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Monday, July 14, 2008

The Fed's Mindless New Mortgage Regulations

Back in December, I commented on the Fed's plan for more mortgage regulations. I said then that it was scary just how clueless the Federal Reserve was as far as what the problems were and how to resolve them. Today, the Federal Reserve made official new mortgage regulations and they continue to show a stunning lack of understanding. Here is a breakdown of what the regulations are.

bar lenders from making loans without proof of a borrower's income.

-- require lenders to make sure risky borrowers set aside money to pay for taxes and insurance.

-- restrict lenders from penalizing risky borrowers who pay loans off early. Such "prepayment" penalties are banned if the payment can change during the initial four years of the mortgage. In other cases, a penalty can't be imposed in the first two years of the mortgage.

-- prohibit lenders from making a loan without considering a borrower's ability to repay a home loan from sources other than the home's value. The borrower need not have to prove that the lender engaged in a "pattern or practice" for this to be deemed a violation. That marks a change -- sought by consumer advocates -- from the Fed's initial proposal and should make it easier for borrowers to lodge a complaint.

These regulations range from useless to nebulous to downright dangerous and counterproductive.

Let's start with the first. The Federal Reserve has totally eliminated stated loans for sub prime borrowers. They are rather late to the ballgame as it turns out since there are no longer any subprime banks offering stated loans. It appears the Fed thinks that the entire market blew up as a result of these stated loans and banks just continued to underwrite the exact same way without taking into account the nightmare that was created. What's frightening is that well meaning politicians, activists, and media will cheerlead the Fed's bold steps in curbing risky behavior. None will realize that the market was a much better and swifter arbitor in removing this risky behavior. Rather than waiting a full year to outlaw these loans, the market eliminated them nearly instantaneously.

Second, the Fed has created a nebulous rule that can be read multiple ways. I assume that the Fed is mandating
escrow accounts. If so, they have just made it that much more difficult for poor borrowers to get loans. I am no fan of escrows, but they are especially punitive to those with little disposable income. What escrows do is hold an account to pay for taxes and insurance. This sounds good in theory, however escrows also need to have enough at any given moment. As such, the account collects at closing enough so that when a payment is due there is enough in the account. Furthermore, banks usually hold an extra two months in reserve. All of this money is held with 0%. As such, if a loan is closed in June, the first payment is August 1, and taxes are due September 1, then the bank will require six months worth of escrows be collected at closing. If taxes are $1800 every six months, then of course that is an extra $1800 the bank will collect on top of normal closing costs. This is a great way to insure that more loans don't close needlessly.

Of course, this rule is nebulous. The Fed never specifically says anything about escrows. Banks could simply read that borrowers have enough money stashed away so that when taxes are due there is enough there. As such, they may simply require that borrowers have a minimum amount of money in the bank before they agree to do a loan. Once again, this will create another reason for a loan to be denied.

The third rule is a combination of needless, counter productive and dangerous. Again, the market banned nearly all pre payment penalties long ago. There are very few out there. That said, the language is punitive. The longer the pre payment penalty the worse it is for a borrower. The Fed says you can't have one in the first two years but you can have one longer. As such, it would only punish those borrowers that held onto a loan long term and then refinanced. Furthermore, while pre payment penalties get a bad rap, they also serve a very important purpose. Everything else being equal, your rate is lower if you accept a pre payment penalty. Now, imagine if a borrower only qualifies with a rate of 7%, and that rate can only be achieved if they take a pre payment penalty. The Fed just made sure this hypothetical borrower doesn't qualify.

Finally, the fourth rule is so outrageous and nonsensical that it will create a stream of litigation that will literally stop the industry in its tracks. What in the world does it mean

prohibit lenders from making a loan without considering a borrower's ability to repay a home loan from sources other than the home's value. The borrower need not have to prove that the lender engaged in a "pattern or practice" for this to be deemed a violation.

Apparently, the Fed thinks that banks play with their thumbs for about a month while they decide whether to approve a loan. The month that it normall takes for a bank to underwrite is spent determing whether that borrower has a "reasonable ability to pay".

Since this is so nebulous it makes lawsuits that much easier. As such, think about what the last part of the rule will do...

That marks a change -- sought by consumer advocates -- from the Fed's initial proposal and should make it easier for borrowers to lodge a complaint.

Yes, it will since "reasonable ability to pay" is very difficult to define. What's truly scary about these rules is that the Fed is supposed to know what they are doing. It is one thing when a clueless politician does something like this. It is quite another when the Federal Reserve acts, and acts cluelessly.


Unknown said...

I also think it is a mistake to outlaw no doc loans. The no doc loan was the only way my wife and I could buy our present home. After being a homemaker for 6 years, my wife had no recent income to show. I was starting a new business and didn't have two years of business records to show my income. The no doc loan allowed us to buy a larger home than the one we were renting while saving $250 month on rent payments compared to our mortgage. Plus we are gaining equity.

Why did we qualify? We had a good down payment and a 800+ credit rating. Our 15 years of credit history showed we were responsible and a good risk. The government should mind its own business and allow private transactions to remain just that, private!

Anonymous said...

I have been in the mortgage industry for over 30 years as both an escrow officer and title insurance agent. When "no doc" loans first creeped in to the marketplace, I thought lenders were crazy. I have been proven right in a most unarguable way.

Any self-employed person can get a fully conforming loan with one year's tax return and a financial statement. That should not unduly inconvenience any responsible borrower. If you are self-employed it is only prudent to know what your income can reliably expect to be before you commit to a loan you may not be able to afford.

Any business owner with a one year financial history and an 800 Beacon score can write their own ticket for a low interest loan at their local bank.

The Fed's regulations are too little and too late, but let's be thankful the Fed acted at all before we had a total financial meltdown.

mike volpe said...

Here are few things about stated loans. I think there is a proper time and place for them. I think that small business owners, those with commissions or other unpredictable income, and those with multiple properties are right for it. Of course, when it started it required very high credit scores and large down payments or equity.

Where it went bad and became abused is when it was opened to W2 earners who simply received a regular salary. If you open it up to those folks, it is simply for someone to lie. Furthermore, it was opened up to those with lower credit scores and with low or even no money down.

It is like anything else. Once it became abused it blew up.

As for the Fed. It is simply too little too late. Nothing they did today did anything to contain a financial meltdown.

Unknown said...

In our situation, I didn't have one year of history (the banks were actually asking for two). My wife was working and we would have qualified for the mortgage on just her salary. Unfortunately, she also hadn't been at work for a year so they wouldn't count her salary either. We weren't considering my income at all as we wanted to be sure we could pay our bills if my business didn't work out.

In hindsight, if we had waited for a year, we probably couldn't have afforded to buy any longer as the prices here in Florida skyrocketed. Our $52,000 house became a $120,000 house. We would not have bought a home as we could not pay a mortgage of that amount safely on her income alone. We had moved to this area from Maryland specifically because of the low housing costs at the time.

I guess I'd like the bankers to have a little more flexibility to look at special cases like ours and still be able to do something. I know these loans were abused by many lenders/borrowers and they should both lose their shirts for being so stupid. The government should not be bailing them out or backstopping their foolishness.

One surefire way to stop the bad loan practices would be to require the lender to hold the mortgage for a certain length of time before it could be sold, say 10 years. They would be far more cautious if they were actually on the hook for the bad loan. Now the loans are sold before you even close on the property. Kind of makes it hard to develop a business relationship with "your" banker!

mike volpe said...

A few things, Timm. First, if banks were forced to hold loans, there would be no liquidity and you could forget any sort of aggressive loan. Fannie Freddie and all this selling allows banks to always have cash for the next loan.

Second, you may in fact have a unique situation however banks can't work on "special circumstances". There are just too many loans to do. As such, they need specific guidelines. You either meet them or you don't.

Unknown said...

Mike, thanks for your patience with me. When we bought our first home in Wisconsin a little over 15 years ago, the mortgage company held the note. In fact, they told us they very rarely ever sold their loans. This was one of the reasons we chose to do business with them. If there was ever a problem, we could walk into a local office and discuss it with a human face to face.

We then moved to Florida a couple years later and decided to build a home. We went to our local bank and sat down with the VP and worked out a building loan that was acceptable to us, the bank and the builder. This loan was automatically converted to a mortgage upon completion of the house. That mortgage was again held by the bank. Both of our first two mortgages were done through FHA with minimal down payments.

It wasn't until we moved again and bought our third house that we started having every mortgage sold immediately. I have a feeling that in the "good old days", banks generally held the mortgages and treated them as a good conservative investment with steady long term returns. They were an asset to hold as the banks were more than just middlemen who were trying to turn a quick buck on each mortgage.

Please remember that I am coming at this from the perspective of a consumer. I am in the boat business, which means I am mentally retarded! I guess I am just thinking that a return to more conservative and more local banking may be in order. I understand the need for guidelines, but much of these are to insure the saleability of the loan later. I don't know what the solution is, but I am pretty sure it isn't more government dictates from those masters of financial management in Congress!

mike volpe said...

That's all good and well, Timm, and there are those banks that hold their portfolios. Usually, those aren't large banks and they usually don't necessarily have a large portfolio of banks.

That said, in order for the market as a whole to provide loans to as many people as possible, banks need to not only sell loans to each other but to fannie mae/freddie mac. Banks would simply not have enough money to continue funding loans if they had to hold onto most of their loans.

Anonymous said...

Stated income loans are being stopped for reasons other than the mortgage meltdown... In fact, this is somewhat of a vehicle for the IRS to increase their income 100 fold...

Most self employed borrowers, which make up a huge sector of the population, write off all of their income as expenses, hence showing virtually no income at all. Many of them make a very comfortable living, I would be living better also if I wrote off all of my fuel, meals, toilet paper, and so on...

if they dont want to pay taxes, then dont let them own houses...sounds great to me

mike volpe said...

I can agree with much of what the last anonymous poster is saying however I will disagree that this is the reason the fed made these new rules. As I said, the banisment of stated loans is largely ceremonial since the market banished them all on its own.