It won't mean the end to no-income verification or high-risk mortgages for subprime homebuyers, but new guidance from federal financial regulators will almost certainly cut their availability sharply.
In a long-awaited policy statement on loans to borrowers with imperfect credit histories, federal financial regulators a week agourged banks, credit unions and their mortgage subsidiaries to verify income, assets and employment on all loans except in special cases where borrowers could demonstrate substantial financial reserves.
The policy guidelines, which took effect immediately nationwide, also instructed lenders to underwrite adjustable-rate subprime mortgage applicants at the "fully indexed" interest rate, not at a deeply discounted teaser rate. During the housing boom years, many lenders had lured credit-impaired homebuyers into "2/28" and "3/27" adjustable-rate mortgages featuring discounted fixed payments for the first two or three years.
After the discount period, payments sometimes soared 50 percent or more, putting homebuyers in serious financial jams. Large numbers of those borrowers are now delinquent on their loan payments and at risk of foreclosure.
The new guidelines target other once-popular lender practices, but do not ban them outright. For example, many subprime 2/28 and 3/27 adjustable mortgages also carried heavy prepayment penalties - up to six months of interest - designed to discourage borrowers from refinancing before the end of the discounted rate period.
Under the new guidelines, lenders will be required to give borrowers a "reasonable period of time" - generally at least 60 days - before the rate reset date to refinance into more favorable loans without penalty.
The federal regulators also stressed that lenders should only approve subprime adjustable loans "based on the borrower's ability to repay the loan according to its terms." That doesn't amount to a formal "suitability" test, but it does require lenders to determine that the loan is appropriate to the applicant's financial status and capacity to handle payments.
The guidelines also instruct lenders to make certain that every subprime applicant understands the risks built into the loan itself, including higher costs in connection with any reduced documentation, prepayment penalties and the borrower's responsibility to keep track of tax and insurance payments if the loan lacks an escrow account.
Consumer advocates generally welcomed the new guidelines but were quick to point out that they won't make a dent in the subprime crisis or prevent lenders from issuing new mortgages with toxic features.
Not only must state financial regulators adopt mirror-image guidelines to cover mortgage brokers and independent lenders, but even then the guidelines "do not have the force of regulations" or law, said Allen Fishbein, director of housing and credit policy for the Consumer Federation of America.
Adoption of the new guidelines state by state "is going to take months, and in the meantime, a lot of consumers will still be getting loans with the same old harmful features," said Fishbein.
Michael Calhoun, president and chief operating officer of the Center for Responsible Lending, a national advocacy group, said his organization had examined subprime mortgages contained in 10 recently closed mortgage bond securitizations on Wall Street and found that 70 percent contained prepayment penalties, 37 percent were "stated income" or low-documentation, and 77 percent were adjustable-rate loans. Ninety percent of the latter carried rate and payment resets in the first two to three years.
"They're still doing this stuff" despite the well-publicized meltdown in the subprime mortgage market, said Calhoun.
Calhoun and Fishbein want the Federal Reserve to adopt tough new regulations prohibiting many of the features now commonplace in subprime lending, and to make escrow accounts mandatory for all players in the market, whether state or federally regulated.
The Fed, after unusually harsh criticism from Congress for its inaction over the past five years, is now considering the possibility of new consumer protection rules, but has given no indication about what they might contain.
In the meantime, homebuyers can adopt their own smart mortgage guidelines:
If you've had credit problems and your current income just barely qualifies you to buy the house you want using a short-term discounted-rate loan, resist the temptation - even if a loan officer or broker is pushing you to sign.
Insist on an escrow account if you have marginal credit. Yes, it means higher monthly payments. But it's also an insurance policy that guarantees that you won't end up owing thousands in property taxes that you don't have the cash to pay.
If your loan officer insists that agreeing to hefty prepayment penalties is the only way you'll ever get a mortgage, shop around more. Who knows - in an increasingly competitive marketplace, you may discover that you're not viewed as subprime by every lender, and you needn't be hog-tied by prepayment penalties.