1) The executive transfer:  A manager is transferred to an area for only two or three years, and afterward will be transferred by his company again. He knows in advance that he will have to sell his house after a couple of years, so locking in a “fixed” payment for 30 years does not help him.  Because he will be paying off the mortgage by selling the house, an ARM may be acceptable, and possibly is a cheaper option.  (2) The young professional with a bright future:  Someone graduates from law school or medical school with little money but a great job and an excellent chance of rapidly escalating income.  A mortgage with small payments up front, changing to larger payments later, may fit his situation exactly.  (3) The high-income borrower with good credit:  He wants an ARM because the rate is cheaper and he can save some interest, particularly on a larger mortgage.  If interest rates go against him, he can afford to absorb an increase in payments; but because of his good credit, he can easily refinance into a mortgage with different terms at any time. (4) The “home-improvement” investor:  He buys a property to upgrade it (perhaps living in it temporarily, or renting part of it out), but plans to sell it in a couple of years at the most.  He wants something more than a “bridge loan,” but doesn’t need fixed payments for 30 years.

Each of these examples shows a borrower who already has substantial financial flexibility, or can realistically be expected to have more flexibility in the future.  These are not subprime borrowers who are “strapped” financially—nor people who are likely to get trapped long-term if the mortgage loan’s provisions become unfavorable for them. These are not individuals with a low level of understanding of what they are signing up for, if they choose an ARM.  

4. Foreclosure Rates

In the U.S. about 15% of outstanding mortgage loans are subprime; and as much as one-fifth of all those subprime mortgages are now delinquent. Some two million mortgages in the U.S. are likely to go into foreclosure this year.  The highest delinquency rates are concentrated in areas of the country where average home prices (and mortgage payments) are much higher than in Oklahoma, or in areas with higher unemployment.

Apparently Oklahoma has almost the same percentage of subprime mortgages (15%) that exists nationally.  However, it’s important to understand what the regulators and others mean by “subprime.” This terminology refers to a borrower’s credit quality, not the particular terms of the mortgage.  It’s not surprising that Oklahoma’s subprime mortgage borrowers are as plentiful percentage-wise as subprime borrowers in other states.  But loans classified within the “subprime mortgage” category in Oklahoma do not necessarily have the same terms as the “exotic” mortgages now so common elsewhere.

When Oklahoma banks make mortgage loans for their own portfolio, including to subprime borrowers, the terms are substantially different from the 30-year subprime mortgages described above.  Oklahoma banks making mortgage loans for their own portfolio usually allow only a 10-year or 15-year amortization—often with a balloon payment, resulting in a two-or-three-year maturity; then an extension is usually granted for two or three additional years, with another balloon payment; and so on.

A “subprime” borrower in Oklahoma who has sufficient income to qualify for the payment schedule required in a 10-to-15-year amortization is a better risk, and less likely to default, compared to a subprime borrower in some other state who needs “teaser rate” initial payments on a thirty-year mortgage just to be able to buy at home at all.

If Oklahoma banks have been originating “exotic” 30-year subprime loans of the types described above, it has probably only been for immediate resale to the secondary market.  Realistically, most “exotic” subprime loans in Oklahoma have been originated by mortgage brokers, not banks.

Currently, Oklahoma’s mortgage foreclosure rate is about half the national average, and only one-third to one-fourth of the rate being experienced in states that formerly had the biggest real estate “bubble.”  Oklahoma banks don’t seem to be experiencing any significant increase in foreclosures.

Because there is no shortage of housing or land in Oklahoma, home prices have remained fairly reasonable.  Most new buyers aren’t tempted by an “exotic” ARM.  It certainly isn’t a case of “no other way to afford a home.”  Nor would the average mortgage broker in Oklahoma strongly recommend these mortgages.  

Most “exotic” ARMs originated in Oklahoma are probably “refinance” lending, instead of home-purchase lending.  In taking out one of these loans, a borrower perhaps is trying to find a way to consolidate all of his bills into a much lower payment, or has been told that he can cash out equity from his home without increasing the resulting mortgage payment very much over the previous mortgage payment.  

Other parts of the country have a lot of “teaser rate” subprime mortgages that were originated in 2005 or 2006 and are now approaching a “reset date” for adjustment of the monthly payment to a much higher amount.  In Oklahoma we are probably not facing anything like the wave of foreclosures that may occur in other states when these subprime mortages reset. 

Oklahoma banks may not feel much direct impact from subprime mortgage foreclosures.  (In some cases, an Oklahoma bank will be affected only because it has another loan of some type to the same borrower—perhaps a credit card, a home equity line of credit, or a car loan.  Of course, when a subprime borrower experiences a drastic increase in mortgage payment at the “reset” date provided in his mortgage, his ability to service other debt will decrease significantly.) 

5. Refinancing: A Way Out?

The financially “stretched” subprime borrower who finds himself trapped in an escalating-payment mortgage will frantically look for a way to escape the greatly-increased payments after his subprime mortgage resets.  However, this individual may run up against several hard truths:

(1) If he had artificially low payments during the initial period of his mortgage (such as a “2/28” or “payment option” mortgage), any refinancing option available to him will require higher payments than he was paying before.

(2) Interest rates have risen somewhat over the past year, resulting in higher monthly payments required now to refinance a previously-originated, similar-sized mortgage.

(3) If a subprime borrower allows himself to become delinquent on his increased payments before he seeks refinancing, his delinquency may further hurt his credit and trap him in his existing mortgage. 

(4) The secondary market for resale of subprime mortgages to investors is drying up.  Even if a subprime borrower’s present payment history is considered satisfactory, he may be unable to refinance into any category of 30-year subprime mortgage loan today, simply because mortgage companies use warehousing lines of credit to fund and carry new mortgage loans before resale, and the lines of credit for many subprime mortgage lenders are being cancelled.

The ideal outcome would be for a payment-challenged subprime borrower to refinance into a fixed-rate, fully-amortizing mortgage, completely free from future payment adjustments. However, the payment amounts on a traditional thirty-year fixed-rate mortgage may not match the finances of a borrower accustomed to making artificially low “teaser” payments on a subprime mortgage. 

The FHA is apparently developing a mortgage “refinance” program targeted at subprime borrowers experiencing unaffordable “payment shock.”  This program will provide a forty-year, fully-amortizing mortgage—and will allow somewhat lower payments than a thirty-year mortgage.  However, some borrowers may be unable to afford the payments even under this option.  With decreases in property values and/or reverse amortization on the existing mortgage, some homes may not appraise high enough to allow refinancing.

An “interest-only” ARM is another possible approach to refinancing.  If even the payments on a 40-year mortgage are too much, the payments on an interest-only” ARM are one step cheaper.  Because an “interest-only” ARM allows “interest-only” payments for five to seven years, it buys the borrower some time, during which an increase in property values may change the borrower’s circumstances enough to provide a more attractive solution.

An “interest-only” ARM is not a complete answer to the “payment shock” problem, because even during the “interest-only” period the payments will increase if market interest rates rise; and at the end of the “interest-only” period, payments must increase further, by an amount necessary to start amortizing the principal balance.  

Interagency Guidance on Subprime Mortgages

The interagency “Statement on Subprime Mortgage Lending,” issued by the OCC, FDIC, Federal Reserve, OTS and NCUA, is no doubt just the first in a series of policy statements, revised regulations, and changed laws that we are likely to see in the next year or two, addressing the “subprime mortgage” problem.

The interagency statement applies to “subprime borrowers,” and focuses specifically on provisions of adjustable-rate mortgages (ARMs) that cause “payment shock,” or otherwise increase the subprime borrower’s risk of default.

The regulatory agencies are particularly concerned about subprime borrowers who (1) may not be adequately informed of the risks and consequences of their loans, and (2) may not have financial capacity to make greatly increased monthly payments that are required after their loans adjust at a “reset” date.

I will discuss the interagency statement’s provisions in more detail.

1. Statement’s Coverage

The interagency statement applies to all types of regulated financial institutions—banks, S & L’s and credit unions—as well as holding companies and any subsidiary (such as a mortgage company) that is owned by either a financial institution or its holding company.

The statement will not apply to mortgage companies and mortgage brokers unless they are owned by a financial institution or its holding company.  (These agencies’ authority only extends so far, limited by statute.)

However, the Conference of State Bank Supervisors (CSBS) and American Association of Residential Mortgage Regulators (AARMR) intend to issue a parallel statement for use with state-regulated mortgage companies—a step that will take us closer to uniform standards for all subprime lenders. 

2. What is “Subprime”?

Although the interagency statement does not define “subprime,” it references the subprime borrower characteristics outlined in the 2001 Expanded Guidance for Subprime Lending Programs. That guidance states, “Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or . . . incomplete credit histories.” 

The 2001 guidance further notes that subprime borrowers may have one or more of the following risk characteristics:

• Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months;
• Judgment, foreclosure, repossession, or charge-off in the prior 24 months;
• Bankruptcy in the last 5 years;
• Relatively high default probability (for example, FICO of 660 or below), depending on the collateral; or
• Debt-service-to-income ratio of 50% or higher, or otherwise limited ability to cover family living expenses after deducting debt-service from income.

“Subprime lending” is a category describing the borrower’s status.  The regulators do not start with any presumption that subprime lending is predatory.

3. Substantial Risk Factors

ARMs offered to subprime borrowers involve “substantial risk” for both consumers and lenders if they have one or more of the following features:

• Low initial payments based on a fixed introductory interest rate that expires after a short period, and then switches to a fully indexed adjustable rate for the remainder of the loan.  (Example: “2/28” mortgages.) 
• Very high or no caps on how much the payment amount or interest rate can increase on reset dates.
• Limited or no documentation of borrower’s income.
• Product features likely to result in frequent refinancing to maintain an affordable monthly payment.
• Substantial prepayment penalties, and/or prepayment penalties extending beyond the initial fixed interest rate period.

Risks are increased if the borrower is not adequately informed of such provisions and the possible negative effects on the borrower.  Ideally, a lender should clearly emphasize the possible negative effects that any of these provisions may have on the borrower.  Mortgage brokers tend not to highlight loan provisions that would cause the borrower to turn away from the transaction, but regulators want the borrower to have this information.

Banks occasionally engage in some of the practices just listed:

(1) On a home equity line of credit (HELOC), banks might offer an artificially low introductory interest rate as a marketing gimmick.  This normally is aimed at prime borrowers.  Rarely would a “teaser rate” on a HELOC be marketed to subprime borrowers who can’t afford the “real” higher interest rate.  Hopefully a bank’s underwriting would eliminate someone who can’t afford the payments after the mortgage adjusts to a normal market rate.  Occasionally, a borrower who is classified as “subprime” based on credit history has lots of income currently. To be safe, a bank may want to be extra-careful to emphasize the interest-rate-adjustment provisions to this “subprime” borrower.

(2)  Some banks originate adjustable first-mortgage ARMs for their own portfolio, or for sale into the secondary market.  Either way, some borrowers could be subprime.  More commonly, banks originate HELOCs—some to subprime borrowers–and these, also, are technically ARMs.

Interest-adjustment or payment-adjustment provisions can vary widely from one type of ARM to another.  Some ARMs (especially those intended for sale to the secondary market) may state that the interest rate cannot adjust upward by more than 1% annually, or more than a total of 5% or 6% over the life of the loan.  Other ARMs simply provide that they will adjust on the “reset” dates in accordance with a formula, with no limitation on how large that interest-rate adjustment can be.  There also may be no aggregate total amount by which the interest rate can increase over the life of the loan, except that the rate cannot exceed the maximum interest rate allowed by law.

  In this statement the regulatory agencies take the position that without reasonable limits on the maximum possible interest rate adjustment per year, and on the total possible upward adjustments over the life of the mortgage, a loan is a “substantial risk” for the subprime borrower.  A bank should be particularly carefully that the subprime borrower understands the possible impact of large interest-rate adjustments under the loan.

(3)  Banks sometimes advertise “no closing costs”–particularly for a HELOC.  Out-of-pocket costs are paid by the bank (such as for an appraisal, credit report, title insurance, flood certification, termite inspection and filing fees), with the bank hoping to earn back these fees through interest received.  

With a “no closing costs” loan, the lender doesn’t want to see the borrower refinance it almost immediately with some other lender.  Lenders sometimes impose a pre-payment penalty, in a dollar amount approximately equal to the absorbed “closing costs.”  This prepayment penalty often applies only for six months or one year.

Under the interagency guidance, if the prepayment penalty period extends past the first interest-adjustment date, the ARM is considered “risky” for a subprime borrower.  If the first rate adjustment occurs in one year, the prepayment penalty period could be almost one year; of if the rate adjustment occurs every six months, the prepayment penalty period could be almost six months.  If the interest rate on the ARM can adjust as often as monthly, a prepayment penalty period lasting more than one month after origination would apparently be “risky” for a subprime borrower.

There are several possible approaches to this problem:  (a) The lender can strongly warn the subprime borrower that the loan is considered “risky” because of the prepayment penalty;  (b) the bank can limit its “no closing cost” loan (with prepayment penalty) to borrowers with a credit score that is above subprime (for example, over  660); or (c) the bank can absorb the closing costs but not include any prepayment penalty provision on subprime mortgages, on the basis that these borrowers are the least likely to prepay quickly (or at all). 

4. Balloon Payments?

Another “substantial risk” for subprime borrowers, as listed above, is “product features likely to result in frequent refinancings to maintain an affordable monthly payment.”  This broad language would seem at first glance clearly to clearly to include any mortgage with a balloon payment.  What is a balloon payment except a “really large” increased payment that forces the borrower to refinance?

However, it is important to make the distinction that Oklahoma banks’ long-standing practice has been to issue fixed-rate mortgages with balloon payments,not ARMs.  For the moment, at least, fixed-rate mortgages with balloon payments are not covered by the interagency statement, and have not yet been formally defined as a “risky” feature for the subprime borrower.

Expanding upon the same logic used in the interagency statement, I would argue that any subprime mortgage with a balloon payment provision is somewhat “risky” from the borrower’s perspective, and especially so in the current lending environment. A subprime borrower will certainly be told that his mortgage provides for a balloon payment, but I doubt that many lenders will stress how much risk the borrower will have if the lender decides not to extend the loan at the balloon payment date.

The subprime borrower badly needs to be able to continue to amortize the debt in monthly installments, but the nature of a balloon payment loan is that the lender retains the right to “pull the plug” on the borrower at the balloon payment date if the borrower’s condition is not satisfactory.

It may be desirable to give clear warning that any mortgage with a balloon payment provision can be “risky” for the subprime borrower. Even if a bank offers no other mortgage product, it’s useful to give this disclosure.  

5. Consumer Protection Principles

The interagency statement also sets out some “fundamental consumer protection principles”:

• Loans should be approved based on the borrower’s ability to repay the loan according to its terms.
• Consumers should be given disclosures of the material costs, terms, features and risks of loan products, and at a time that will help them to select a product.  (Mortgage product descriptions and advertisements should provide this information.)  Consumers should get clear and balanced information concerning the relative benefits and risks of the products. They should not be steered to certain products without being informed of other products for which they may qualify.

As applicable, consumers should be informed of (1) the risk of “payment shock” (potential payment increases, how the new payment will be calculated, and when the introductory fixed rate expires); (2) prepayment penalties (how they will be calculated and when they may be imposed); (3) balloon payments; (4) and the lack of escrow for taxes and insurance (warning that these expenses are not included in the mortgage payment and may be substantial). The regulators are working on some sample disclosure language.

• Prepayment penalties should not be applied after the first interest-reset date under the mortgage.  Generally, consumers should have a reasonable period of at least 60 days prior to the first reset date to refinance without penalty.  (Existing mortgages are excluded from this provision.)

6.  Underwriting Standards

The regulatory agencies’ Real Estate Guidelines already provide that prudent underwriting of real estate loans includes evaluating the capacity of the borrower to service the debt.  The interagency statement clarifies that a borrower’s “repayment capacity” includes an evaluation of the borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. 

As some examples, if a mortgage has a discounted interest rate for an introductory period, or the first few years’ payments are “interest only,” the borrower’s repayment capacity should not be evaluated based just on these initial payments, but rather based on “full” payments that will be required later. (Some mortgage brokers in areas with high real estate prices have been “fudging” by considering only the buyer’s ability to make the artificially cheap payments required during an initial period.)

The regulators also make clear that in evaluating a borrower’s repayment capacity based on a “debt-to-income (DTI) ratio,” all of the borrower’s monthly housing-related payments (principal, interest, taxes and insurance) should be included in the “debt” portion of the ratio.  Apparently, by not adding non-escrowed taxes and insurance to the borrower’s mortgage payment, some mortgage brokers have qualified the borrower for a higher mortgage amount. The interagency statement halts this practice.  (In states with home prices much higher than in Oklahoma, taxes and insurance can be several times as much.)

The interagency statement also addresses “risk layering features”—reduced documentation loans and simultaneous second-lien mortgages.  Lenders should verify and document a subprime borrower’s income (both source and amount), assets and liabilities, due to the elevated credit risk presented by this type of borrower.Although some lenders have been originating “reduced documentation” loans or “stated income” loans (without verification of income) for subprime borrowers, the interagency statement rejects originating these as subprime products, in the absence of carefully documented “mitigating factors” that reduce a lender’s risk.

A “simultaneous second-lien mortgage” refers to the practice of originating a first mortgage to the subprime borrower, such as at an 80% loan-to-value ratio that avoids the requirement to obtain mortgage insurance, while also making a second-mortgage loan (HELOC) at the same time, instead of requiring an actual down-payment. For subprime borrowers, the regulators strongly criticize this practice, absent special “mitigating factors.”

 (By originating a simultaneous second mortgage, the lender undercuts the underwriting standard for the first-mortgage product.  The lender ends up with a borrower who can’t afford a down-payment; there is no equity to cushion the loan in the event of foreclosure; and the borrower may be more likely to walk away, not having any equity of his own at stake.)

7. Control Systems

Lenders should develop strong control systems to make sure that actual subprime lending practices line up with policies and procedures.

This process includes complying with regulatory requirements and giving proper consumer disclosures.  It requires appropriate criteria for hiring and training loan personnel, and for entering into relationships with third parties, such as agents or loan brokers.

There must be adequate monitoring of the lender’s own personnel, and also of third parties such as mortgage brokers or correspondents who take applications or originate mortgages on the lender’s behalf.

Compensation programs should not provide incentives to originate loans inconsistent with sound underwriting and consumer protection principles.  Consumers should not be steered into less-appropriate products because of higher compensation levels for employees, brokers, and correspondents originating these particular products.