Defining 'Affordable' Loans: There's No Easy Answer

First of two articles

Stories of subprime loans that have gone to foreclosure often generate righteous indignation. In hindsight, many if not most of them look as if they should never have been made.

Such indignation is one important motivator for recent demands that government require all home mortgages to be "affordable."

While affordability is difficult to define rigorously, one well-defined rule has emerged with the approval of bank regulators, community groups and many legislators. It applies to adjustable-rate mortgages, which have more than their share of foreclosures.

In many cases, lenders assess the ability of ARM borrowers to make their payments at the initial interest rate, which is artificially low. When the rate increases, the payment also increases and may become unaffordable.

I will use the 2/28 ARM, the most widely used instrument in the subprime market, to illustrate. The rate is fixed for two years, after which it is adjusted every six months to equal the value of the rate index at the time of the adjustment, plus a margin, which is fixed for the life of the loan. Any rate increase may be limited by a rate-adjustment cap.

For example, assume the initial rate is 6 percent; the index is the one-year LIBOR, which currently is about 5.4 percent; the margin is 6 percent; and the adjustment cap is 3 percent. If the index remains unchanged, the rate after two years will rise to 9 percent, the maximum permitted by the cap (the initial 6 percent plus the 3 percent limit), and six months later to 11.4 percent (the 5.4 percent index plus the 6 percent margin).

Assuming a 30-year mortgage, the payment will increase by 32.7 percent in Month 25, and by another 21.3 percent in Month 31. The borrower may not be able to manage such formidable increases.

The affordability proponents propose that lenders be required to qualify borrowers at the fully indexed rate, which is the current value of the index plus the margin, rather than the initial rate. In the example, the fully indexed rate is 5.4 percent plus 6 percent, or 11.4 percent. The logic is that borrowers who at the outset can meet the payment calculated at the fully indexed rate will find it affordable 24 or 30 months later when the rate increases.

The requirement, however, would have little impact because it can be so easily and legally evaded. This may be a good thing, because the consequences of an effective rule might well be unacceptable.

Borrowers are qualified for a loan using a maximum ratio of mortgage payment plus other housing expenses to income. Assume the maximum ratio is 36 percent and that the borrower taking out the 2/28 ARM described above barely qualifies -- his ratio is 36 percent -- when the payment is calculated at 6 percent. Calculating the payment at the fully indexed rate of 11.4 percent would push the ratio to 51 percent, making the borrower ineligible.

The maximum ratio, however, remains within the lender's discretion. This means that a lender who wants to make the loan has only to increase the maximum ratio to 51 percent and, presto, the borrower qualifies at the fully indexed rate. This would be a completely legal evasion. In the subprime market, ratios of 50-55 percent are not uncommon.