28 September 2009

Fed Ends Hard Money Subprime Lending

The Federal Reserve is issuing new regulations that end the practice of "hard money" lending that ignores ability to repay from income or other assets because the loan to value is high enough, given current housing price trends, to make up any losses in a foreclosure.

The final rule [effective October 1, 2009] adds four key protections for a newly defined category of "higher-priced mortgage loans" secured by a consumer's principal dwelling. For loans in this category, these protections will:

• Prohibit a lender from making a loan without regard to borrowers' ability to repay the loan from income and assets other than the home's value. A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan. To show that a lender violated this prohibition, a borrower does not need to demonstrate that it is part of a "pattern or practice."
• Require creditors to verify the income and assets they rely upon to determine repayment ability.
• Ban any prepayment penalty if the payment can change in the initial four years. For other higher-priced loans, a prepayment penalty period cannot last for more than two years. This rule is substantially more restrictive than originally proposed.
• Require creditors to establish escrow accounts for property taxes and homeowner's insurance for all first-lien mortgage loans.

What are subprime loans under the new definition?

The rule's definition of "higher-priced mortgage loans" will capture virtually all loans in the subprime market, but generally exclude loans in the prime market. To provide an index, the Federal Reserve Board will publish the "average prime offer rate," based on a survey currently published by Freddie Mac. A loan is higher-priced if it is a first-lien mortgage and has an annual percentage rate that is 1.5 percentage points or more above this index, or 3.5 percentage points if it is a subordinate-lien mortgage.

Hard money and liar loans make short term economic sense when real estate prices are soaring rapidly turning low loan to value loans into high loan to value loans, but are disasterous when real estate prices collapse.

All mortgages are subject to additional limitations on pyramiding late fees, and requirements regarding when payment must be credited and balances due must be provided. Specific kinds of deceptive advertising, and coercing appraisers to give inaccurate appraisals, both of which were arguably already illegal in many cases, have been banned for all residential mortgages.

The new rules on underwriting subprime loans and requiring escrow accounts for first mortgages that are subprime, basically give the force of law to what has always been represented a best practice in the industry. And, given that subprime lenders who didn't follow best practices are now overwhelmingly defunct, there aren't many private interests around to complain about this decision. There are good arguments that regulations of this type, that merely reinforce existing market incentives, create unnecessary paperwork. But, in the short term, they are unlikely to do much harm. And, recent experience has shown that systemic bad underwriting by private parties can spill over to hurt the larger economy, not just those who made the bad decisions.

Two year pre-payment penalties are still permitted in subprime mortgages with a fixed payment for the four four years or more, which will now have a property tax an insuance escrow, and verified income and non-real estate assets that show an ability to pay for the first seven years of the loan. It isn't entirely clear, at first glance, how these regulations with interact with parallel state law restrictions on pre-payment penalties.

All of this matters, of course, only if the market decides to rebuild the subprime mortgage industry that the financial crisis virtually eliminated.

Unless housing prices are rising rapidly and likely to stay high until the property is sold, subprime loans are a bad choice for anyone who can qualify for a prime rate loan (a surprisingly large share of subprime loans entered into by minority borrowers) who should seek another lender, and subprime loans are also a bad choice relative to renting for almost everyone else. Subprime loans are a product that almost nobody needs, so growth in this market segment is a symptom of an economy that is out of whack.

Those hardest hit by the new regulations are self-employed people and other people with incomes that are difficult to document (e.g. people who receive reliable streams of discretionary trust fund and gift payments). At some level of loan to value, that is sufficiently cushioned against housing bubble collapses, it isn't obvious that a ban on no document loans really makes sense.

Employed people generally benefit in loan underwriting from a presumption of continued employment at current income or better, that is often unrealistic, while self-employment people face a high burden to show that their future incomes will be regular and high enough. The distinction is legitimate, but the process can overstate the differences in risk between the employed and the self-employed.


Michael Malak said...

Surprised to learn that
a) The Federal Reserve is in charge of establishing consumer mortgage protections
b) The authorizing legislation, HOEPA, evidently applies even when all parties are in a single state (violating the Constitution)

Andrew Oh-Willeke said...

Your view of the scope of the interstate commerce clause is hopeless fantasy. If economic activity has an impact on economic activity in other states, however, attunated, it is constitutionally valid.

I haven't looked at the law closely enough to see which institutions are in and which are out. The Fed has a big chunk of banking regulation, but it is possible that some institutions with other regulatories are not included.

Michael Malak said...

If Bush had deferred to Eliot Spitzer (rather than take him down) and other state-level officials, the subprime crisis would have been attenuated, at least somewhat.