FRB: Federal Reserve Bank of Atlanta - July 11, 2006 - Transcript

Building Sustainable Homeownership:
Responsible Lending and Informed Consumer Choice

Federal Reserve Bank of Atlanta
1000 Peachtree Street N.E., Atlanta, Georgia 30309
July 11, 2006

Agenda | Transcript

Pages 1-25 | 26-50 | 51-75 | 76-100 | 101-125 | 126-150 | 151-175 | 176-200 | 201-226

Transcript	Line	Page
Most significantly, any new or revised disclosures	1	101
for any loan product type must meet the disclosure of rate,	2	101
fees, costs, and points uniformly regardless of distribution	3	101
channels chosen by the consumer. In so doing, we will give	4	101
meaning to the ability to comparison shop. In addition, we	5	101
must protect consumer choice by maintaining a competitive	6	101
marketplace that is free from excessive government	7	101
intervention or regulations that distort competition equity	8	101
among the various distribution channels.	9	101
We should not ban products from the market, nor	10	101
should we even attempt to set compensation or de facto usury	11	101
caps. These efforts have failed in the past. Rather, it	12	101
should be left to market forces, simple supply and demand,	13	101
to determine the utility and longevity of any loan product.	14	101
Consumers are the only ones that should select their	15	101
mortgage, not the government, consumer advocates, banks,	16	101
lenders, credit unions, or mortgage brokers.	17	101
Third, we must ensure that every originator that	18	101
handles the 1003 application is required to complete both	19	101
free employment and continuing education requirements. Each	20	101
and every consumer deserves to work with a knowledgeable	21	101
loan originator, especially when considering non-traditional	22	101
loan products that are inherently more complex.	23	101
Fourth, we should ensure that all loan originators	24	101
submit to a criminal background check so that the bad actors	25	101
are not able to move freely from one distribution channel to	1	102
another. Lastly, we must ensure that consumers have the	2	102
financial acumen necessary to shop for loan products and	3	102
make informed financial decisions. This means that we must	4	102
allocate funds across the financial literacy programs in	5	102
this country starting at the middle school level. Thank	6	102
you.	7	102
MS. BRAUNSTEIN: Mike? Thank you, Kate.	8	102
MR. WRIGHT: Good morning. I'm Mike Wright,	9	102
representing both Prudential Georgia Realty and the National	10	102
Association of Realtors. The National Association of	11	102
Realtors has been concerned about the impact of predatory	12	102
lending on homeowners for many years.	13	102
In 2005, our board of directors on which I serve	14	102
approved a report from our subprime lending work group. The	15	102
subprime lending work group report encourages realtors to	16	102
help consumers avoid predatory lending and support	17	102
strengthening the Home Ownership and Equity Protection Act,	18	102
including expanding its coverage to incorporate purchase	19	102
money mortgages and lowering the triggers.	20	102
As part of implementing the subprime lending work	21	102
group report, the National Association of Realtors has	22	102
issued two consumer education brochures, one on traditional	23	102
mortgages to assist consumers in understanding the options	24	102
and the other on non-traditional or specialty mortgages to	25	102
assist consumers in understanding the risks and advantages.	1	103
Both of these brochures are available in Spanish and English	2	103
and are readily available to our members for use with their	3	103
customers and clients.	4	103
The National Association of Realtors strongly	5	103
supports most of the proposed non-traditional mortgage	6	103
guidelines being developed by the banking agencies. We are	7	103
concerned, however, that if the guidelines require banks to	8	103
approve borrowers for non-traditional mortgages, only if	9	103
their income today is high enough to handle the fully	10	103
indexed mortgage payment, which kicks in after several	11	103
years, families whose income can grow to meet the future	12	103
obligation will be denied access to home ownership.	13	103
We strongly support enhanced disclosure of the	14	103
potential future impact on monthly payments as a result of	15	103
rising interest rates and the impact of equity due to	16	103
negative amortization. My business experience includes most	17	103
of the traditional special lending options available today.	18	103
I started selling real estate as an agent when traditional	19	103
mortgages were about the only way that consumers could	20	103
finance a home. Now, in my role as managing broker, we are	21	103
aware of a new specialty product practically weekly. As a	22	103
general rule, most of our transactions are completed using	23	103
traditional financing. However, we have seen a steady rise	24	103
in non-traditional or specialty financing over the past	25	103
several years resulting in the highest ownership levels in	1	104
U.S. history.	2	104
One of the biggest challenges for the real estate	3	104
associate today is understanding the terms of the proposed	4	104
loan with enough advanced notice to be able to offer counsel	5	104
to his or her clients prior to the closing. We believe that	6	104
an informed consumer is in a much better position to	7	104
understand the risks associated with all loan products and	8	104
is, therefore, less likely to suffer payment shock down the	9	104
road.	10	104
These issues can be greatly reduced through	11	104
enhanced disclosure of all of the loan terms early in the	12	104
loan shopping process. This early disclosure will also	13	104
allow real estate agents to suggest to their customers that	14	104
they consider other lending options when it is apparent that	15	104
they are being steered toward higher risk, non-traditional	16	104
financing unnecessarily. The bottom line is that as	17	104
realtors we continue to seek ways to assist our clients in	18	104
becoming informed consumers as they seek the American dream	19	104
of home ownership.	20	104
MR. BRAUNSTEIN: Thank you, Mike. Allen?	21	104
MR. FISHBEIN: Good morning. My name's Allen	22	104
Fishbein, and I'm director of Housing and Credit Policy with	23	104
the Consumer Federation of America which is a federation of	24	104
some 300 consumer organizations that tries to promote the	25	104
consumer interest. We appreciate the opportunity to be	1	105
invited to appear here today, and we want to commend the Fed	2	105
for holding these hearings to investigate ways that consumer	3	105
protections need to be strengthened or revised in light of	4	105
changing market conditions and the new problems that are	5	105
emerging that pose threats, we believe, to sustainable home	6	105
ownership.	7	105
CFA's concerned about the mass marketing of non-	8	105
traditional mortgage products, products such as interest	9	105
only loans and payment option adjustable rate loans,	10	105
particularly to vulnerable borrowers, such as first time	11	105
home buyers, modest and fixed income borrowers, and those	12	105
who rely on higher cost subprime financing to purchase homes	13	105
and refinance their properties. Evidence suggests that	14	105
these groups are less financially savvy and more susceptible	15	105
to victimization from abusive and predatory lending	16	105
practices.	17	105
The majority of subprime adjustable rate mortgage	18	105
borrowers have loans that are due to reset in the next two	19	105
years, and rising rates could mean that these loans are	20	105
unaffordable to refinance for some portion of borrowers.	21	105
It's been estimated by reliable industry estimates that one	22	105
out of eight of these loans could default, which is an	23	105
indication in our mind that they were not well underwritten	24	105
to begin with and that something's amiss in the mortgage	25	105
finance market that permits these conditions to exist.	1	106
Existing consumer protections in such cases may not be	2	106
enough to protect those who are facing these problems from	3	106
being victimized and preyed upon by unscrupulous lenders,	4	106
and changes in consumer protection will be needed.	5	106
Non-traditional mortgage borrowers generally have	6	106
been described as wealthier with better credit profiles than	7	106
the typical mortgage borrower and often as -- as choosing	8	106
these instruments as financial options. However, recent CFA	9	106
research that analyzed the database of some 100,000	10	106
mortgages found that this often is not the case. Example,	11	106
one out of six interest only and one out of eight option	12	106
ARMs borrowers had incomes that were at or below the median	13	106
income of 44,000. More than one-half of payment option ARM	14	106
borrowers and 38 percent of interest only borrowers had	15	106
credit scores under the median credit score with one out of	16	106
five option ARM borrowers and one out of eight interest only	17	106
borrowers having credit scores under 660.	18	106
This segment, therefore, is particularly	19	106
vulnerable to the payment shocks that are often featured in	20	106
non-traditional products. CFA believes that more could be	21	106
done to ensure consumers are fully aware of financial risks	22	106
of the complex and potentially risky mortgage products that	23	106
they choose. And we have some specific recommendations.	24	106
One is we believe consumers need timely, clear,	25	106
and balanced disclosures to help them make wise choices,	1	107
certainly in view of changing market conditions. And the	2	107
proliferation of a bewildering array of new products, loan	3	107
disclosure rules need updating. Reg Z should be revised to	4	107
reflect key informational needs for consumers considering	5	107
deferred interest and exploding products. And certainly the	6	107
CHARM booklet and certain booklets that are geared to non-	7	107
traditional products ought to be provided to consumers. But	8	107
even so, we don't think that's enough, and expanded consumer	9	107
protections will be needed.	10	107
We believe that the interagency guidance as	11	107
proposed ought to be adopted, but recognize at the same time	12	107
there are limitations to it. It's not enforceable on the	13	107
part of individual consumers, leaves out key actors in the	14	107
marketplace, and we believe ultimately it does not go far	15	107
enough. Therefore, we believe that the Federal Reserve	16	107
Board also should be exercising its unfair and deceptive	17	107
practices authority to apply certain rules in the	18	107
marketplace more broadly. Some of these specific practices	19	107
that ought to be prohibited were mentioned by Alys Cohen in	20	107
her prior remarks.	21	107
Third, we believe there's a need for mortgage	22	107
broker fiduciary standards to put the issues squarely that	23	107
they are representing the interest of borrowers or	24	107
alternatively, the establishment of suitability standards or	25	107
a duty of good faith and fair dealing for lenders and	1	108
mortgage brokers more broadly. Next, we believe that the	2	108
HOEPA protections ought to be expanded to cover more loans.	3	108
They should include yield spread premium and prepayment	4	108
penalties in the points and fees calculation, lower HOEPA	5	108
thresholds for points and fees, rescission remedies that	6	108
would apply through HOEPA for purchase money mortgages. And	7	108
lastly, let me say we believe that assignee liability ought	8	108
to be extended to promote greater accountability in the	9	108
secondary mortgage market.	10	108
MS. BRAUNSTEIN: Thank you very much, Allen.	11	108
Thank you to all our panelists. We're going to open it up	12	108
for discussion. One of the things that we heard in previous	13	108
-- well, we heard a little discussion of this in the	14	108
previous panel, and we heard in other HOEPA hearings,	15	108
especially around the non-traditional mortgages were a lot	16	108
of concerns around stated income. And I heard a little of	17	108
that but not a lot here.	18	108
And I was wondering if anyone would like to	19	108
comment further on that. We heard that that is a practice	20	108
that can be abused, and it's something that we ought to be	21	108
concerned about quite a bit. So I didn't hear a lot this	22	108
time, and I'm kind of curious about that. Who wants to	23	108
start?	24	108
MR. DUNCAN: Excuse me. I'll just make a comment	25	108
about broad aggregates in the marketplace. We've looked at	1	109
the loan cohorts that are out there and, particularly, those	2	109
which are securitized. We tend to find that the credit	3	109
scores on those kinds of loans tend to be significantly	4	109
higher than for loans where you have fuller documentation.	5	109
So the market appears to be assessing the risks related to	6	109
the lack of information by taking the pieces of information	7	109
that they have and raising standards, so be it in the	8	109
aggregate.	9	109
MR. REYNOLDS: Just to comment from -- in terms of	10	109
the results of our examination program. I think we have	11	109
seen a correlation between the inappropriate use of stated	12	109
income and the prevalence of mortgage fraud. In the case of	13	109
some lenders, we have had to, in administrative actions,	14	109
address the appropriate use of stated income and make sure	15	109
the -- that it's only being used in an appropriate sense and	16	109
not being used as a way of circumventing normal underwriting	17	109
standards.	18	109
MS. BRAUNSTEIN: How have you found that and	19	109
addressed it? I'm just curious.	20	109
MR. REYNOLDS: Well, I think it's -- There are	21	109
very few situations, I think, where stated -- use of stated	22	109
income loans are appropriate. And you have to look at the	23	109
employment situation of the borrower to make sure that it's	24	109
appropriate. You know, if it's an individual that has a	25	109
normal employment status where they're an employee, I think	1	110
the use of stated income is inappropriate. It's very	2	110
similar, I think, to low documentation loans. I mean, we've	3	110
noted a prevalence between low doc loans and also the	4	110
prevalence of mortgage fraud.	5	110
And as a department, we have been very intently	6	110
focused on mortgage fraud as a priority. And I think some	7	110
of the practices that were described in the previous panel,	8	110
I mean, to us are obviously out and out mortgage fraud and	9	110
have been a focus of concern for the department.	10	110
MR. BRAUNSTEIN: Alys, were you going to comment?	11	110
MS. COHEN: The experience that we see from	12	110
attorneys around the country is that no doc and low doc	13	110
loans are essentially used to create fraudulent income for	14	110
borrowers on fixed incomes or on low incomes. And as far as	15	110
we can tell, the only reason you need to do a no doc or low	16	110
doc loan is either because the borrower doesn't want to	17	110
report their income to the IRS or the originator wants to	18	110
fake the income and make an unaffordable loan, and we don't	19	110
need to get behind either one of those practices. So we	20	110
would like to see them eliminated. They're called liar	21	110
loans in the industry and there's a reason for that.	22	110
MR. COSTELLO: One quick comment I want to add	23	110
there just to amplify on that. You know, it has been true	24	110
in the mortgage pools that we've seen in the securitization	25	110
market that traditionally the use of stated income was to	1	111
borrowers who are not people who received wage income and	2	111
didn't have, you know, the same kind of income statements	3	111
that someone who received wages did, so it's self-employed	4	111
borrowers for the most part. We found, in fact, and to	5	111
Doug's comment, they both had higher credit. But what's	6	111
been interesting is over time their performance in terms of	7	111
defaults has not been worse than those people who did have	8	111
full documentation, suggesting that there was an	9	111
underwriting process going on that did account for the fact	10	111
that borrowers were using stated income.	11	111
Having said that, I mean, we have seen more of	12	111
what's been discussed here occurring more recently, which is	13	111
borrowers who do have wage income who can presumably	14	111
document their income choosing not to. And that is a	15	111
concern for us in terms of an incremental risk that some	16	111
people are, you know, above and beyond just the fraud issue	17	111
but that people are stretching, you know, to basically, you	18	111
know, give an income number that will help them afford a	19	111
home in some of the markets that have become so expensive.	20	111
MR. CHANIN: Glenn, let me follow up on that. In	21	111
terms of where you haven't seen a problem with the stated	22	111
income loans, has that analysis been done regardless of	23	111
income level or has it been at the higher levels, whatever	24	111
that�s defined, or across all income levels?	25	111
MR. COSTELLO: It's -- You know, we've looked at	1	112
all income levels. We've actually focused on it more in the	2	112
subprime market because that's where, you know, we've had	3	112
concerns about it in terms of potential risk. And that's	4	112
where I can state that, you know, recent analysis of	5	112
historical performance, you know, hasn't indicated a, you	6	112
know, significant amount of additional default.	7	112
MR. FISHBEIN: Yeah. I just want to comment on	8	112
that, as well, and I think what -- the point Glenn made is a	9	112
correct one. I think relying on historic analysis has	10	112
certain limited application here because the growth of	11	112
stated income, particularly, seems to have occurred recent	12	112
years as affordability has eroded in many markets. And so	13	112
that certainly opens and suggested a new category of	14	112
borrowers coming in that's not the traditional borrower of	15	112
stated income. And that should be a cause for concern.	16	112
Certainly a lot of anecdotal information, as Alys	17	112
mentioned, to suggest that these loans -- these features are	18	112
being used inappropriately, and I'll just mention one	19	112
personal reference. A CEO of a large mortgage lender told	20	112
me that his son was trying to take out a mortgage loan, was	21	112
informed he didn't have sufficient income to pay for the	22	112
home he wanted to buy. In which case the broker said, well,	23	112
why don't you just go stated income loan instead, so.	24	112
MR. SANCHEZ: I've got a clarification. Is stated	25	112
income the primary form of mortgage fraud, per se, or is	1	113
appraised values? What -- Something was eluded to earlier	2	113
that talked about appraisals, and I just wanted to ask that	3	113
question.	4	113
MR. REYNOLDS: Well, our experience is that	5	113
mortgage fraud can come from a variety of areas and we see	6	113
mortgage fraud related to appraisal alterations. We see	7	113
mortgage fraud related to income that has been basically	8	113
changed on loan applications. We see issues related to	9	113
stated value and other concerns. So I don't think any one	10	113
area can basically be said to be the main source of mortgage	11	113
fraud.	12	113
MR. CHANIN: In an ideal world, at least in my	13	113
view, consumer disclosure should be the solution to	14	113
everything. That is, if they were perfect and if consumers	15	113
read them and understand them and use them, then, you know,	16	113
we wouldn't be having these discussions in terms of all of	17	113
these problems, I think. That is, if the disclosures were	18	113
there, people read them, said, no, this loan's not for me.	19	113
But that obviously does not occur and probably will never	20	113
occur because of different levels of financial	21	113
sophistication, etc.	22	113
The prior -- and this question is for Kate and	23	113
Ken. The prior panel indicated a number of instances of	24	113
I'll call it abuse. And one example they gave was, for	25	113
example, a -- I don't know if it was a broker, but a lender	1	114
who made a loan, I think a refinancing, where the consumer's	2	114
income -- fixed income, I believe, was $1,000 per month and	3	114
yet their mortgage payment was $800. And that leaves aside	4	114
real estate taxes. I don't know if there was insurance.	5	114
And thus, the consumer is left with $200.	6	114
Again, ideally, consumer disclosures would fix	7	114
that. The consumer wouldn't get that loan. If I were in my	8	114
former home of Macon, I would have invited the person into	9	114
my home and then sicked my dog on him. But the question is,	10	114
so what do we do about that, aside from having criminal	11	114
background checks? That is, how do we address those types	12	114
of issues where either brokers or lenders are simply not	13	114
doing what is appropriate in the circumstances? They're	14	114
making loans -- and I think we'd agree an 80 percent debt to	15	114
income ratio in that instance is a loan that should not be	16	114
made. So how do we address that particular circumstance?	17	114
MS. CRAWFORD: Until there's adequate enforcement	18	114
of some of the laws, it's going to go on. There's a lot of	19	114
crooks in every industry. And obviously, this person that	20	114
did this, whether whatever -- wherever they came from was	21	114
not out for the benefit of the consumer but for the benefit	22	114
of their pocketbook. And clearly, that loan should never	23	114
have been made.	24	114
There are underwriting guidelines, and there --	25	114
and every loan is looked at by at least two or three	1	115
different set of eyes in my office, and then it goes to a	2	115
different place for a final decision. And I do think that	3	115
maybe the underwriting guidelines should be toughened up at	4	115
each lender, not necessarily a federal standard, but at each	5	115
lender. And the lenders that made this loan need to get	6	115
their act cleared up, too, because underwriters have quotas	7	115
they have to meet, too. Everybody's got a quota they have	8	115
to meet.	9	115
And the other thing is if there is a bad broker,	10	115
the lenders need to stop doing business with that broker,	11	115
and they don't. They continue to -- They might get cut off	12	115
by lender, but they'll get signed up with somebody else.	13	115
And that's the same way with some of the small banks that	14	115
are brokers and some of the mortgage bankers that do it,	15	115
too. If they're doing a bad practice, they might get cut	16	115
off by one lender, but they keep on getting signed up with	17	115
somebody else because it all boils down to your bottom line.	18	115
It needs stricter enforcement.	19	115
MR. CHANIN: Ken?	20	115
MR. LOGAN: In reference to that loan example, let	21	115
me just clarify. I've been a lender for a number of years,	22	115
but my role now is as a warehouse lender. So I provide the	23	115
capital to fund those loans. What I would question on that	24	115
particular example is knowing what I know about the	25	115
secondary market is -- you know, I'm not aware of any	1	116
lenders that have an 80 percent debt ratio as a qualifying	2	116
criteria, nor any that would allow somebody with $200 of	3	116
disposable to make that loan.	4	116
So I would really suggest the enforcement issue	5	116
clearly is an area that would help flush out the fact from	6	116
the fiction about that loan and whether the actors were just	7	116
the broker, was it a broker and loan officer, was it, in	8	116
fact, the borrower involved in it. And I would surmise, not	9	116
knowing the deal, that there was probably additional	10	116
information that was actually provided somewhere in the	11	116
chain that was inaccurate. And that -- You know, at that	12	116
point in the process, those people should be dealt with.	13	116
In reference to another example where the, you	14	116
know, purported 180 or 200 percent loan to value loan,	15	116
again, I don't know of any process or any loan products out	16	116
there that would do that sort of a mortgage. I believe	17	116
there was an appraisal in there that indicated it was, in	18	116
fact, a 90 percent loan or 95, whatever the number was. And	19	116
that, you know, there was supposedly an inaccurate	20	116
appraisal.	21	116
Same thing. I believe the examiner, Joan,	22	116
indicated they look at all the loans. Having been at the	23	116
banks that's been examined, they look at all production,	24	116
sold or unsold. It's not a singled out portfolio. They	25	116
look at production.	1	117
So I would suggest that between the states	2	117
examining the brokers and the lenders for patterns and	3	117
practices and the circumstances that, you know, sound on the	4	117
surface to be so horrific need to be investigated. And if	5	117
you find that in fact that occurred, then that needs to be	6	117
what's dealt with.	7	117
MS. COHEN: Can I take a try at this question?	8	117
MR. CHANIN: Sure.	9	117
MS. COHEN: Even though I have a different name,	10	117
and you didn't call on me. Thank you. I'm all in favor of	11	117
enforcement. I was an enforcement officer with the Federal	12	117
Trade Commission for five years. Enforcement's great.	13	117
Compliance with underwriting rules is great.	14	117
Good people like George Reynolds and Barbara Kent	15	117
have been doing enforcement for decades, and we still have a	16	117
huge problem. So I want to quote George. He said, we need	17	117
market discipline. The example that everyone's discussing	18	117
this morning is one example, but it's not an isolated	19	117
instance. And so it's not something where we can say, oh,	20	117
you just get rid of that bad guy and everything will be	21	117
fine.	22	117
We need the originators to impose rules that their	23	117
employees will follow, and we need the investors to create	24	117
guidelines and enforce those guidelines so that there isn't	25	117
a flow of money into loans that shouldn't be made. With	1	118
underwriting and assignee liability, you will have market	2	118
discipline and the practices will change.	3	118
MR. FISHBEIN: Leonard, could I make an	4	118
observation, as well?	5	118
MR. CHANIN: Sure.	6	118
MR. FISHBEIN: We started out talking about	7	118
disclosures in the perfect world. And I think we're an	8	118
organization that believes in financial education and	9	118
certainly full disclosure to consumers about risks involved	10	118
in loans. But we also recognize it's going to be a	11	118
significant segment of consumers, which is just not going to	12	118
work for them.	13	118
And so the question becomes where do they turn.	14	118
Wealthier people can turn to trusted advisors. And if they	15	118
don't, they perhaps are in a better position to pay for the	16	118
mistakes they make. More moderate income people are not in	17	118
that position, less likely to have trusted advisors that	18	118
could explain the complexity of the products that are	19	118
available in the marketplace today.	20	118
It seems to me we have a force out there, the	21	118
mortgage brokers who are professionals. What is not	22	118
required of them typically is that they have a legal	23	118
obligation to the borrower to put them in the best loan for	24	118
which they're suited. And by changing that standard, it'd	25	118
certainly be a way of using the expertise of the mortgage	1	119
brokerage force that understands the complexity of these	2	119
products, can compare products, and try to narrow the	3	119
choices that consumers have to make.	4	119
But what's missing is that, as we know, they	5	119
aren't necessarily operating in the interest of the consumer	6	119
in any particular time and that their compensation structure	7	119
is such that they may not be motivated to put the consumer	8	119
into the best loan, the cheapest loan for which they	9	119
qualify. So we think getting at that issue for the channel	10	119
that's responsible for majority of mortgage originations	11	119
today and in the subprime market even larger than that is an	12	119
important consideration.	13	119
MR. CHANIN: Thank you.	14	119
MR. SANCHEZ: I've got a question -- I'm going to	15	119
shift gears here for a moment -- regarding the IOs, and	16	119
obviously the state of Georgia is a state where IOs are very	17	119
popular. You had made a comment that 25 percent of closings	18	119
were IOs. And I'm just curious whether you have information	19	119
as to who's taking the IOs, who's getting into those	20	119
mortgages themselves, and what's the probability of default?	21	119
MR. DUNCAN: Well, there is some data available	22	119
from the secondary market on the structure of the households	23	119
and their credit characters. I don't have that in front of	24	119
me. I'll be happy to supply what we have on that. The	25	119
performance characteristics on those loans to this point	1	120
have been very comparable to fixed rate products because, in	2	120
fact for many of them, there's -- the initial structure of	3	120
interest only period is fairly long, five to ten years.	4	120
When they initially came out, they were shorter periods.	5	120
The market assessed that those were actually a little	6	120
riskier than were IOs which had longer payment terms because	7	120
households have more time to adjust their income.	8	120
But a critical component in evaluating the risk is	9	120
to what standard -- not standard, but to what rate or what	10	120
terms is the loan underwritten. If it's underwritten to the	11	120
fully indexed rate, then just because there's a teaser rate	12	120
doesn't mean that the borrower is going to -- doesn't have	13	120
the capacity to take on the fully indexed payment because	14	120
that's where they were underwritten in most instances. It's	15	120
just whether between that time period that they got the	16	120
teaser rate and what it adjusts if they manage their money	17	120
well. And that's where I think you see the differentiation	18	120
in their performance from -- from fully amortized fixed rate	19	120
kinds of products.	20	120
MS. BRAUNSTEIN: Doug, I'd like to follow up on	21	120
that a little bit because we've heard conflicting	22	120
information from various people as to how many of these	23	120
actually are, though, underwritten at the fully indexed rate	24	120
because I think what we've heard, and even from our own work	25	120
in doing some horizontal reviews in lenders, what we saw was	1	121
actually that a large percentage of these loans are	2	121
underwritten at the teaser rates. And you know -- And I'd	3	121
like to hear what you think. And also, what Glenn thinks in	4	121
terms of the rating -- the risk rating of these. And is	5	121
that something that you look in rating these as to how	6	121
they're underwritten at which rate?	7	121
MR. DUNCAN: Well, they're clearly not all	8	121
underwritten at the fully indexed rate. Whether a large	9	121
share -- and I'm not sure how you define large, and I don't	10	121
want to parse that word. But no question, a significant	11	121
portion of loans are not underwritten at the fully indexed	12	121
rate. But there are reasons for that.	13	121
If you take a 10/1 that amortizes principal for	14	121
the last 20 years of a 30-year period and compare that to a	15	121
228, you will find that underwriting to the fully indexed	16	121
rate would disadvantage the prior mortgage, and that may	17	121
well be in the best interest of the consumer to take that	18	121
loan. So the loan doesn't get underwritten at the fully	19	121
indexed rate. But it's with consideration that the consumer	20	121
has an option that -- which depending on how you make the	21	121
calculation may work better for them. So we're not arguing	22	121
that all loans are. I don't know what your data show.	23	121
MR. COSTELLO: You know, I agree with Doug's	24	121
comments. Just a couple of things that I would say in terms	25	121
of trying to segment the market. You know, if you look at	1	122
borrowers with prime to -- you know, to average credit, the	2	122
prime in the all day markets, as we refer to them, those	3	122
borrowers, you know, there -- a significant percentages of	4	122
them are taking IOs, probably the majority in some of the	5	122
pools that we see. We don't view those as particularly	6	122
risky, even if they are underwritten to the initial rate	7	122
because the initial rate does tend to be very long: five,	8	122
seven, ten years. So I'm not sure if you can call something	9	122
a teaser if somebody's going to be paying that rate for ten	10	122
years.	11	122
When you get into the subprime market, however,	12	122
it's a little bit of a different story. In the subprime	13	122
market, while the IO term might be for five years, that	14	122
borrower's often in an adjustable rate mortgage. The	15	122
adjustable rate mortgage is going to adjust after two years.	16	122
And so if that borrower is underwritten to the initial IO	17	122
payment but they're still facing a large payment shock due	18	122
to the adjustment of the ARM not to the IO adjustment but	19	122
the ARM adjustment at month 24, that's when we sometimes	20	122
see, you know, very substantial payment changes at month 24.	21	122
Now, our analysis of how bad this is at this point	22	122
is largely hypothetical because we really haven't seen	23	122
borrowers at the point when that reset comes where they	24	122
don't have an option to refinance into a new loan or make	25	122
some other kind of a change into a different product. But	1	123
it is something that we've noted as being the one segment	2	123
that is concerning. And I definitely can state that among	3	123
the subprime lenders whose pools that we analyzed, they are	4	123
for the vast majority are underwritten to the initial rate.	5	123
MR. DUNCAN: Just to piggyback on that to extend	6	123
some of the earlier data that we -- that I presented in my	7	123
verbal commentary on delinquencies and production, what	8	123
we've seen in some of those households are the prepay rates	9	123
on the subprime product is much faster. And when I	10	123
commented on the shift from adjustable to fixed rate	11	123
products, what we're seeing is many of those households that	12	123
are in that category are now refinancing where the fully	13	123
indexed adjustable rate is actually greater than what a	14	123
fixed rate IO would be. So as long as they've been making	15	123
their payments, they're able to make those shifts to manage	16	123
affordability across products.	17	123
That said, clearly in our most recent delinquency	18	123
release the one group which saw a rise in delinquencies was	19	123
the subprime adjustables. So we're not naive about that,	20	123
but adjustables always have a higher delinquency rate than	21	123
fixed rate, even in the prime market.	22	123
MR. MICHAELS: I want to take this discussion a	23	123
little bit further. And for some time the Federal Reserve	24	123
has been hearing from consumer advocates in a number of	25	123
different contexts, not just these hearings, that what we	1	124
need to do is focus consumers not just on what their	2	124
payments will be when the rate becomes fully indexed, but	3	124
that we ought to have disclosures that are geared towards	4	124
what consumer's payments will be under the worst-case	5	124
scenario for the loan over the full life of the loan.	6	124
And to take that one step further, I think I've	7	124
read in some of the written materials for today's hearing	8	124
that there are some who would advocate that that not just be	9	124
a matter of disclosure, but that there be underwriting based	10	124
on worst-case payment over the life of the loan. And that	11	124
raises questions in my mind about how you underwrite a	12	124
worst- case payment for events that may occur fairly long	13	124
term, whether it's, you know, five years, seven years, or	14	124
ten years when what you have for the consumer is	15	124
affordability that's based on current financial data. And	16	124
this really is for virtually everybody here on the panel	17	124
today.	18	124
You know, what are your thoughts about the ideas	19	124
of dealing first with disclosure of worst-case payment	20	124
scenarios and then with underwriting that goes beyond just	21	124
the fully indexed rate but to some, you know, worst-case	22	124
scenario?	23	124
MS. CRAWFORD: I'll start. Talking with my	24	124
customers every day and doing adjustable rate mortgages and	25	124
pay option ARMs and interest only, I do show them the worst-	1	125
case scenario. So I do that now. And if they don't ask, I	2	125
show it anyway because I want to make them known about what	3	125
they are getting themselves into if they want that loan.	4	125
And if they don't want that loan, they'll usually do a 30-	5	125
year fixed rate. And frankly, right now, 30-year fixed	6	125
rates are about what everybody's doing, except for the	7	125
interest only because the fixed rates are better than the	8	125
ARMs right now.	9	125
As far as underwriting to the worst case, the main	10	125
reason a lot of people will use an adjustable rate mortgage,	11	125
and you can probably attest to this, is your three -- three-	12	125
ones, five-ones, seven-ones, they're not going to be in that	13	125
house more than three years or five years. That's their	14	125
plans and the way that they -- they might be transit or	15	125
they're with a company that's going to move them around or	16	125
maybe they're just going to retire in a couple of years.	17	125
What's the point of trying to get them into that	18	125
higher payment and tell them that they're not going to be	19	125
there to have that higher payment. They're going to be	20	125
there for three or five or seven, and that's it. I don't	21	125
see any point in going -- going into the worst-case	22	125
scenario.	23	125
Standard underwriting guidelines have worked in	24	125
the past for the three, five, seven, and ten, and they	25	125

Nancy Lee & Associates, Atlanta, Georgia, 404-315-8305

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2006 Hearings

Building Sustainable Homeownership: Responsible Lending and Informed Consumer Choice

Federal Reserve Bank of Atlanta 1000 Peachtree Street N.E., Atlanta, Georgia 30309 July 11, 2006

Building Sustainable Homeownership:
Responsible Lending and Informed Consumer Choice

Federal Reserve Bank of Atlanta
1000 Peachtree Street N.E., Atlanta, Georgia 30309
July 11, 2006