Regulators Say Banks Should Better Judge Creditworthiness

The Federal Reserve Board and other regulators urged lenders yesterday to more closely assess the ability of borrowers to repay certain types of home mortgages linked to an alarming rise in delinquencies and foreclosures.

The regulators targeted adjustable-rate mortgages made to subprime borrowers, who typically suffer from blemished credit. Those types of mortgages offer low introductory rates that later rise sharply.

Regulators yesterday recommended that lenders qualify borrowers at the higher rate that kicks in once the loan resets. To that end, they said lenders should, with a few exceptions, verify a borrower's income. That practice had fallen by the wayside as housing prices climbed in the first half of this decade and lenders relaxed their standards.

"It's only good business sense for the lenders and it is the right thing to do for the borrowers' sake," Federal Reserve Governor Randall S. Kroszner said in a written statement.

The agencies also told lenders that prepayment penalties should expire at least 60 days before the rates reset so borrowers can refinance with a cheaper loan.

The guidelines, proposed in March, were also prepared by Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration. They were adjusted to reflect some concerns raised by industry trade groups and consumer advocates before they were made final.

Reaction to the guidelines was generally positive. But some consumer groups said the guidance alone wouldn't do much to solve the mounting subprime problems because it does not apply to all lenders. It affects only those banks, thrifts and credit unions that the federal agencies oversee.

John E. Taylor, chief executive of the National Community Reinvestment Coalition, said the lenders affected generally are not the "bad actors." The worst offenders, he said, are mortgage companies and brokers.

"There has to be a national standard and law that addresses these unsavory practices," said Taylor, whose trade association promotes fair lending.

Other consumer advocates said the recommendations have no teeth because "guidance" is not binding. "It's not enforceable by homeowners," said Alys Cohen, a staff attorney at the National Consumer Law Center. "In light of the current crisis, people deserve substantial protections."

Like many of the consumer groups, the Mortgage Bankers Association said the guidance was useful. But the agencies made a "key error" by asking lenders to make sure they qualify borrowers at higher rates that kick in when the loans reset. That kind of mandate would limit the ability of some borrowers to obtain credit, said Kurt Pfotenhauer, one of the group's senior vice presidents.

Pfotenhauer cited what are known as 2/28 and 3/27 mortgages, which regulators have singled out as especially risky. Those loans offer low rates for the first two and three years, respectively, and then adjust to a much higher rate for the remaining 28 or 27 years.

"We find that the vast majority of borrowers refinance before [these loans] reset," Pfotenhauer said. Some improve their credit and secure less-expensive prime loans, he said. Some would not qualify for loans of any kind under the guidelines released yesterday, effectively ruining their chances of home ownership.