Subprime Lenders On Notice

It won't mean the end of high-risk mortgages for subprime home buyers, but new guidance from federal financial regulators will almost certainly cut sharply the availability of some such loans.

In a policy statement June 29 on loans to borrowers with imperfect credit histories, federal financial regulators urged banks, credit unions and their mortgage subsidiaries to verify the income, assets and employment of all borrowers, except when borrowers can show that they have substantial financial reserves.

The guidelines also say lenders should underwrite adjustable-rate subprime mortgage applicants at the "fully indexed" interest rate, not at a deeply discounted teaser rate. During the housing boom, many lenders lured credit-impaired home buyers into "2/28" and "3/27" adjustable-rate mortgages, with discounted fixed payments for the first two or three years.

After the discount period, payments sometimes rose 50 percent or more, putting borrowers in serious financial jams. Large numbers of those borrowers are now delinquent on their loan payments and at risk of foreclosure.

The new guidelines target other once-popular lender practices, too. For example, many subprime 2/28 and 3/27 adjustable loans also carried heavy prepayment penalties -- up to 6 months of interest -- designed to discourage borrowers from refinancing before the end of the discounted rate period. Under the new guidelines, lenders would give borrowers a "reasonable period of time" -- generally at least 60 days -- before the rate reset date to refinance into more favorable loans without penalty.

The federal regulators also stressed that lenders should approve subprime adjustable loans based only on "the borrower's ability to repay the loan according to its terms." That doesn't amount to a formal "suitability" test, but it does require lenders to determine that each loan is appropriate to the applicant's financial status and capacity to handle payments.

The guidelines also say lenders should make certain that every subprime applicant understands the risks built into the loan, including higher costs in connection with any reduced documentation, prepayment penalties and the borrower's responsibility to keep track of tax and insurance payments if the loan lacks an escrow account.

Consumer advocates generally welcomed the new guidelines but were quick to point out that they won't make a dent in the ongoing subprime crisis or prevent lenders from issuing new mortgages with toxic features. Not only must state financial regulators adopt mirror-image guidelines to cover mortgage brokers and independent lenders, but even then the guidelines "do not have the force of regulations" or law, said Allen Fishbein, director of housing and credit policy for the Consumer Federation of America.

Adoption of the new guidelines state by state "is going to take months, and in the meantime, a lot of consumers will still be getting loans with the same old harmful features," Fishbein said.

Michael D. Calhoun, president of the Center for Responsible Lending, a national advocacy group, said his organization had examined subprime mortgages contained in 10 recently closed mortgage bond securitizations on Wall Street and found that 70 percent contained prepayment penalties, 37 percent were "stated income" or low-documentation, and 77 percent were adjustable-rate loans. Ninety percent of the latter carried rate and payment resets in the first two to three years.

"They're still doing this stuff" despite the well-publicized meltdown in the subprime mortgage market, Calhoun said.

Calhoun and Fishbein want the Federal Reserve to adopt tough regulations prohibiting many of the features now common in subprime loans and to make escrow accounts mandatory for all lenders, whether state or federally regulated. The Fed, after criticism from Congress for its inaction over the past five years, is now considering new consumer protection rules but has given no indication about what they might contain.

In the meantime, home buyers can adopt their own smart mortgage guidelines:

· If you've had credit problems and your current income just barely qualifies you to buy the house you want using a short-term discounted-rate loan, resist the temptation, even if a loan officer or broker is pushing you to sign.

· Insist on an escrow account if you have marginal credit. Yes, it means higher monthly payments. But it's also an insurance policy that guarantees that you won't end up owing thousands of dollars in property taxes that you don't have the cash to pay.

· If your loan officer insists that agreeing to hefty prepayment penalties is the only way you will ever get a mortgage, shop around more. Who knows? In an increasingly competitive market, you may discover that you're not viewed as subprime by every lender and needn't be hogtied by prepayment penalties.

Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.