Commercial real estate lending: In the 2005 survey of lenders, the OCC found that lenders had relaxed standards of LTV and debt service coverage, longer maturities, and lower collateral requirements. One third of national banks have commercial RE holdings equal to 300% or more of their Tier I capital.
Residential real estate lending: In 2004, half of all mortgages were I/O. By H1 2005, half of all mortgage originations were payment-option ARMs, a higher level of risk than I/O loans. By the time of his talk, end 2005, half of all mortgages were piggyback and/or reduced doc. This layering of risky products makes the ultimate loan even more risky than the sum of the parts. (“Tthe whole is greater than the sum of the parts” is a law of nature.)
Most option-ARM borrowers, both at the high and low end of the FICO score spectrum, make the minimum payment on their mortgage each month. Half of the least credit-worthy borrowers have higher loan balances resulting from accrued interest.
Dugan gives an example to show that an option ARM’s payments will go up 50%, even if interest rates REMAIN THE SAME. A 5/1 ARM at 6% interest goes from $1600/month to $2500/month at the beginning of year 6. If interest rates rose to 8%, the payment would double to $3166 in year 6. The borrower won’t qualify to refinance if interest rates are high or the home’s value has decreased. For this reason, option ARMs are the riskiest product out there.
These concerns prompted the interagency guidance, which seeks to tighten underwriting standards, and improve borrower disclosure and portfolio risk management.
The guidance was written because the government is concerned with option ARMs, the riskiest of all loans out there, because of its negative amortization feature. The second concern is lending to increasingly subprime borrowers; in other words, people who don’t qualify for 30 year fixed rate loans are qualified for the much riskier option-ARM! Does that even make sense? They are also concerned that lenders are not providing adequate disclosure of increased future payments.
The guidance requires that lenders evaluate a borrower’s ability to pay AFTER the teaser rate and intro period expires. The fact that they are not already doing this just boggles the mind!
This is where it might have some teeth: institutions which make collateral-dependent loans (the borrower must rely on refinancing or sale of the house after the amortization period begins) are subject to criticism, corrective action, and higher capital requirements.
To whom will this guidance apply? It was written jointly by The FDIC, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Office of Thrift Supervision, and the National Credit Union Administration. So it would apply to all federally chartered and insured (NCUA, FDIC) banks, thrifts, and savings? But not to private lenders, such as Option One, right?
What percentage of loan volume would be exempt from this guidance?
