MORTGAGE LENDERS ON THE FRONT LINE: PART DEUX
By: John Cleary

Now that analysts and economists have finally acknowledged the gravity of the residential real estate market in Southern California, the bottoming-out can get underway already.  Over the last few months, words such as “cautionary” and “leveling” have given way to “ominous” and “dire.”  In San Diego County, existing home sales fell in September by 35 percent from last year, marking the biggest drop since 1991. 

During the frantic, go-go real estate market of the early-2000s, the median price for a resale home in San Diego skyrocketed to a peak of $570,000 in May of this year.  Over the summer, that figure fell to $545,000.  That’s a five percent drop in the last three months alone.  The current sentiment is this is just the beginning.  According to one UCLA analyst, the future of the Southern California real estate market is “rather ominous.” 

A drying loan pipeline is just one of the problems mortgage lenders have to manage in this new environment.  Lenders also face a confluence of two factors that will wreck havoc on the industry like it has never seen before.  First, on September 29, federal agencies released their final guidance curbing the use of creative, payment-option loans.  This guidance not only casts a further pall on loan volumes by tightening lending standards, but also creates a legal and compliance minefield that will lead to significant changes in the way home loans are marketed and sold.  Second, the Wall Street firms who bought and bundled these high-risk loans into securities are beginning to attack past underwriting practices and force lenders to buy-back bad loans.  The nation’s largest home lenders have started boosting reserves to account for the buy-backs that are sure to come.  This will cause massive hits to earnings in an industry already reeling from a drastic market correction.   

The bell has rung signaling the end of the heady days where even a bad loan is a good loan.  It is time for underwriters and compliance professionals to roll-up their sleeves, adapt to this new environment and implement tougher underwriting standards and internal controls. 

Federal Agencies Issue Guidance On Non-Traditional Loans

As expected, on September 29, the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the national Credit Union Administration issued their final guidance warning mortgage lenders on the liberal use of payment-option loans.  Although termed as “guidance,” from a compliance perspective the agencies’ report is at least quasi-regulatory. 

Payment-option mortgages allow borrowers who do not qualify for a traditional, fully-amortized loan to structure their payments in a way that makes home ownership possible.  The most common payment-option mortgages are interest-only mortgages and negative-amortization mortgages.  Interest-only mortgages allow the borrower to pay only the monthly interest on the loan, with no payment toward paying down the principal.  Negative-amortization loans carry the most risk.  With a “neg-am,” borrowers make an established minimum payment each month regardless of the interest rate.  None of the payment goes toward paying off the principal balance, and the unpaid interest is added to the principal balance owed.  Borrowers hope to maintain their equity in the home through market appreciation.         

The key risk factor in payment-option loans is the “reset.”  After a specific period of time – usually anywhere from one year to seven years – the introductory, or “teaser” interest rate ends and the true, fully-indexed rate kicks in.  At that time, the borrower’s monthly payment increases sharply to cover the deferred interest and shifts to a higher rate.  The industry has coined a term for this – “payment shock.”  In this time of rising interest rates and sinking home values, many payment-option borrowers are now staring down the barrel of foreclosure.   

Marketing Limitations

The agencies specifically call to task lenders who mass market payment-option loans.  They outline specific limitations on advertisement and solicitation of payment-option and other “creative” loans.  Much like the restrictions imposed on securities brokers, the agencies seek to limit the marketing of payment-option loans to financially sound consumers with the sophistication to understand and appreciate the risks. 

As home prices in Southern California soared beyond the reach of most consumers in the few years, new home lenders lured potential buyers into model homes with low interest rates offers.  Newspaper ads smartly played down the wholly unaffordable price of the home in favor of touting rock-bottom interest rates and “creative” financing solutions.  The agencies’ guidance requires home lenders to limit these advertisements. 

This does not mean lenders have to change their advertisement strategy entirely.  That would not be prudent and, indeed, would be disastrous for lenders as decreased loan volumes have only heightened the already hyper-competitive industry.  Home lenders simply need to tighten-up their marketing and advertising campaigns so that creative loan solutions, and the bells-and-whistles that come with them, are clearly and conspicuously tagged as available only to those who qualify. 

Disclosure Obligations

The agencies’ guidance also calls for increased disclosure and transparency of risk by mortgage lenders.  The obvious suggestion is that currently risk disclosures in the industry are not acceptable.  Although federal regulations such as the Truth in Lending Act (TILA) mandate specific risk disclosures, the agencies want more.  In truth, most borrowers truly do not appreciate the risks associated with payment-option loans.  At the time of closing, borrowers vaguely remember discussions about historically low interest rates and record market appreciation.  By the time the fine print disclosures are presented, most buyers have minimized the risk of a drastic reset payment.  To be fair, though, borrowers rarely perform their own due diligence when presented with a wholly affordable mortgage payment for a home above their means.  By that time, they are thinking about curtains. 

Unless home lenders demonstrate some effort to enhance risk disclosure, they will be vulnerable to claims of per se non-compliance.  Compliance professionals and legal counsel should take a cue from the securities industry, where offering materials begin and end with an exhaustive, full-size and plain-English explanation of the risks – both real and possible.  Home lenders need to drop the fine-print and err on the side of disclosure in this environment.  Before selling any payment-option loan, lenders would be wise to have borrowers acknowledge by signature all the risks of payment-option loans, particularly the monthly payment obligations after the loan resets. 

Suitability Limitations

Perhaps most controversial, the agencies also call on lenders to impose stricter underwriting standards in the use of payment-option loans.  Put simply, the agencies seek to limit the use of these loans.  The agencies’ guidance is firm that payment-option loans should not be sold to borrowers who cannot currently afford the payments at the fully-indexed rate.  Specifically, they expect lenders to “maintain qualification standards that include a credible analysis of a borrower’s capacity to repay the full amount of credit that may be extended.  That analysis should consider both principal & interest at the fully indexed rate.” 

In markets like Southern California, payment-option and other non-traditional financing have been crucial in providing working folks with a piece of the American dream.  But for these loan options, the average Californian cannot afford to own a home.  Most consumers do not have the $100,000 to $200,000 down payment to make a fully-indexed loan affordable. 

The agencies’ guidance seeks to drastically cut collar sub-prime lending.  They have essentially cast a suitability standard on payment-option loans where the only appropriate candidates are those consumers who have the financial means for a more traditional loan, but choose to use their extra cash in a different manner.  It doesn’t take an Economics degree to see that this will lower demand in the market, thereby fueling an already volatile housing market teetering on the edge of a historic collapse.

Surely the agencies did not intend to shut down sub-prime lenders.  With “corrected” home prices in Southern California still well-over $500,000, creative and non-traditional loans are essential to the viability of the real estate market.  Unless and until home prices fall to respectable levels, the fact is most buyers will be highly leveraged.  To be sure, the agencies specified they did not intent to eliminate payment-option and other non-traditional loans.  Their guidance only warns that they will “carefully scrutinize” lending practices as they relate to non-traditional loans.  It seems, then, the agencies’ goal is to distinguish legitimate sub-prime lending from predatory financing.  Problem is, the agencies do not give the industry any suggestions on how to implement their guidance without wiping out sub-prime lending entirely.

Until the agencies issue some specific guidance, lenders can take certain steps toward compliance without abandoning their customer base.  For instance, lenders can curtail negative amortization and payment shocks by increasing “teaser” rates.  They also can eliminate no-documentation, stated income loans and tighten loan-to-value ratios without substantially affecting deal flow.  Some of the largest sub-prime lenders are now offering the option of re-financing into a low-fee 30-year or 40-year fixed rate mortgage.

Perhaps most important, home lenders should follow a cue from the Sarbanes-Oxley Act and implement well-defined, written internal controls to ensure loan terms and underwriting practices are consistent with prudent lending practices.

Wall Street Begins Calling on Lenders to Buy Back Bad Loans

In recent years, mortgage lenders have “securitized” a huge amount of loans.  That is, they sold their loans to Wall Street firms who package them and sell them to investors as securities.  According to The Wall Street Journal, of the $3 trillion in residential home loans originated last year, 68 percent were securitized.

During the housing boom of the last four years, the relationship between the investment banks and home lenders has been good – or, synergistic as they say.  The banks rely on the lenders to feed their pipeline of new securities offerings, and the lenders rely on the banks to turn loan portfolios into cash.  This is about to change.  Because payment-option loans represent approximately 25 percent of all loans written, suffice it to say Wall Street is sitting on a ton of risky paper.  Mortgage defaults in California were up 67 percent in the second quarter of 2006 when compared to the same period last year, according to a DataQuick Information Systems report.  As the risks of payment-option and other non-traditional loans are coming home to roost, the investment banks that bought them are becoming vigilant about opening up the books and examining the loans they bought.

The securitization contracts between investment firms and lenders require lenders in certain circumstances to repurchase loans that default.  Usually when a loan defaults early-on or when there are clear underwriting mistakes, the lender must repurchase the loan under the terms of the agreement.  These protections are heightened in the market for sub-prime loans for borrowers with scuffed credit.  Primarily because of their reliance on investment banks to turn loans into cash, home lenders are opening up the coffers.  Recently, H&R Block added more than $100 million in reserves for loans it agreed to buy-back.  Maintaining a working business relationship with the investment banks is only one motive for lenders’ cooperation.  Because they agreed to have their work securitized, lenders also are at risk for securities fraud claims in the event of misrepresentations or a fudged appraisal.

It is easy to investment banks to now criticize sloppy, creative or aggressive underwriting.  For the most part, since the mid-1990s no loan was a bad loan in California.  As interest rates held at historically low levels and appreciation rates turned California homeowners into real estate millionaires, the only real trick was keeping up with loan volume and outpacing the competitors.  Home lenders should not now be held solely accountable to the investors who bought securitized loans.  The investment banks that bought the loans certainly did thorough due diligence prior to acquiring the loans and offering them to the public.  They certainly were not ignorant of the risks – a key element for an investment bank to prove in a legal proceeding to rescind a loan purchase.

For an industry already grappling with finding ways to maintain loan volume and access to cash, fighting the investment banks on buy-back demands is not sound business.  However, lenders should not just roll over.  They should only agree to buy-backs where there is a clear showing of improprieties.  Otherwise, the home lenders writing the loans and the investment banks that securitized them are in this together. 

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