Tougher rules eyed on risky mortgages

Federal regulators fear surge in alternative loans will lead to more defaults


WASHINGTON -- Federal regulators are proposing tougher standards on nontraditional mortgage loans, saying that expanded use of new interest-only and adjustable-rate loans has put both borrowers and the financial system at greater risk.

The guidelines proposed last week come amid growing concerns that many borrowers have signed up for mortgages they cannot afford, setting the stage for widespread defaults in coming years. Nationwide, mortgage debt has surged by about 70 percent since 1999, to nearly $8 trillion.

The widespread use of alternative loans - combined with relaxed standards in evaluating the creditworthiness of borrowers - "present unique risks that institutions must appropriately measure," the Federal Reserve said in a statement with other regulators.

To ease the dangers, the federal agencies proposed requiring lenders to assess the ability of borrowers to repay the full burden of loans after low-cost introductory periods have expired.

Lenders also would be required to give borrowers "clear and balanced information about the relative benefits and risks of these products."

The affected loans include popular "payment option" adjustable-rate mortgages, in which borrowers receive loans with low initial rates that adjust higher over time, and so-called interest-only loans in which borrowers don't pay any principal for several years.

Industry observers worry that many of the new borrowers will be caught off-balance when their payments shoot upward in the future.

An analysis by Deutsche Bank found that $83 billion in loans with adjustable rates were subject to increases this year, soaring to more than $300 billion next year and $1 trillion in 2007.

Federal officials share that concern, noting that lenders also have relaxed standards for approving loans. Further, alternative loans often are marketed to people with weak credit histories "who may not fully understand the associated risks of nontraditional mortgages," the Fed said in a joint statement with the Comptroller of the Currency, Federal Deposit Insurance Corp., Office of Thrift Supervision and National Credit Union Administration.

The financial agencies proposed that lenders:

Consider the ability of borrowers to repay their debts based on the fully indexed loan rate that kicks in after a cheaper introductory period ends, as well as the added costs of negative amortization (in which unpaid interest piles up, expanding the size of the debt).

Set up reporting systems that provide warning of potential, or increasing, risks from nontraditional loans.

Maintain sufficient reserves to cover potential losses from loans that go into default, recognizing that some of the new products have yet to be tested in times of financial stress.

The proposal was released for a 60-day public comment period. If approved, regulators would review lenders for compliance, and could demand remedial action.

By improving standards and disclosure requirements, "financial regulators are acting prudently to mitigate the growing risks associated with these nontraditional products as their share of institutional portfolios grows," Bryan Hubbard, a special adviser at the Comptroller of the Currency, said in a statement.

Deborah Goldstein, executive vice president at the Center for Responsible Lending, a consumer advocacy group, called the proposal "a good first start."

In particular, she said, the requirement that lenders consider the full payment burden of a loan would address "one of the most critical" problems.

Lenders were more cautious. An industry trade group representative pointed out that nontraditional loans have helped make homeownership possible for people who could only rent in the past.

"Our view is that innovation is a good thing," said Doug Duncan, chief economist for the Mortgage Bankers Association, who said his group would review the proposals carefully.

"We'll be looking just to ensure that there isn't a mindset that will throw out the baby with the bath water," Duncan said.

Jonathan Peterson writes for the Los Angeles Times.

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