The Standards for subprime home loans

U.S. banking regulators told mortgage lenders to toughen standards for subprime home loans in a belated effort to end abuses that led to a surge in defaults and the highest foreclosure rate in five years.

Lenders, in most cases, should verify income levels instead of relying on borrowers' statements, the Federal Reserve, the Federal Deposit Insurance Corp. and other regulators said in guidelines issued today in Washington. They also said banks should consider potential interest-rate increases when judging whether homebuyers can pay off loans.

``We clearly have a profound problem,'' FDIC Chairman Sheila Bair said in an interview today. ``It is going to get worse before it gets better, and decisive action was required,'' she added. ``Everybody was asleep at the switch.''

The guidelines come too late to repair the growing crisis in subprime mortgages. The effort also didn't satisfy lawmakers, who want regulators to complement the guidelines with enforceable rules. While bank examiners can strong-arm banks with the recommendations, consumers can't file lawsuits based on them because they aren't laws.

Focus now turns to the Fed, which is reviewing whether there's a need to codify the standards. While central bank policy makers have preferred to rely on guidance and disclosures, Fed Governor Randall Kroszner said they will ``seriously consider'' using its rule-making authority to prevent abuses.

Pushing for Rules

``The Federal Reserve must take the guidance, strengthen its protections'' and turn it into rules that apply to all lenders, Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, said in a statement. ``Subprime borrowers, who are disproportionately black and Hispanic, deserve strong protections.''

Bair, 53, also put pressure on the Fed to act quickly in adopting regulations that ``apply across the board.'' Today's guidance applies to lenders overseen by federal regulators, not to the mortgage brokers that write most subprime loans, she said. Those lenders are overseen by state regulators.

The Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators said in a statement they will issue similar guidelines for state regulators ``in the next two weeks.''

Further Than Expected

Lenders and consumer advocates said today's guidelines went further than they expected and signal that regulators have determined such loans are high-risk products for consumers that require standards and protections.

``The regulators stuck to their guns,'' said Allen Fishbein, director of credit and housing policy at the Consumer Federation of America in Washington. ``The key point is that it requires a sound analysis of the borrower's capacity to repay.''

Subprime loans are those made at higher interest rates to borrowers with weak credit histories or high debt burdens. Fraud increased and lending standards fell as Americans borrowed $2.8 trillion for home loans from 2004 to 2006, the largest mortgage boom of any three-year period on record.

Lenders should be able to ``readily document'' a borrower's salary by checking annual income statements, pay stubs and tax returns, according to the guidelines, which were released by the Fed, FDIC, Office of the Comptroller of the Currency, Office of Thrift Supervision and National Credit Union Administration.

Warning on Documents

``Stated-income and reduced-documentation loans should be accepted only if there are mitigating factors that clearly minimize the need for direct verification'' of the borrower's ability to repay, the regulators said. That phrase is in effect a warning to lenders to avoid low-documentation loans, consumer advocates said.

The subprime meltdown led two Bear Stearns Cos. hedge funds to the brink of collapse and prompted at least 50 mortgage companies to halt business or put themselves up for sale since the start of 2006.

Bear Stearns was forced to put up $1.6 billion to rescue one of its hedge funds, which lost money betting on mortgage bonds and collateralized debt obligations. CDOs are fixed-income securities that invest in other debt instruments, often subprime mortgages.

Dodd, who is seeking his party's 2008 presidential nomination, and House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, have said regulators shirked their responsibility to protect consumers from abusive lending during the housing boom.

`Use It or Lose It'

Frank told Kroszner at a hearing June 13 the Fed must ``use it or lose it'' when it comes to its rule-making authority. Frank is reviewing the new guidance and had no comment today, spokesman Steve Adamske said.

Mortgage Bankers Association Chairman John Robbins said the new guidelines will ``constrain consumer credit choices.'' The Washington-based group, which represents the mortgage industry, also discouraged Congress from passing legislation that would subject lenders to ``rigid underwriting standards and litigation risk,'' according to Robbins's statement.

Subprime loans fell 10.3 percent to $722 billion in 2006 from a record $805 billion in 2005, according to JPMorgan Chase & Co. Credit Suisse Group predicts loans will fall as much as 60 percent this year.

Consumer groups say subprime lenders targeted homebuyers with so-called 2/28 mortgages that they couldn't afford. Such loans have a fixed interest rate for two years and a rate that fluctuates for the remaining 28 years. Borrowers sometimes face stiff financial penalties if they try to get out of such mortgages.

Refinancing Option

Borrowers should be able to refinance subprime loans at least 60 days before the interest rate changes without facing penalties, according to the guidelines.

``That's at a minimum,'' Bair said. ``I would encourage lenders to provide an even longer period.''

Washington Mutual Inc., the biggest U.S. savings and loan, said today that it will refinance up to $2 billion in subprime loans to help borrowers avoid foreclosure. The Seattle-based bank said it's ``well positioned'' to implement the Fed's new guidelines.

source:bloomberg.com