Adjustable rate mortgage loans, which have built in interest rate increases and increased payments, are becoming more and more widespread, especially among borrowers with poor credit histories, raising questions about how and why these loans spread so quickly. Recent evidence suggests lenders have done little to assess a borrower’s ability to pay over the life of the loan by underwriting to the fully-indexed rate, but have instead, assessed a borrower’s ability to pay during the initial introductory teaser rate. While underwriting for the length of the loan sounds like basic common sense, it has not been standard practice in the subprime mortgage market.
Earlier today, however, federal financial regulatory agencies released a new round of interagency guidance arguing that very point. In today’s proposed Statement on Subprime Mortgage Lending, federal regulators call on lenders to underwrite subprime hybrid ARMs to the fully-indexed rate—correcting what many have called a glaring and dangerous omission from their original round of guidance on non-traditional mortgage products released in November of 2006.
During this most recent housing boom, many families across the income spectrum took advantage of broader access to adjustable rate mortgages to purchase a home. While ARMs were traditionally considered a more sophisticated wealth-building tool for higher income borrowers, this most recent housing boom saw a significant campaign to market and offer these products to lower-income borrowers under the guise of affordability.
Many lower-income borrowers were lured by the reduced initial loan payments, but due to the complexity of these products, many were also unaware of their exposure to sharply higher future payments. This leaves homeowners dangerously exposed to interest rate changes. Two cases in point are the most aggressive subprime ARM products, so called 2-28 and 3-27 ARMs, both of which boast payment shocks that are quick and fierce after the initial rate expires after the second and third year of the ARM, respectively.
In the case of a 2-28 subprime ARM, the Center for Responsible Lending used mid-year 2006 analysis from Fitch Ratings to report that with current interest rate increases, the built in payment shock on these products is nearly double at 48 percent. Yet, at present, a lender is only required to underwrite these borrowers for those first two years—even if it is clear that the borrower won’t be able to afford the payment shock built in to the loan product that they are underwriting.
Though the guidance is technically non-binding, it certainly sends a strong signal to the lending community and could change lender practices. It also represents a critical recognition on the part of the regulatory community that there are serious concerns about some of the practices in the subprime mortgage lending market. We hope this is but a first step toward addressing some of those concerns.
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