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Last week, a consortium of federal regulatory agencies released their long awaited “Guidance on Nontraditional Mortgage Product Risks.” The linked-to press release tells us exactly what they mean by “nontraditional”:

These products, referred to variously as “nontraditional,” “alternative,” or “exotic” mortgage loans (referred to below as nontraditional mortgage loans), include “interest-only” mortgages and “payment option” adjustable-rate mortgages. These products allow borrowers to exchange lower payments during an initial period for higher payments later.

As Will Carless pointed out back in June, 70 percent of San Diego home loans in 2005 were of either the interest-only or payment-option type. So it would appear that the new regulations put some of San Diego’s favorite loan products directly in the crosshairs.

Some highlights of the new guidelines follow:

For all nontraditional mortgage loan products, an institution’s analysis of a borrower’s repayment capacity should include an evaluation of their ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. In addition, for products that permit negative amortization, the repayment analysis should be based upon the initial loan amount plus any balance increase that may accrue from the negative amortization provision.

This means that lenders can’t qualify borrowers based on those initial low teaser rates, but instead have to account for borrowers’ ability to make the eventual higher payments.

Loans with minimal or no owner equity generally should not have a payment structure that allows for delayed or negative amortization without other significant risk mitigating factors.

Stacking loans to minimize down payments has been all the rage in recent years – last year, 35 percent of homebuyers made no down payment at all. This guideline states that borrowers don’t get to use non-traditional loans unless they have some skin in the game.

Institutions should minimize the likelihood of disruptive early recastings and extraordinary payment shock when setting introductory rates.

This means that inititial option ARM “teaser” rates used to determine the minimum payment shouldn’t be too out of whack with the “actual” rate on the full payment.

Clear policies should govern the use of reduced documentation. For example, stated income should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity.

This example suggests that it should be a lot harder to get one of those highly popular low-doc loans.

There’s plenty more – as I said, these are just highlights. The guidance document does a very thorough job of covering the risk areas in today’s lending environment.

Nonetheless, there are some questions as to how much of an effect the new guidelines will have. They are, after all, called “guidelines” – does that mean that they are just suggestions, or will they actually be enforced? The document states:

The Agencies will carefully scrutinize risk management processes, policies, and procedures in this area. Institutions that do not adequately manage these risks will be asked to take remedial action.

“Asked to take remedial action”… that’s bad, right? Perhaps the agencies intend to really enforce these guidelines, but it’s also possible that this effort is more about demonstrating that they “did something” about risks in the mortgage industry than anything else. After all, if they really wanted to prevent reckless lending, these regulations are too late by a couple of years.

A second and possibly more important concern is that even if these guidelines turn out to have teeth, they do not apply to all lenders. The issuing agencies regulate the banking industry and thus have no authority when it comes to non-bank lenders such as Countrywide or many of the subprime lenders that are making the riskiest loans. These latter entities are regulated at the state level, and while many analysts are forecasting the many states will soon adopt very similar guidelines, I haven’t yet seen any evidence to this effect.

EZ-credit is the lifeblood of profoundly overpriced housing markets like San Diego. Without it, people simply cannot buy homes at these prices. These very thorough guidelines could have a substantial effect on our market if they are applied to all players and truly enforced. Whether that will happen remains to be seen.

– RICH TOSCANO

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