House's Lending Bill Would Hurt Some Borrowers It Intends to Help

In the wake of the subprime mortgage crisis, the market has turned against all except "cream-puff" borrowers -- those with no weaknesses.

These borrowers can still get loans on pretty much the same terms as before the crisis, but borrowers with blemishes on their applications are paying much higher prices and face a much higher risk of being turned down.

As if that were not bad enough, mortgage legislation that the House of Representatives passed before its Thanksgiving break would worsen their plight. That is not the intention, of course, but it would be the unintended consequence of the Mortgage Reform and Anti-Predatory Lending Act. The Senate has not yet considered the legislation.

Blemished borrowers have one or more of the following risk factors: They can make only a small or no down payment, they cannot fully document their income and assets, their property is something other than a single-family house, their loan is intended to raise cash or to purchase an investment property, they have low credit scores, their income is low relative to their expected total obligations, and their mortgage carries an adjustable rate that will result in substantially higher payments in a few years.

During the go-go years, 2000 through 2005, the mortgage market was extraordinarily tolerant of those risk factors. It was not unusual to see several of them present in an accepted mortgage, a phenomenon called "risk layering." Lending to a borrower who had no money for a down payment, who could not document adequate income and who had a poor credit history was a kind of market insanity associated with the rapid run-up in house prices. Inflation of house prices converts even the worst loans into good loans. When the housing bubble burst in 2006, the chickens came home to roost in the form of mortgage defaults, which are rising to levels not seen since the 1930s.

Markets tend to overreact. Just as the housing bubble was accommodated by insanely liberal lending terms, the pendulum has now swung toward Scrooge-like stringency. The price increments associated with risk factors are now two to three times as high as they were a year ago, and risk layering has gone way down. Roughly speaking, if you have two risk factors, the price is substantially higher, and if you have three, the deal is rejected.

A major provision of the mortgage legislation establishes "minimum standards for mortgages," which include requirements that borrowers have an "ability to repay" and that they receive a "net tangible benefit" from a refinancing. What these rules have in common, in addition to their discriminatory impact on borrowers already victimized by misfortune, is their vagueness and lack of specific operational guidelines. In a recent column on the net-tangible-benefit rule, I gave example after example whereby the ultimate determinant of whether there was a net benefit to the borrower could not be known by the lender without reading the mind of the borrower.

The inability to know whether they are in compliance creates risk for lenders, which must translate into higher costs for borrowers. But the legislation also provides a way to avoid this risk. It offers a "safe harbor," which is a presumption that the standards have been met, provided that the loan at issue is a "qualified mortgage" or a "qualified safe-harbor mortgage."

A "qualified mortgage" is one with an interest rate that meets certain benchmarks -- it does not exceed the rate on Treasury securities or an average mortgage rate by more than three percentage points or 1.75 percentage points, respectively. On second mortgages, the maximum spreads are five and 3.75 percentage points.

A "qualified safe-harbor mortgage" is a loan that is fully documented; is not a negative-amortization adjustable-rate mortgage; and either meets an income adequacy test, has a fixed payment for at least five years or is an ARM with a margin of less than 3 percent. The overlap between a qualified mortgage and a qualified safe-harbor mortgage will be very high.

The combination of vague standards and a safe harbor means that lenders would classify loans with regard to whether or not they belong to the safe harbor. Loans that do not belong would have a higher price or not be made. Loans that won't qualify for the safe harbor are those with the most significant blemishes.

The safe harbor removes some of the sting from the imposition of vague standards because most loans would qualify for the safe harbor. But not all would qualify -- a new subclass of mortgages would be created that would either be priced even worse than they are now or would disappear. These are mortgages with multiple blemishes. Already clobbered by the market, they would get the coup de grace from Congress.

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

Distributed by Inman News Features