Jack M. Guttentag The Mortgage Professor

The Board has spoken - but is it too late?

On December 18 of last year, the Federal Reserve Board released its long-awaited proposals for curbing abuses in the home mortgage market. In this set of three articles, I examine Board proposals to curb lax underwriting rules, unfair practices by mortgage brokers, and abusive practices by loan servicing agents.

The proposals were long delayed, probably because home loan reform is not a Board priority. Monetary policy is its first priority, bank regulation comes second, and consumer protection is a poor third. The delay is particularly problematic in connection with its proposals for changing underwriting rules, the subject of this first article in the series.

The Major Underwriting Rules

Underwriting rules determine whether or not a particular borrower is eligible for a particular loan. The major rules are the minimum down payment, minimum credit score, maximum ratio of housing expense to income, and required mode of documenting income and assets. On conventional loans (those not FHA or VA), underwriting rules have been set by the private market with minimal oversight by government.

Underwriting requirements set by private markets tend to become increasingly liberal when house prices are rising. Rising prices convert bad loans into good ones -- good, at least, from a lender perspective. If the borrower can't make the payments, having equity in the property allows the borrower to refinance into a mortgage with lower payments, or to sell.

During 2000-2006, house price appreciation was extraordinarily large, and underwriting requirements were relaxed to a degree never seen before. In the subprime market, loans with no down payment were made to borrowers with poor credit who couldn't fully document their income.

What the Board Could Have Prevented

If the Board in 2002 had intervened by requiring a minimum down payment of 10 percent on subprime loans, the crisis that erupted in 2007 never would have happened. Even if the Board didn't take action until 2004, the very worst batch of loans, those made in 2005-2006, would have been markedly reduced. The down payment is the appropriate tool for early regulatory intervention because it is easy to define and enforce, and has a marked effect on borrower demand and loan quality.

But Board actions won't come until later in 2008, which is terrible timing. The mortgage market has already done a 180 percent reversal in underwriting requirements. The price sheets I get from the remaining subprime lenders show down payment requirements of 15 percent. And I now hear complaints from prime borrowers that lenders are examining documents with a microscope, and asking for more and more verifications. Santa Claus has become Scrooge. In this kind of market, regulatory tightening of underwriting requirements is "piling on."

Further, with one exception, the Board proposes that it intervene in the most complex and judgmental parts of underwriting. The proposed rules would prohibit lenders from making loans that borrowers cannot afford, and require lenders to verify income and assets. (The rules would apply to "higher-price loans," which include subprime loans). In my view, regulators should steer clear of these areas because rules that are very difficult to define are also difficult to enforce.

Interestingly enough, this may be the Board's unstated view as well. Their lengthy explanations of how they intend to enforce the new rules indicate very clearly what a quagmire such enforcement is going to be.

Unclear Rules Hard to Enforce

For example, the rule against making unaffordable loans would only be enforced in connection with a "pattern or practice" of making such loans, and would take account of "the totality of circumstances in the particular case." Similarly, the requirement that lenders verify income and assets only applies to the income and assets the lender "relies upon" in approving the loan, and would not apply if failure to verify "would not have altered the decision to extend credit."

The Board does not have the army of highly-trained and sophisticated examiners that would be needed to enforce rules like these. Implicitly, enforcement will be delegated to community groups and class-action lawyers, who like murky rules because they provide additional grounds for suing lenders. That may help a few individual borrowers, but it won't make the market work better.

The one defensible underwriting rule proposed by the Board would require that all "higher-priced" loans carry escrow accounts for the payment of taxes and insurance. In contrast to the rules regarding affordability and income verification, this rule is unambiguous and easy to enforce -- a loan either has an escrow or it doesn't. Further, the cost is small because borrowers can opt out after one year.

But it raises an interesting question: Why should an escrow opt-out be limited to borrowers with higher-priced loans? How about prime borrowers who have had their insurance cancelled and tax liens placed on their homes because the servicer failed to pay the insurance and taxes?

Next week: How the Board would deal with abuses by mortgage brokers.