By Jack Guttentag
Saturday, June 23, 2007

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.

In principle, government could close this escape valve by freezing the qualification ratio. Twenty-five years ago, this might have been possible. Ratios of 36 percent and 28 percent, measured with and without non-mortgage debt service, were then more or less the norm. As underwriting systems have evolved, however, maximum ratios have changed. They now vary from one loan program to another and with other factors that affect risk, such as credit score, down payment, type of property and loan purpose.

Government intrusion into this complex process to make the fully indexed rate rule effective would be a disaster, and nobody has suggested it.

Proponents of the fully indexed rate rule either don't realize how easily the rule can be evaded, or are satisfied just to go through the motions. If the rule were effective, they might be forced to confront a really thorny issue.

Any government underwriting rule that is more restrictive than those selected by lenders, and which cannot be evaded, will reduce the number of households that qualify for loans. Of the group that is cut from the market, some would have lost their homes through default and foreclosure had they received loans. This is the intended benefit of the more restrictive rule.

A larger number, however, would have become successful homeowners under the previous rules and are now denied this opportunity. This is the unintended but inescapable cost of the restrictive rule.

To prevent one foreclosure by tightening standards, we prevent a larger number of successful loans. I don't know what that number is, or what society should view as an acceptable number. These questions have been studiously avoided.

Next Saturday: Unaffordable loans that are in the public interest.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007, Jack Guttentag

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