Rex Nutting,
MarketWatch
More than a year after Alan Greenspan warned of the "potential for individual disaster" from a new breed of mortgages that were helping to fuel the housing boom, federal regulators finally are trying to do something about it.
On Friday, in a jointly crafted message on so-called exotic mortgages, multiple government agencies warned banks in strong terms to make sure borrowers can pay back the full amount of what they borrow and that homeowners know that a low monthly payment today could be shockingly high later.
America's real-estate boom may be over now, but millions of homeowners who thought they were borrowing their way into wealth find themselves instead holding a ticking time bomb, a toxic mortgage with a potential payment far larger than they can afford.
Bank regulators knew more than a year ago that lenders were aggressively marketing interest-only and payment-option adjustable-rate mortgages to consumers who didn't fully understand what they were buying. In July 2005, several government agencies teamed up to write guidelines intended to set lenders straight.
In the meantime, the runaway writing of these mortgages went on unchecked, and the fact that nobody in government stood in the way highlights the fact that a patchwork of government bureaucracies was ill-equipped to bring the practice under control, lawmakers and regulators say.
Policing new mortgage products that skate close to the edge of what's legal is no easy task, because it's not the responsibility of any one agency in Washington. The regulatory void took time to fill, as the Office of the Comptroller of the Currency tried to get four other federal agencies to unanimously endorse the guidelines that went into effect Friday.
"We saw the potential for problems occurring," said John Dugan, the comptroller of the currency, a Treasury Department unit that regulates nationally chartered banks. "There have been some very abusive problems" by institutions not covered by the guidelines. "We just don't have jurisdiction," Dugan added, expressing hope that state regulators would follow with strong guidelines soon.
economic cycles and are fundamentally sound loan products," Countrywide wrote in its official comment on the proposed guidelines. Requiring lenders to qualify borrowers on the true cost of a loan, the company said, "would tend to defeat the intended function of the loan and would significantly reduce the number of borrowers that could qualify."
While Dugan's group wrangled among themselves and with the industry about how to word their warning, the popularity of the mortgages exploded, particularly in the booming subprime market that targets borrowers with lower credit ratings who are generally less sophisticated. The subprime market is largely outside the jurisdiction of federal regulators.
About one-third of the mortgages sold in the last year were devised to minimize the initial monthly payment to make it seem as if buyers could afford a more expensive home.
The cost of that Mephistophelian bargain comes later, when the monthly payment is reset to cover all the deferred interest charges, plus, in some cases, the extra principal.
Banking industry officials are quick to defend exotic mortgages as financial innovations that have enabled more people to be homeowners even when prices were soaring.
Countrywide Financial, the nation's largest residential mortgage lender, argued against new rules. "Interest-only and payment option adjustable mortgages have been tested in previous
Collateral-dependent loans
In some instances, according to regulators, the lenders knew that the only way the loan could be repaid was to either refinance or sell the home. Such "collateral-dependent" loans fit the classic definition of unfair and deceptive lending practices under federal consumer protection laws, the regulators reminded lenders on Friday.
Studies show that a large number of borrowers with simple ARMs don't understand the terms and underestimate the amount their mortgage payment could rise. Nontraditional ARMs are even more complex.
The housing credit bubble led to the growth of exotic loans, which, in a vicious spiral, drove prices even higher, said one observer. In a bubble, "the financing gets progressively worse. At the end, you get nuttiness," said Dean Baker, an economist for the Center for Economic and Policy Research, a Washington think tank.
Finally, prices got so high that "the only way people could buy houses was by bending the rules," said Baker, who's been warning about the real-estate bubble for years.
In the Orwellian parlance of the mortgage industry, loans that ignore the true ability of the borrower to pay for the loan are called "affordability" products.
Most of the exotic loans have low introductory interest rates that ultimately adjust to market rates, usually after two years. Some loans require that only the interest be paid, putting off the day when the borrower must start to pay down the principal. Some of the loans allow borrowers to make a monthly payment that doesn't even cover the interest, resulting in a negative amortization when the unpaid interest charges are added to the principal.
And most of such loans sold in the subprime market have large prepayment penalties that make it expensive to refinance.
As long as house prices are rising and interest rates stay low, borrowers can always refinance an exotic mortgage when the interest rate resets. But now, with housing prices flattening out, many buyers will find they don't have enough equity in their homes to refinance, and it may be difficult to find someone who's willing to take the house off their hands at the inflated price they paid. Their only option could be foreclosure.
The payment shock can be extreme even if interest rates do not rise. For example, Sandra Thompson, acting director of supervision for the Federal Deposit Insurance Corp., told senators recently that the monthly payment on a $200,000 option ARM could rise from $643 in the first year to $1,578 by the sixth year. And the unpaid principal would rise from $200,000 to $214,857.
Exotic mortgages are most popular in the metropolitan areas that saw the biggest price gains from 2003 through 2005. They allowed ordinary families to bid up the prices of ordinary homes to nearly $400,000 in Miami; nearly $500,000 in Bridgeport, Conn.; $600,000 in Orange County, Calif., and more than $700,000 in San Jose and San Francisco.
And the loans helped homeowners to convert about $2 trillion in home equity into cash since 2002, a major boost to consumer spending.
The government's newly issued guidelines suggest that lenders refrain from layering risks, such as accepting reduced documentation on income and assets, or selling simultaneous second mortgages on top of an exotic mortgage. The regulators suggest that negative amortization loans not be sold to buyers with little or no down payment.
Under current conditions, lenders are showing no signs of slowing down their marketing methods -- and may even be stepping up their efforts while they're still allowed. The most recent survey of senior loan officers at banks showed that most were still loosening their standards for mortgage lending as the second quarter ended.
Brokers
The regulators say the risks in exotic loans are manageable.
Manageable for the lenders, that is. Federal regulators' main concern is the security and soundness of the banking system; they are not primarily concerned with the security and soundness of borrowers.
Consumer advocates fear the government's guidelines have come too late to protect millions of homebuyers who have been lured into buying houses they can't afford. They say the Federal Reserve in particular should have stepped in much earlier to stop the spread of predatory lending that could ruin lives, devastate communities and unleash a wider economic ripple effect.
In a sense, the new federal guidelines overlook the biggest part of the problem. The majority of residential mortgages are no longer originated in federal and state regulated savings and loans, but by mortgage brokers and state licensed lenders, according to Felecia Rotellini, an Arizona state official who represents the Conference of State Bank Supervisors.
At the same time, Washington's guidelines could hurt some businesses at the expense of others.
"The guidelines will likely have a chilling effect on option ARM lending at regulated institutions," said Frederick Cannon, a banking analyst for Keefe, Bruyette & Woods. However, unregulated lenders such as investment banks and real estate investment trusts, could have a competitive advantage because they aren't covered by the new federal guidelines, he said.
Some members of Congress say the guidelines may not go far enough.
"Further steps may be necessary by federal and state regulators to ensure borrowers understand what they're getting into when they sign up for one of these mortgages," Sen. Jim Bunning, R-Ky., said at a recent hearing.
Sen. Paul Sarbanes, D-Md., the ranking Democrat on the banking committee, agreed it will take more than just issuing a warning to lenders. "It's not the final step, but it's a good start," Sarbanes said.
A patchwork federal and state regulatory system monitors financial firms, depending on ownership and organizational structure, not upon the services they provide.
Many overseers
To a consumer, a bank is a bank. But five separate federal agencies regulate banks -- the Fed, the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Office of Trust Supervision, and the National Credit Union Administration. State-chartered banks are regulated by agencies in their home state.
And there are other companies selling mortgages that are unregulated or that fall under state regulation.
The federal agencies try to issue consistent rules, to make sure that one part of the industry doesn't end up with a regulatory advantage over another. An umbrella group of state regulators has promised to issue similar rules on exotic mortgages to cover companies not under federal supervision.
The regulators face conflicting goals. They want to ensure the safety of the banking system without intervening too much in decisions about what products and services to offer. Protecting consumers from unfair and deceptive lenders is another goal that may be at odds with yet another goal: Increasing homeownership in the United States.
Finally, regulators have to be wary of overregulation. "You heap disclosure upon disclosure, and at some point they have negative consequences," said Ned Gramlich, a former Fed governor who's now a senior fellow at the Urban Institute specializing in credit for low-income households.
Federal regulators say they don't want to stifle innovation in financial services, especially for new products that make the American dream of owning a home a reality for many families.
"We tell them to be careful, but we let them run their businesses," Gramlich said.
But the regulators also defend their turf with vengeance. When New York Attorney General Eliot Spitzer wanted to investigate national banks' lending practices in the African-American community, he was told to mind his own business.
While the Fed shares the responsibility for bank supervision with many other agencies, federal truth-in-lending laws give the Federal Reserve in particular the responsibility of ensuring that no lender of any kind engages in unfair or deceptive lending practices.
Gramlich said the Fed has used most of its authority under Regulation Z to rein in unscrupulous lenders, but Dean Baker of the Center for Economic and Policy Research charges that the Fed has hesitated to declare some of the current practices to be "unfair and deceptive."
By contrast, Baker says, the Fed wasn't shy about extending its authority into a new realm when needed to protect investors, such as the stock market crash of 1987 or the hedge-fund collapse in 1998.
Once upon a time, mortgage lending was as staid a business as you could find. Bankers offered 30-year fixed mortgages to borrowers who had a 20% down payment and sufficient income to make the monthly payments. They would reject any loan that required a payment more than 29% of a buyers' gross income or that would result in total debt service higher than 36% of gross income.
Those stringent standards kept a third of American families renting. Gradually, the industry began offering mortgages to families that didn't previously qualify. Adjustable-rate loans, balloon loans, second mortgages and other innovations allowed more people to buy. Today, a near-record 68.7% of U.S. homes are owner-occupied, up from 63% in the early 1960s.
Since 2000, the pace of change has intensified, contributing to an unprecedented housing boom. First, the growth of the secondary mortgage-backed securities market has meant that the risks of default or prepayment are being shunted away from the lender to others, such as pension funds or hedge funds, where potential losses are of no concern to federal banking supervisors.
Second, the subprime market has exploded, rising from under 9% of the market in 2003 to more than 20% today.
Third, competitive pressures have driven even the stodgiest and most conservative bankers into the embrace of exotic mortgages. The top lenders for interest-only loans include such old-line companies as Wells Fargo, Lehman Bros., Citigroup and Bank of America.
'Moral dilemma'
"At a time of a speculative boom in real estate, market participants find themselves in a moral dilemma: lenders cannot easily maintain their high lending standards and stay competitive when other lenders are weakening standards," said Robert Shiller, an economics professor at Yale who's become known as an expert on financial bubbles. "At this time, regulators of lending institutions have some of their most important work to do, and, at the same time, it is especially difficult for them to do it."
People who borrow large sums of money are expected to know what they are doing, just as they are expected to shop carefully for milk, gas and shoes. However, federal law recognizes that buying credit is fundamentally more complicated than noticing which gas station has the lowest prices. For most people, sums like $100,000 or $500,000 are so far out of the scope of daily transactions that they might as well be $1 trillion.
So home buyers rely on professionals to advise them, to tell them what products are best for their circumstances, what they can afford. "That creates an agency problem," said economist Dean Baker. The person you've hired to take care of your interests, Baker says, might have interests of his own that conflict with yours.
Such as a mortgage loan officer.
The mortgage broker has information and methods unavailable to the home buyer. The approval process is a black box, Baker said. The broker knows the credit score of the buyer, but the buyer doesn't. The broker knows how the ARM payment will reset over time, but the buyer doesn't.
And that's assuming good will. If the broker is trying to be deceptive, it's easy to mislead a buyer.
Increasingly, loans are sold, not on the basis of the final cost, but on the initial payment. The approval process in many cases begins by having the buyer state how much she can pay as an initial monthly payment.
Although the regulators have finally taken a tough stance against the most aggressive marketing of exotic loans, it may be the market that finally reins them in.
Such loans only make sense to most buyers if they think can build equity from rising house prices. But prices have flattened out and probably will decline in many areas. Few buyers will stretch their ability to pay for a home when they know they can just wait for lower prices.
"The mortgage market works, and the data demonstrate that fact," said Robert Broeksmit, a top official in the Mortgage Bankers Association, in recent testimony before lawmakers. "The market is serving more borrowers who are benefiting today from unparalleled choices and competition resulting in lower prices and greater opportunities than ever before to build the wealth and well-being that home ownership brings to our families and communities." 
