Must Mortgages Be “Suitable” For Borrowers?
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How come we have so many toxic loans?
“The system is out of balance,” says Sen. Chris Dodd (D-CT), “There is a chain of responsibility that makes these abusive loans possible.”
The way Washington works is that you have to read between the lines. Notice that Dodd’s core concern is not “predatory” loans or even “subprime” mortgages. The bigger issue — the one that impacts more households and more voters — are “abusive” mortgages, a potentially huge and important matter in every state.
Dodd says he does “not believe that all subprime or exotic lending is predatory or abusive. To the contrary, subprime credit can be a valuable tool in helping people become homeowners, and in unlocking the equity in their homes.”
But Dodd does wonder why so many people have faced foreclosure in recent years.
“I understand that many argue that the impact of the economy and other ‘life events’ such as illness, job loss, divorce, and the like, are the key variables in determining mortgage delinquencies and foreclosures,” he says.
“No doubt this is true,” he continued. “But those economic and personal factors do not fully explain the precipitous rise in defaults and foreclosures. It is time for the Congress, the Administration, and the lending industry to face up to the fact that predatory and irresponsible lending practices are creating a crisis for millions of American homeowners at a time when general economic trends are good.”
“Predatory” lending practices we understand — these are loans with unfair and unconscionable rates and terms. In many cases, predatory mortgages are “loan-to-own” financing where the lender hopes the borrower will be foreclosed. Such lenders are actually engaged in the “encouragement of default,” a process entirely at odds with the objectives of any ethical lender.
“Irresponsible lending practices,” on the other hand, are a much more interesting subject. What does such a term mean?
As Dodd explains, “the problem is, most of these loans are perfectly legal, even as they do real harm to borrowers and neighborhoods.” In other words, some of the very loans you can get today are not “predatory” in the traditional sense, but they are abusive in other ways.
Dodd does not mention the term “suitability” in his statement, but that’s really the issue. Should lenders be required to meet a “suitability” standard before granting a loan?
Lenders argue that suitability standards are actually in place — the underwriting guidelines they use concerning credit, debt, income and assets. Speaking before Congress last week, Douglas G. Duncan, Senior Vice President with the Mortgage Bankers Association, said “the data does not show that unsuitable products or predatory lending are the cause of delinquencies and foreclosures. The foreclosure problem is based on economic difficulties that confront borrowers.”
But if it’s true that the economy is expanding, income is up and the job base is growing, then why has there been such a dramatic increase in foreclosures? According to RealtyTrac.com, foreclosures topped 1.2 million units in 2006, up 42 percent from 2005.
By any standard, one of the “economic difficulties that confront borrowers” is nothing other than rising monthly mortgage payments.
Indeed, says Dodd, “Mark Zandi, Chief Economist at Moody’s Economist.com, notes that the current high delinquency rates are unusual because the economy is relatively strong. Zandi attributes the increasing delinquencies, in part, to the resetting of subprime and other ARMs at higher rates. This is particularly worrisome given the fact that about $600 billion in ARMs will reset this year.”
The worry for lenders is that a suitability standard will create new problems. First, “rigid” guidelines will cause fewer loans to be issued, thus reducing volume and profits. Second, what’s “suitable” to Jones may be unsuitable to Smith, meaning that lenders may have significant liabilities when turning down borrowers if they cannot plainly justify underwriting decisions.
Alternatively, we have in place a system where we allow lawful loans that produce curious results. Dodd raises these points:
- Over half of subprime mortgages are stated-income loans, loans which the industry often refers to as “liars loans.” The question is, who’s lying? According to a survey of over 2,000 mortgage brokers, 43% of brokers who make these loans do so because they know that their borrowers don’t have the income to qualify for the loan. Why do they make these loans? Because they are paid more to do so.
- Brokers “upsell” borrowers. That is, they put borrowers in loans with higher interest rates than they could otherwise qualify for, because the brokers make greater commissions, called “yield spread premiums,” by doing so. YSPs are a perfectly legitimate tool to provide borrowers with no closing cost loans. But HUD has told us that half of the YSPs paid, about $7.5 billion, do not go to closing costs, but go simply to increase broker profits.
- Minority borrowers are being targeted for higher cost subprime mortgages, regardless of their financial health. The 2005 Home Mortgage Disclosure Act (HMDA) data show that over half of African-American borrowers and 46% of Hispanic borrowers were given high cost subprime loans. By comparison, only 17% of whites took out such loans. Yet, according to the Federal Reserve, borrower-related characteristics such as income could explain only about 20% of this disturbing difference
- About 70% of subprime loans have costly prepayment penalties that trap borrowers in high cost mortgages, mortgages that strip wealth rather than build it, and these penalties keep borrowers from shopping for a better deal. Unfortunately, living in a minority neighborhood puts a homeowner at significantly higher risk of having a prepayment penalty.
- Approximately 8 in 10 subprime loans today are 2/28 adjustable rate mortgages, mortgages whose monthly payments will spike up by as much as 30% to 50% or more. Many of the borrowers who take these loans — unaware of the payment shocks that await them — have no prospects of being able to make the higher payments, and are forced to refinance the loan, if they have sufficient equity to do so. Each refinance generates new fees for the lenders and brokers, and strips more equity from the homeowner. One lender, in discussions with my office, called subprime 2/28 loans “foreclosure loans.”
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“When it comes to real estate financing we don’t want mortgages which promise ownership today but result in foreclosure tomorrow,” says Jim Saccacio, RealtyTrac’s Chairman and CEO. “Both our borrowers and lenders have a stake in making the system better and more secure, and so do our neighbors and communities.”
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Published originally by RealtyTrac.com during February 2007 and posted with permission.
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