Much has been written lately about the risks posed by some adjustable rate subprime mortgages. Attention has focused on loans underwritten in reliance on favorable short-term assumptions and, in some cases, without income verification, which may leave borrowers exposed to payment shock. Concerns have also been raised about prepayment penalties, inadequate disclosure of mortgage terms, and the negative implications of repeated refinancings.

Subprime adjustable mortgages have now emerged as a high priority focus for federal bank regulators. Their Proposed Statement on Subprime Mortgage Lending, released on Friday, March 2 (OCC News Release 2007-19), presents a set of principles that depository institutions are encouraged to follow in order to address both consumer issues and safety and soundness concerns.

This raises some very tricky policy issues. Any message that subprime loans will create examination and regulatory risk is likely to rapidly reduce the offering of such mortgages and thereby reduce the mortgage financing available to a significant portion of the borrowing public. After all, risk-based subprime lending was, in part, an outgrowth of the fair lending initiatives of the 1990s aimed at expanding home ownership and the general availability of credit, particularly to underserved communities. The Proposed Statement acknowledges that tightening of subprime lending standards may adversely affect the very borrowers these initiatives were intended to protect. Balancing these competing public policy concerns will be very difficult if the past is prologue to the future.

It is important to note, as the regulators understand, that subprime lending is not intrinsically dangerous, unsafe or reckless. It can be as safe, profitable and beneficial a lending channel as any, as long as it is done properly and consistent with reasonable underwriting standards.

But mortgage lending that has not been based on reasonable, verifiable underwriting standards, but rather on a presumption that the ever-escalating value of the collateral will be the easy financial fix to any future payment or foreclosure problem, is now faced with some serious challenges.

The Proposed Statement lays out two courses of action the regulators may pursue with respect to recent subprime lending concerns.

First, the agencies could seek to enforce the prohibition against unfair or deceptive acts or practices in Section 5 of the FTC Act against institutions that engage in predatory lending. Three predatory practices in particular have been noted: (i) lending based on the foreclosure value of collateral, rather than the borrower’s ability to repay, (ii) fraudulent concealment of the true nature of a mortgage from the borrower and (iii) inducing a borrower to repeatedly refinance in order to generate high points and fees. While a lender may be confident that it has consistently provided proper disclosure and based its loans on the borrower’s ability to repay, it could be more difficult to defend against a charge of leaving borrowers in a position that requires repeated refinancings of their home loans.

The second enforcement course of action available to the regulators involves the underwriting standards set out in the Interagency Guidelines for Real Estate Lending, as supplemented by the regulators’ guidance on subprime lending. In that regard, the Proposed Statement takes the position that a lender’s analysis of the borrower’s capacity to repay the loan should evaluate the borrower’s ability to repay an adjustable rate mortgage according to its final maturity at the fully indexed rate. For more risky loans, the lender’s verification of the borrower’s income and resources becomes more important. The Proposed Statement underscores the likelihood that the regulators will bring safety and soundness enforcement actions with regard to inadequate loan underwriting practices, much as has been the case in the last five years for deficiencies and violations in the BSA/AML area. Lenders that did not qualify borrowers with respect to the fully indexed mortgage rate while also obtaining little or no documentation of the borrowers’ income may experience close regulatory scrutiny. Last, the Proposed Statement sets out familiar “Dos and Don’ts.” Subprime lenders are urged to provide clear, balanced and timely information to potential borrowers. Prepayment penalties should not extend beyond the fixed-rate period of an adjustable loan and should, in fact, provide a window for refinancing without penalty right before the first reset date. The statement also reiterates the requirement that lenders have robust internal controls to ensure that their actual practices comply with their policies and procedures. Significantly for the mortgage market, the regulators point out that regulated institutions are potentially responsible for third parties, such as mortgage brokers and correspondents. These guidelines are likely to play out in enforcement actions carefully chosen to delineate the conduct that the regulators view as problematic.

On the same day that the Proposed Statement was issued, Fremont General Corporation announced in an SEC filing on March 2, 2007, that it expects to enter into a voluntary cease and desist order with the FDIC, under which it would agree to cease operating its brokered subprime mortgage lending and commercial real estate construction lending businesses with inadequate underwriting criteria and without effective risk management policies and procedures. The order will also require Fremont General to take a number of steps, including revising its lending and disclosure policies and implementing improved internal controls.

Business Implications of the Current Crisis

The financial press has made sure that subprime lending is and will remain front and center for some time. In that regard, the promulgation of the Proposed Statement is the dropping of only the first of many shoes. The focus on subprime lending will also engage the attention of Congress, other federal regulators, state authorities, the private plaintiffs’ bar, consumer advocates, investors and commercial interests for the foreseeable future. In that regard, a number of complex question are likely to be debated:

  1.  Should there be additional regulation of non-bank mortgage lenders? 
  2. Will the concept of “borrower suitability” be required to be built into the underwriting standards of depository institutions, and, if so, how would that and other regulatory principles developed in response to the current issues in the mortgage markets impact the availability of mortgage credit, particularly to lower income families?
  3. How can additional disclosure ameliorate these concerns when the disclosures that consumers already receive are too daunting to be useful?
  4. Can the mortgage lending industry adopt best practices and consumer education programs to avert legislation and further regulation?
  5. How will capital markets conduits and investors react, and how will their reaction impact the origination market?