Is This the End of E-Z Credit?

This past week, a group of federal agencies released a draft of their guidelines on non-traditional mortgage lending . Christmas came early for those of you who like to pore over 42-page regulatory manifestos; for the rest of you, highlights follow.

The issuing agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration) have done a good job of covering the notable areas of risk in non-traditional lending. They begin with loan underwriting standards, addressing the following topics:

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  Appropriate borrower repayment analysis, including consideration of comprehensive debt service in the qualification process
  
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  The potential for collateral-dependent loans, which could arise when a borrower is overly reliant on the sale or refinancing of the property when loan amortization begins;
  
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  Mitigating factors that support the underwriting decision in circumstances involving a combination of nontraditional mortgage loans and reduced documentation;
  
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  Below market introductory interest rates;
  
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  Lending to subprime borrowers; and
  
• Loans secured by non owner-occupied properties.

Later in the report they give some more detailed guidance—some of it fairly strict—regarding the above list. Some of the more interesting snippets:

• "Loans with minimal owner equity should generally not have a payment structure that allows for delayed or negative amortization." This means that if you want an interest-only loan, you need to put down a "non-minimal" down payment. Southern Californians don’t tend to like big down payments: last year, for example, 37% of San Diegans put down less than 10% on their home purchases. This policy could have a huge impact here, as it could force those without money for a down payment into mortgages with higher rates.
• "Nontraditional mortgages to finance non owner- occupied investor properties should require evidence that the borrower has sufficient cash reserves to service the loan in the near term in the event that the property becomes vacant." This means that investors, including but not limited to our beloved condo flippers, will have to show that they have enough cash on hand to make mortgage payments even if the property is vacant. This won’t have a huge effect but it could knock some speculators out of the market.
• "Reduced documentation, such as stated income, should be accepted only if there are other mitigating factors such as lower LTV and other more conservative underwriting standards." In other words, if you want a no-doc loan, you need to make a bigger down payment. Again, this will take out some of the folks who are unable (or unwilling) to make a big down payment.
• "…an institution’s qualifying standards should recognize the potential impact of payment shock, and that nontraditional mortgage loans often are inappropriate for borrowers with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low credit scores." This means that neg-am loans shouldn’t be made based on the ability to make the current payment, but to make the larger eventual post-adjustment payment—and that these loans shouldn’t be used to allow borrowers to stretch further than they otherwise could. It segues into this next item:
• "Institutions should avoid the use of loan terms and underwriting practices that may result in the borrower having to rely on the sale or refinancing of the property once amortization begins." This kind of says the same thing as the prior bullet: when the adjustment comes, the borrower must be able to make the higher payment via income or savings, and must not have to depend on selling, refinancing, or otherwise tapping the equity of the home in question. Given SoCal’s complete lack of affordability, this rule will likely pack quite a wallop in terms of who is able to qualify for what mortgages. Interestingly, this guideline is the only one that contains its own warning as to what will happen if it is not followed: "Institutions determined to be originating collateral-dependent mortgage loans, may be subject to criticism, corrective action, and higher capital requirements."

The guidelines also cover the need to disclose future payments, prepayment penalties, fees, and the like to borrowers, but given that borrowers’ almost insatiable appetite for risk I doubt this set of rules will have much affect.

The banks’ own portfolio and risk management practices are addressed as well. That subject matter is pretty esoteric, so I will spare you the details, but suffice it to say that they address standards for loans originated by third parties (i.e. mortgage brokers) and for mortgages sold into the secondary market—both very important topics.

So what effect will these guidelines have? Is this just agency ass-covering, or will these regulations be enforced? According to the document,

"The Agencies will carefully scrutinize institutions’ lending programs, including policies and procedures, and risk management processes in this area, recognizing that a number of different, but prudent practices may exist. Remedial action will be requested from institutions that do not adequately measure, monitor, and control risk exposures in loan portfolios."

So to hear the regulatory agencies say it, they mean business. Whether this is true—and how strictly they enforce the guidelines, and over what time period—remains to be seen. It’s also not exactly clear how these regulations, which only affect banking institutions and not private lenders like Countrywide, will affect the mortgage lending climate as a whole. To determine these things, we can only wait and watch.

But there are a couple of things we do know. One is that these new guidelines reinforce the trend we’ve been discussing for a while in the monthly credit market reports: that of a slow but pervasive tightening of credit conditions. The other is that, if the new regulations are strictly enforced, they will likely serve as the needle that pops the housing bubble.