Subprime lending: Abuse as usual

NEW YORK (CNNMoney.com) -- It would appear that subprime lenders have yet to learn from their mistakes. According to a consumer advocate group, abuses persist industry wide, despite the recent subprime mortgage meltdown.

At a Senate subcommittee hearing on ending mortgage abuse this week, the Center for Responsible Lending (CRL) presented its findings on subprime loans included in 10 recent packages of mortgage backed securities.

"A lot of the terms that make these loans so dangerous are still being used," said Keith Ernst, CRL's senior policy counsel. "We had been told that these things are going away."

More than three quarters of the subprime loans CRL looked at turned out to be adjustable rate mortgages (ARMs). 90 percent of those were hybrid ARMs - otherwise known as "exploding" ARMs.

Hybrid ARMs have two- or three-year periods of cheap, low-interest, fixed-rate payments, or "teaser rates." But after two years, the loans reset at much steeper rates, which can prove fatal for homeowners who can't handle the higher payments.

On a $200,000 loan with a teaser rate of 5 percent, for example, borrowers would pay about $1,074 a month. At reset, the interest rate could jump to 8 percent, adding nearly $400 to payments, which could continue to increase every six months.

CRL also found that more than two thirds of the subprime loans it looked at contained prepayment penalties. By charging borrowers up to six months of mortgage payments to retire mortgages, prepayment penalties lock borrowers into onerous loans by making it very expensive to refinance out of them and into a lower-rate fixed rate mortgage.

CRL also uncovered many "liar loans," which don't require proof of earnings, assets or both.

During the last housing boom, increased home equity insulated lenders and borrowers from the worst impacts of these loans. Your loan reset and you could no longer afford the payments, but your property value had risen 50 percent, so you could just skim off some of that increased equity with a cash-out refinancing.

And if lenders were ever forced to actually take back a property through foreclosure, the increased equity would make it worth their while.

"Foreclosure is a product of the cycle [of high price appreciation and tapping equity] that allowed the subprime market to balloon and that cycle now has been broken," said Ernst.

But why should lenders continue to offer subprime loans when they've proven so dangerous?

According to Doug Duncan, chief economist for the Mortgage Bankers Association, troubled lenders are aggressively making new loans for an infusion of cash.

"They're gambling," said Ernst, "doubling down and that's a recipe for disaster."

But not everyone at the Senate hearing agreed with the CRL. Anthony Yezer, an economics professor at George Washington University, expressed little regard for its findings.

"As an academic economist I really pay attention to literature in peer-reviewed academic journals," he said. "This doesn't have much credibility."

But Yezer did say that consumers have been careless in making some of their most important financial decisions. "It's tough to protect people who won't shop," he said. "They just go to a lender and ask for a mortgage."

Steve Habetz, a mortgage broker with Threshold Finance in Connecticut, agreed that many abusive practices persist but some progress has been made.

Fannie Mae and Freddie Mac, the government-sponsored enterprises that buy loans in the secondary market have said they will not buy any hybrid ARM loans unless the originators have tied their underwriting approvals to the ability of borrowers to pay at fully indexed rates.

Despite the contentions, Calhoun said that most of the recent loans CRL examined are only underwritten to the low, teaser rates.

But with subprimes, "People are still pushing these things," Habetz conceded, blaming a lack of professionalism among some brokers. "There are not a lot of barriers to entry."

There's no national registry and many states require little beyond registration. Bad brokers can go from place to place leaving a trail of foreclosures and ruined credit behind. What should be done to prevent abuse is less clear.

"Anybody can talk about anecdotes," Yezer said, "but major regulatory depositors [lenders] have all sorts of checks on rogue brokers, run fair lending exams and steer subprime borrowers into prime loans - away from subprime - if they qualify."

He's more concerned that any legislation enacted as a result of the subprime crisis could make things worse.

"It is important to recognize that the vast majority of borrowers have used subprime credit successfully and regulations that would deny them access to mortgage credit could force them to use higher cost sources," he said.

(Correction: An earlier version of this story incorrectly stated the name of CRL's CRL's senior policy chair as Armstrong, not Ernst.)