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New guidance on non-traditional mortgages released

The hot real estate market of recent years has lured some consumers into getting in over their heads with what are known as non-traditional, alternative or exotic mortgages including interest-only mortgages and payment option adjustable rate mortgages (ARMs) that allow borrowers to pay less during an initial period in exchange for higher payments later.

When house sales were hot in many areas of the country, some speculators would purchase a house to “flip” it a short time later, hoping to make thousands in profits. Others purchased more home than they could afford without expecting interest rates to increase. But as the housing market has cooled, and interest rates have gone up, there is concern about the potential fallout.

The Mississippi Department of Banking and Consumer Finance recently adopted new regulatory guidance covering non-traditional mortgages sold by state-licensed entities.

The intent of the guidance for the subprime mortgage market is to make sure that risks are disclosed and consumers know what they are getting into when they get a non-traditional mortgage.

“The guidance is intended to promote consistent regulation in the mortgage market and to clarify how residential mortgage providers can offer non-traditional mortgage products in a way that clearly discloses the risk borrowers may assume,” said Mississippi Banking Commissioner John Allison.

To date 19 other states have taken similar action on the guidance, which was developed by the Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR). It is in line with guidance issued jointly by the U.S. Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration in the fall of 2006.

CSBS and AARMR are concerned that some borrowers may not fully understand the risks of these products. While many of these risks exist in other adjustable-rate mortgage products, the concern of CSBS and AARMR is elevated with non-traditional products because of the lack of principal amortization and potential for negative amortization.

The guidance from the Mississippi Department of Banking and Consumer Finance said the problem is compounded because providers are increasingly combining these loans with other features that may increase risk. Those features include simultaneous second-lien mortgages and the use of reduced documentation in evaluating an applicant’s creditworthiness.

Allison said while it is currently guidance and not law, he expects the portions of the guidance may be copied into a regulation by the Legislature.

“The Mississippi Mortgage Act comes up for review this year and we are adding several things to strengthen that act,” Allison said. “There may be some more felony charges for criminal violations of the act for defrauding the people or the government — for example, the Department of Housing and Urban Development (HUD) — in these flipping schemes.”

Allison said adoption of guidance will help reinforce consumer’s awareness of the potential pitfalls of the exotic products.

Many of the non-traditional products are being offered by financial institutions other than banks. Allison said banks are more likely to scrutinize customers carefully to see if the consumer has the means to assume increases in payment amounts.

Real estate experts expect the tighter regulations on non-traditional mortgages could mean that some people with borderline credit histories or high debt-to-income ratios won’t be able to qualify for a mortgage. But the regulations could also prevent foreclosures resulting in people losing their homes.

Non-traditional mortgage products have been available for a long time, but in recent years the number of institutions and providers offering them has increased substantially. There is concern about the result both on individuals and the general economy.

A study called “Losing Ground” released recently by the Center for Responsible Lending (CRL) predicts that that despite low interest rates and a favorable economic environment during the past several years, one out of five subprime loans issued during 2005-2006 will fail.

“The research we’re releasing today shows that subprime lenders are selling the most dangerous loans to the most vulnerable borrowers, creating the largest rash of foreclosures in the modern mortgage market,” said Michael Calhoun, president of CRL.

“This conclusion is driven by some powerful numbers: 2.2 million subprime home loans made in recent years have already failed or will end in foreclosure. These foreclosures could cost as much as $164 billion — an amount that could send more than four million children through college.”

Once just a small part of the market, it is estimated that in 2006 these types of products made up nearly a quarter of all loans made during the year.

“For most people, owning a home is their best chance to achieve sustainable economic security,” Calhoun said. “Losing that home, in many cases, means losing life savings. Given the size of the subprime market today, this epidemic of foreclosures will have a negative impact on the economy as a whole, with potentially devastating consequences for African-American and Latino communities, who receive the highest share of subprime loans.”

The study concluded that recent high appreciation in many areas masked problems in the subprime market, and that the cooling housing market will cause failure rates to rise sharply in many major markets. California, Arizona, Nevada and greater Washington, D.C., are expected to be especially hard hit.

CRL looked at the factors driving loan failures, and concluded it has become clear that the subprime market has basically created a recipe for producing foreclosures by taking the highest-risk loan features, packaging them into an adjustable-rate mortgage with a temporary low monthly payment, and then approving the loans without considering whether the borrower can afford the loan after the payments increase.

“Today about 80% of all subprime loans come with adjustable rates,” Calhoun said. “A majority of these are 2/28 mortgages, known as ‘exploding ARMs,’ which begin with a temporary low fixed payment, but then shift to an adjustable rate payment that rises dramatically. After the introductory low payment ends, the monthly payment on these loans jumps by 30% to 40% — a significant amount for any family. In addition, many of these loans come with expensive prepayment penalties — meaning the homeowner must pay thousands of dollars when forced to refinance to avoid the unaffordable high payments. To top it off, subprime lenders often approve these loans without considering whether the borrower can actually afford the loan when scheduled payment increases occur or even documenting the amount of the borrower’s income.”

The study showed there is a 72% higher risk of foreclosure on an ARM versus a fixed-rate loan.

The new guidance on non-traditional mortgages said providers should avoid practices that obscure significant risks to the consumer.

“For example, if a provider advertises or promotes a non-traditional mortgage by emphasizing the comparatively lower initial payments permitted for these loans, the provider also should give clear and comparably prominent information alerting the consumer to the risks,” the guidance states.

Contact MBJ contributing writer Becky Gillette at bgillette@bellsouth.net.


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