New Mortgage Guidelines Planned

Regulators Fear Growth
In Offerings May Raise
Risk to Borrowers, Lenders

By RUTH SIMON and JAMES R. HAGERTY
Staff Reporters of THE WALL STREET JOURNAL
May 19, 2005; Page D2

Federal banking regulators, concerned about growing risks in the mortgage market, are planning to issue new guidelines for mortgage lenders.

The new guidelines, which could be completed as soon as early next year, come at a time of growing concern that the proliferation of new mortgage products could mean higher risks to borrowers and lenders. Regulators are turning their attention to mortgages after issuing their first-ever guidelines for credit-risk management for home-equity lending this week, warning financial institutions to re-examine their loan criteria.

FURTHER READING • Concerns Mount About Mortgage Risks1 05/17/05

"Our next challenge is to look at what our expectations are for first mortgages," says Barbara Grunkemeyer, deputy comptroller for credit risk at the Office of the Comptroller of the Currency, which is taking the lead on this issue. "There's a consensus among regulators that we need to be working on this."

Worries about risks in the mortgage market have been heightened by the growing popularity of adjustable-rate mortgages and more novel lending products such as interest-only mortgages, loans for which borrowers provide little or no documentation of their financial resources, and loans that can result in negative amortization, or a rising loan balance. Interest-only loans accounted for 17% of originations in the second half of 2004, according to the Mortgage Bankers Association. Adjustable-rate mortgages, not including interest-only ARMs, accounted for an additional 46% of originations. The MBA figures reflect dollars lent, not the actual number of mortgages.

TAKING A CLOSER LOOK Here are some of the mortgage products on regulators' radar screen: • Interest-only mortgages: Borrowers can pay interest and no principal in the loans' early years. • Low- or no-documentation loans: Borrowers provide less than full or no verification of income and assets. • Option ARMs: Borrowers have multiple payment choices; electing the minimum payment can result in a rising loan balance.

The MBA survey also found that 8% of mortgage originations were so-called Alt-A loans, which are typically made to borrowers who have good credit but don't necessarily fit traditional lending standards. More than two-thirds of Alt-A mortgages are made with less than full or no documentation of income and assets, according to UBS AG.

Interest-only loans allow the borrower to pay only the interest due during an initial period, typically five years or so. After that, the borrower must begin paying off the principal, resulting in a sudden jump in the monthly payments. With an adjustable-rate, interest-only mortgage, the onset of principal payments could coincide with a rise in the interest rate, creating a double payment shock.

Many of these loans are especially popular in high-cost markets. In California, interest-only loans accounted for 61% of the mortgages taken out to buy homes in the first two months of this year, up from 47% in 2004 and less than 2% in 2002, according to LoanPerformance, a unit of First American Corp. Option ARMs, which can result in negative amortization, accounted for nearly one-third of jumbo mortgages -- currently loans above $359,650 -- in the fourth quarter of 2004, up from roughly 6% in the first quarter of that year, according to UBS.

These loan programs can provide benefits to borrowers and lenders, but many are relatively new or are being used more broadly than ever before.

In addressing the rapidly growing home-equity market, banking regulators said they were concerned about looser underwriting standards. Problems with home-equity loans can be particularly troublesome for lenders, regulators say, because the home-equity lender is second, behind the provider of the first mortgage, if a borrower can't make payments.

Risk factors identified in the home-equity guidelines include interest-only payments, limited or no documentation of borrowers' assets, and higher loan-to-value and debt-to-income ratios. "We're very mindful that many of the things we see in home equity are also prevalent in first mortgages," Ms. Grunkemeyer says.

Regulators are also likely to address the risks to both borrowers and lenders posed by the increasing popularity of adjustable-rate mortgages. "Borrowers are going for the ARMs because they can qualify for a slightly bigger mortgage," she adds. "There are a lot of issues to be addressed there."

Regulators say they have just begun discussing the risks in the mortgage market and have yet to take pen to paper. Before issuing any guidance, they expect to consult with Fannie Mae and Freddie Mac, which, as the biggest buyers of mortgage loans from lenders, effectively set many standards in the industry.

Tom Lund, Fannie Mae's interim head of the department that buys loans for single-family homes, said interest-only loans and other newer types of credit being offered by lenders make sense for some borrowers. But, he says, lenders should be concerned if these loans are being used by people who are hard-pressed to meet their monthly payments. "In many cases the consumers may not understand all the risks," Mr. Lund adds. Since late last year, he says, Fannie has tightened its criteria for buying certain types of loans.