"you can't just make a loan and then sell it to investors and expect no legal
liability
for putting people into a mortgage that never made sense for their
situation."
- Rep Barney Frank, Chaiman- House committee on Financial Services
When the American Dream Turns Into a Nightmare: A Suitability
Standard Will Soon Govern the Mortgage IndustryBy: John Cleary, Esq.,
Shustak & Partners, P.C., New York and California1Although the
California housing market has cooled from the twenty percent increases
of the early 2000s, the price of home continues to be out of reach for
most people. Currently, the median price of an existing, single-family
detached home in California is more than $500,000. Compare this to the
Midwest where the median homeprice remains in the mid-$100s. Suffice it
to say California presents unique challenges to home ownership. During
the last decade, Californians have stretched themselves financially to
buy a home. Buyers have turned to non-traditional,
“creative” mortgages to boost affordability. The
traditional 20-percent-down, fixed-rate, 30-year mortgage just is not
an option for Californians hoping for a piece of the American Dream.
Lower-interest, adjustable-rate mortgages, or ARMs, have allowed
Californians the financial leverage to buy a home they might not
otherwise afford. ARMs, though attractive to lower initial monthly
payments, carry significant risks in the event of rising interest
rates. Coupled with a slowing of real estate appreciation or, worse
yet, a market correction, ARMs are disastrous for borrowers. Just
recently, federal banking regulators warned mortgage brokers and
lenders to ease up on the use of “creative” mortgage loans
to get consumers into a home. They have offered guidance on
non-traditional mortgage products that would, among otherthings, impose
a suitability requirement on mortgage brokers and lenders the same as
that governing investment advisors and stockbrokers. When implemented,
this guidance will go a long way toward protecting homebuyers by
requiring more complete disclosure of ARMs and a full assessment of
each home buyer’s risk profile. Accountability for these loan
products is long-overdue in California where loan balances generally
are so high even slight fluctuations in market conditions can mean
financial ruin. The ABCs of ARMsBorrowers who use ARMs make monthly
payments of their choosing over a certain period, maybe only for a
year, after which the mortgage rate changes. Theinterest rate
fluctuates according to a designated market indicator – such as
the weeklyaverage of one-year U.S. Treasury Bills – over the life
of the loan. When interest rates rise, the monthly mortgage obligation
increases. When interest rates decrease, the mortgage payment decreases.
Lenders generally charge lower initial interest on ARMs in order to
make theinitial payments more attractive and affordable. With an ARM,
borrowers will qualify for a larger loan because lenders make their
credit decision on the basis of current income and the first
year’s payments. It is a trade-off, where borrowers get a lower
rate with an ARM in exchange for assuming more risk. The three most
common ARM products are known as
“fully-amortized,”“interest-only” and
“negative-amortization” loans. A fully-amortized ARM is the
most like a traditional loan in that the monthly payments include a
pay-down of principal on the loan. After the introductory fixed-rate,
or “teaser” period, the monthly payment rises and falls
each month based on the prior month’s fully-indexed rate, loan
balance and remaining loan term. An interest-only ARM is just what it
sounds like. Borrowers pay only the monthly interest on the loan, which
also fluctuates each month after the introductory period. Unlike the
fully-amortized loan, none of the monthly payment goes toward paying
down the principal. In exchange for a lower payment, borrowers gamble
thehousing market will continue to rise and hope to build equity from
appreciation of theproperty. A negative-amortization loan carries the
most risk. With a “neg-am,” you continue to make the
minimum payment after the end of the introductory period regardless of
rising interest rates. Depending on interest rates at the time, the
payment may or may not be enough to pay the interest charged on the
loan each month. If interest rates increase, the unpaid interest is
added to the principal balance owed on the note, resulting in what is
known as negative amortization. If a borrower continues to make the
minimum payment, the loan balance will grow. If interest rates rise, it
will grow even faster. The increased loan balance makes for an even
higher interest expense, escalating the problem and the loan balance
over time. ARMs work well to make home ownership less expensive in the
short term. However, the affordability is illusory. As interest rates
rise, ARM holders are forced to shell out more and more each month to
pay the mortgage. By the time the “teaser” payment ends and
the true mortgage obligation kicks-in, borrowers have adjusted their
lifestyles based on their mortgage payment and available cash flow,
thus compromising their ability to service the loan. The industry has
even coined a term for this – “paymentshock.”
Usually, it is not until this point that home owners learn the true
risk of their loan.Real Estate Speculation for the MassesWith ARMs,
borrowers’ ability to pay the mortgage and the safety of their
down-payment equity are at the mercy of market conditions. ARM loans
are not similar to real estate speculation – they are exactly
like real estate speculation. By purchasing an ARM, home buyers are
betting on continued growth in the housing market, stable interest
rates, and the U.S. economy as a whole. If the market moves the other
way, borrowers can very quickly find themselves owing more than their
home is worth.
With loan-to-value ratios in California commonly at 95 percent –
and in some cases even 100 percent – home owners literally can go
upside-down overnight. Most borrowers do not appreciate the risks
associated with ARMs or the speculative nature of the loans. Mortgage
brokers and lenders have been quick to understate the risks by citing
historically low interest rates and record market appreciation. To be
fair, buyers rarely perform their own due diligence when presented with
a wholly affordable mortgage payment for a home above their means. The
problem is perhaps best illustrated by David Lareah, chief economist
with the NationalAssociation of Realtors. He points out that
“[t]he brochure starts out by saying, ‘Here is your monthly
payment.’ It looks so low, you make an appointment, go to the
lender. They have to tell you eventually it’s negative am, but by
the time they tell you, you areemotionally into it.”2Due to
competition and the need for loan volume, mortgage brokers sell these
loans without regard to risk, creditworthiness or a home buyer’s
risk tolerance. This isparticularly troubling as banks are taking on
greater risks with less vigilance on their underwriting requirements.
With competition for borrowers increasing and profit margins shrinking,
there is a move toward even looser standards. The risk consequence of
ARMs and other interest-sensitive mortgages is just nowcoming home to
roost. With the economic slowdown in the last two years, some owners
who negotiated ARMs in 2004 and 2005 are facing interest rate increases
that areboosting their monthly payments by as much as 50 percent. On
May 10, 2006, theFederal Reserve increased the federal funds rate for
the sixteenth time in the last two years. Mortgage delinquencies are at
an all-time high. As interest rates continue to rise and the California
housing market cools, millions of home owners in highly-leveraged,
low-payment loans are staring down the barrel of foreclosure. Federal
Regulatory Agencies Propose a Suitability Standard on Brokers and
Lenders Offering Non-Traditional LoansIn December 2005, the federal
financial regulatory agencies issued for commentproposed guidance on
residential mortgage products that allow borrowers to deferrepayment of
principal and sometimes interest. Specifically, the Federal Reserve
Board (FRB), the Office of the Comptroller of the Currency (OCC), the
Federal Insurance Deposit Corporation (FDIC), the Office of Thrift
Supervision, and the National CreditUnion Administration have targeted
“non-traditional mortgage loans, including ’interest-only
mortgages and ‘payment option’ adjustable rate
mortgages.”3These agenciestogether regulate virtually all
mortgage lenders in the country. The agencies call to task mortgage
brokers and lenders for their liberal use of ARMs. Of concern is the
increasing availability of these “creative” mortgages and
the volume of borrowers making use of them. The proposed guidance
includes restrictions2Kathleen Pender, The Hazards of Option ARMS, San
Francisco Chronicle, June 21, 2005. 3Interagency Guidance on
Non-Traditional Mortgage Products, and limitations on the offering of
non-traditional mortgages to home buyers “who may not otherwise
qualify for traditional fixed-rate or other adjustable-rate mortgage
loans, and who may not fully understand the associated risks,”
the regulators said in astatement. The comment period on the guidance
closed in March, and currently the agencies are preparing to release
their final guidance. Of the regulators’ proposals, none is more
controversial that the imposition of astandard of care obligating
mortgage brokers and lenders to only offer suitable mortgageproducts to
consumers. Essentially, it imposes an affirmative duty on the part of
mortgage brokers and lenders to assess whether a particular product is
suitable for a consumer on a case-by-case basis. More specifically,
“[w]hen an institution offers nontraditional mortgage loan
products, underwriting standards should address the effect of a
substantial payment on the borrower’s capacity to repay when loan
amortizationbegins.” Particularly applicable to California home
buyers, “an institution’s qualifying standards should
recognize the potential impact of payment shock, and that
nontraditional loans often are inappropriate for borrowers with high
loan-to-value (LTV) ratios.” This legal duty matches that
governing stockbrokers and investment advisors. The agencies’
guidance is long-overdue in the mortgage industry. The conflict of
interest in the mortgage industry is at least equal that in the heavily
regulated securities industry. Without question, ARMs and other
non-traditional loans are the profit centers for mortgage brokers and
lenders because they necessitate short-term refinancing. In agood
economy, borrowers refinance in order to lower their mortgage cost
because appreciation increases their loan-to-value ratio. In a bad
economy, borrowers refinance to avoid payment shock and, in many cases,
foreclosure. In this regard, ARM sales are alot like built-in annuities
for mortgage brokers and lenders because they act as a pipeline source
of continuing, fee-heavy business. Also, in California, a majority of
mortgage brokers do business with only a real estate broker’s
license. The license that allows the listing and sale of real property
(thetraditional activities associated with a real estate broker
license) is the same license that allows the solicitation of borrowers
and the negotiation of loans. Put simply, the motivation of mortgage
brokers and lenders is misaligned with the interests of their
customers. Historically, borrowers have had no recourse against their
mortgage broker or lender for steering them unwittingly into real
estate speculation. For the most part, courts have treated mortgage
brokers as sales people with disclosure obligations, but have putfull
responsibility on home owners for their mortgage decisions. When
implemented, the agencies’ guidance will at long last impose
accountability for the non-traditional, high-risk mortgage products
brokers and lenders push on unsophisticated home buyers. PROTECT
YOURSELF FROM PREDATORY BROKERS AND LENDERSUnfortunately, home buyers
in California need creative, highly-leverage financing to afford a
home. Whether because of negligence or misconduct by brokers and
lenders,or home buyers’ own failure to investigate the loan
before purchase, millions of
California home owners have unknowingly put their family home at the
mercy of economic tides. The good news is even with ARMs many of these
risks are avoidable. Shop Around for the Best Deal▪Interest rates and
fees vary among lenders. They are negotiable. Compare the interest
rates and the total costs of loans offered by several lenders. ▪Ask
brokers and lenders for referrals to see if other customers have found
themselves in unsuitable loans. ▪Don't take the first loan you are
qualify for. Run From the Predators▪Be wary of lenders who solicit your
business by e-mail or telephone solicitations.▪If it is too good to be
true, e.g., guaranteed loan approval regardless of credit history, it
is. ▪Be wary of post-close promises like a guaranteed, lower-rate
refinancing in the future. Watch Out For Hidden Terms▪Early pay-off
penalties make a refinancing very, very expensive. When you have to
refinance to avoid foreclosure, you are at the mercy of these terms.
Plan for the worst. ▪Avoid "balloon" payments—some loans keep
monthly payments down by requiring a big payment at the end of the loan
term. ▪Plan against “payment shock” – make sure the
monthly payments after interest-rate increases are well within your
monthly budget. Use Your Rights▪Ask your broker and lender to explain
every term. They have a legal obligation to tell you the cost of the
loan, the annual percentage rate, the monthly payments and how long you
have to pay back the loan. ▪Have all fees and points explained to you
before applying for a loan. The worst-case scenario for interest rates
and the housing market, and have your broker and lender explain to you
their effect on the mortgage they are selling you. ▪Question your
appraisal. Many times brokers and lenders influence your appraisal to
over-value the home to qualify you for the loan. At the time of sale or
refinance, this will spell disaster.