The Mortgage Professor
Scapegoating Stated-Income Loans
A stated-income loan qualifies a borrower by using the income the borrower states, as opposed to the income the borrower can document. With a stated-income loan, the lender agrees not to verify the income the borrower states on the application.
As one might expect, such loans are priced higher than fully documented loans, and the foreclosure rate is also higher. With overall foreclosure rates reaching uncomfortably high levels, stated-income loans have emerged as a possible weak point in the underwriting process. Regulators and legislators have been considering whether they should bar or limit them in some way.
Singling out stated-income loans for special regulatory treatment is strange on the face of it because there are many alternative forms of documentation now available. Furthermore, stated-income loans, when ranked by restrictiveness, stand immediately below full documentation -- and above all the others.
Although lenders don't verify income on stated-income loans, they do verify assets and employment. On a "no ratio" loan, income is not reported at all; on a "stated income, stated assets" loan, both income and assets are stated; on a "no income, no assets" loan, neither income nor assets are reported; and on a "no doc" loan, nothing is reported, including employment.
These alternative-documentation loans are priced even higher than stated-income loans and have higher foreclosure rates, but they have not attracted the same attention. No doubt, the reason is that stated-income loans are the most common type of alternative-documentation mortgage and may account for as many loans as all the others put together.
The Borrower's Protection Act of 2007, introduced by Sen. Charles E. Schumer (D-N.Y.), declares: "A statement provided by the borrower of the income . . . of the borrower, without other documentation, . . . is not sufficient verification for . . . assessing the ability of the consumer to pay."
Restricting stated-income loans would be costly. The loan was itself a response to limitations of the underwriting system: Many prospective home buyers have the income to afford a mortgage but can't meet the standards of full documentation.
Full documentation generally requires that applicants show that the income they claim was earned in each of the past two years. This is usually done by presenting W-2s or tax returns for those two years. Self-employed borrowers usually have the most trouble meeting this requirement, and stated-income loans were originally designed to deal with them, but other legitimate cases quickly emerged.
Many applicants with income from salaries can't meet full-doc requirements. They may not have held their position long enough, or their latest increase in salary may not be reflected in documents covering past income.
If a married couple pool their incomes and one spouse has a much lower credit score than the other, the full-doc rule is that the lower score is the one used. Stated income allows the partner with the higher score to claim all the income, which appears reasonable in most situations, especially in community-property states, where husband and wife share legal rights to each other's incomes.
Full-documentation rules are backward-looking; forecasts of future changes in income are not accepted, no matter how well grounded they may be. This means, for example, that the low-paid medical resident who, barring a catastrophe, will triple her salary in three months can declare only her current salary for a full-documentation loan. Using a stated-income loan, however, the resident can declare her future income.
The valid rap on stated-income loans is that some borrowers, without any realistic basis to expect a rise in income, lie about their income and take loans they cannot afford. This irrational behavior by some borrowers may be encouraged by rational behavior on the part of rapacious loan officers or brokers, who get paid only if a loan closes and have no interest in what happens afterward.
Because borrowers with high credit scores are much less likely to be irrational in their financial affairs, lenders place a lot more weight on the scores of stated-income borrowers than of full-doc borrowers. Stated-income loans will not be available to borrowers with very low credit scores, and when they are available, the price difference between good credit and poor credit is much larger on stated-income loans than on full-doc loans.
The federal financial regulatory agencies looked at stated-income loans in their analysis of problems in the subprime market and concluded that they "should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity."
Because the rules governing stated-income loans are part of the mosaic of underwriting rules in which everything depends on everything else, there are always mitigating factors. In effect, the agencies elected to go through the motions but not to do any harm. Hopefully, our legislators will elect to do the same.
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:/
Copyright 2007 Jack Guttentag
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