Risky home loan standards tightening
Federal regulators proposed guidance to make it harder to qualify for exotic home loans.
By Shaheen Pasha, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) - Attention homebuyers: getting approved for those popular non-traditional mortgages may be a lot more difficult in the near future.

Federal banking regulators recently proposed guidance to mortgage providers that urges lenders to assess a borrower's ability to repay interest-only and option adjustable rate mortgages -- products that have increasingly been used by homebuyers as a means of affording homes that may otherwise be out of reach.

Of the different payment options for homeowners each month, two options have raised the most concern. Those who opt for interest-only loans just pay the monthly minimum, but those payments aren't applied towards their principal. Another option is to pay less interest than what accrues on the loan which results in a lower monthly payment too but can lead to homeowners owing more than they originally borrowed, also known as negative amortization.

An affordability tool

Regulators worry that the popularity of these exotic mortgages may result in consumers defaulting on their loans once the typical three to five-year honeymoon period is over for borrowers, and mortgage payments can double to reflect a rise in interest rates. And they hold the lenders responsible for marketing these products to those that may not be able to afford them.

"Increasingly, they are being mass marketed as affordability products to borrowers," John Dugan, the head of the Office of the Comptroller of Currency, which regulates financial institutions, said in a recent speech before the Consumer Federation of America. "The fundamental problem with payment option ARMs, other than the growing principal balance due to negative amortization, is payment shock."

According to the new Option ARM standards, banks should make it clear to consumers that although certain loans offer small monthly payments, they may result in negative amortization after the introductory period. And that loan balance could be subject to higher interest rates after the introductory period in their loan.

Banks also must make it clear in their own accounting that certain nontraditional mortgage loans are untested and could require them to boost capital reserves to protect against loan losses. Boosting capital reserves could restrict total lending, resulting in more limited availability of these mortgages.

Letting the air out of the bubble

If banks can't lend to as many people as they now do analysts expect this will contribute to a slowdown in the housing market.

"Right now these loans are ubiquitous but if banks are going to have to tighten their standards, the loans will become a smaller share of the market," said Andy Laperriere, managing director at ISI Group, a research firm. "It will have a meaningful impact on the housing market."

Laperriere said over 40 percent of the homes purchased in 2005 were financed by either option ARMs or interest-only loans as an increasing number of homebuyers found themselves priced out of the marketplace.

According to data from the Office of Federal Housing Enterprise Oversight, the average U.S. home price rose 12.2 percent year-over-year as of Sept. 30 and prices climbed 2.86 percent from the second quarter. (Click here for more on that story.)

Laperriere said the housing market, which is already showing some signs of cooling, may be further impacted if consumers are unable to use exotic mortgages to finance their homes.

Barbara Ryan, associate director at the division of insurance and research at the FDIC, however, was cautious about making the leap. She said if a large percentage of mortgage lenders were underwriting mortgages in a careless manner, then the new guidance could reduce interest in these loans.

But if real estate prices slow down or soften -- due in part to the new regulation -- that could also have a negative financial impact on those consumers that already used these products to purchase a home and were banking on selling their property or refinancing it before the end of their honeymoon period, experts said.

"These borrowers could face the bleak prospect of loan balances that exceed the value of the underlying properties," said the OCC's Dugan said in his speech. "In that case, selling the property or refinancing the loan would not be a viable escape valve for avoiding huge payment shocks."

Waiting for comment

The banking industry has 60-days to comment on the proposed standards.

But Washington Mutual (Research), one of the largest providers of exotic mortgage products, had already taken steps to tighten its standards before the guidance was proposed.

The company raised its starter rate for option ARMs to 1.375 percent from 1.25 percent in October and said it will continue to evaluate changes to the initial rate., said company spokeswoman Sara Gaugl.

"Detailed disclosures are made to customers to ensure an understanding of the payment options at the inception of the loan and potential adjustments throughout the life of the loan," she said. "The option ARM product is not the right mortgage product for every customer. It can, however, provide financial flexibility for the right customers."

Until a few years ago, interest-only loans were primarily offered to consumers who purchased homes as investments and wanted to preserve their cash flow, or for people who earned most of their income from one-time bonuses.

In the last two years, with mortgage lenders offering low teaser rates and so-called "no-doc" loans that don't require an income check, the market for these loans has shifted from affluent homebuyers to the middle-class buyer seeking more affordable payment options.

"We're glad to see the agencies address this issue because the switch to higher risk mortgage lending has been quite dramatic," said Allen Fishbein, director of housing and credit policy at Consumer Federation of America. "A mortgage is not just about consumers being able to buy a home but being able to actually stay in the home that they purchased."

Fishbein said he was surprised that regulators had issued a 60-day comment period before enforcing the guidance and he was interested in hearing what the banking industry will say.

"The challenge is to balance more prudent policies but not be so restrictive that consumers that understand the risk and benefits can't still obtain these loans," he said.


Mortgage rates ticked lower with the new year. Find outmore here.

What are the most overvalued housing markets? Click here for that story. Top of page

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