In Part 1, I discussed the dangers of not regulating an industry that has a “deep impact” in our economy. Enron’s collapse, and the collapse of similar companies, highlighted the absolute necessity of oversight to instill investor confidence and insure that “what you see is what you get.” Similarly, the recent failure of subprime lenders has unquestionably contributed to our current economic downturn, leading to calls for greater governmental oversight of the mortgage industry.
So, what exactly are these subprime lenders doing wrong?
In a hearing with the Federal Reserve on June 14, 2007, consumer advocates plead with regulators to restrict or eliminate the most questionable of practices currently employed by the subprime industry: Stated-income loans, no-escrow requirement, and prepayment penalties.
Stated-income loans must be the most abused business practice since “mark to market accounting.” According to a recent article in the USA Today, nearly 50% of all subprime loans in 2006 were based upon stated income with virtually no supporting documentation required to prove an applicant’s income. In the past, a “No-Doc” loan was reserved only for very specific circumstances, such as a small business owner who had been in business for a long time but might not be able to produce traditional proof of income.
In recent years, however, the abusive application of this practice has resulted in many buyers being approved for a greater mortgage than they can afford. Most subprime loans “reset” the interest rate after a couple of years, resulting is much higher mortgage payments. Shortsighted lenders approve mortgages that borrowers can afford today but not after the interest rate reset. Borrowers are often told that they can just refinance before the reset (See the BLN article How The Subprime Scam Works). One suggestion being offered is to test for affordability of the loan by requiring a 1:2 debt-to-income ratio.
The no-escrow requirement also takes advantage of the naïve borrower. The “oversold” borrower often has just enough money to make the mortgage payment, but often hasn’t enough in the bank to pay the property taxes and homeowner’s insurance premiums that come due once per year. If the property taxes aren’t paid, either the county taxing authority places a lien on the property or the mortgage company advances the tax payment to the borrower. Either way, the borrower is in a hole. Even more treacherous is the lapsing of homeowners insurance because the lender will “force place” insurance on the property at a tremendous cost to the borrower. Force place insurance protects only the bank, and will not pay the homeowner for damage done to the home.
Traditionally, borrowers are required to “escrow” taxes and insurance, meaning that each mortgage payment includes 1/12th of these annual expenses. This forced budgeting ensures that the borrower never misses the property tax or insurance premium payments. Additionally, escrowing reveals the “true” expense of home ownership. When banks fail to require escrow, unsophisticated borrowers mistakenly believe they have more room in the monthly budget for a greater mortgage payment. The greater the mortgage, the more money mortgage brokers and bankers earn from closing costs and interest.
Prepayment penalties insure that borrowers hold their loans for a minimum number of months. Typically, a prepayment penalty is equal to 6 months of interest. A big problem with the prepayment penalties is that they often extend beyond the rate reset, so that the borrower cannot refinance before being hit with a huge interest rate jump. Additionally, while most borrowers understand at the outset that they cannot refinance until the period expires, many don’t understand that they cannot sell their home during the penalty period without incurring a huge cost. Quite frankly, prepayment penalties are the hallmark of predatory lenders, and for that reason, they are illegal in some states.
The bottom line is that unsophisticated borrowers should be guided by the mortgage industry to borrow only what they can afford to repay. While, in the short term, lenders make more money on bigger loans with abusive terms, the long term stability of the marketplace demands fair dealing. The current market is fraught with predatory lenders thinking mostly in terms of how much money can be siphoned off the back of the subprime mortgagee before he collapses under the weight of his loan. It is clear that the mortgage industry will not police itself, making government regulation of the industry necessary to insure strength in the housing market, stock market and overall economy.