June 4, 2007

Because many sub-prime loans have not been affordable, Government is adopting rules to mandate affordability, ignoring that many unaffordable loans are in the borrower's interest. Fortunately, the major new rule is easily and legally evaded.

Many Sub-Prime Loans Have Not Been Affordable

Case histories of sub-prime loans that have gone to foreclosure often generate righteous indignation. With benefit of hindsight, many if not most of them look as if they never should have been made. Such indignation is one important motivator for recent demands that Government should require that all home mortgages be “affordable”.

A Rule For Establishing the Affordability of ARMs

While affordability is a difficult concept to define rigorously, one well-defined affordability rule has emerged with the approval of bank regulators, community groups and many legislators. It applies to adjustable rate mortgages (ARMs), which have more than their proportionate share of foreclosures. The rule is that affordability on ARMs be determined using the fully-indexed interest rate.

In many cases, lenders assess the ability of ARM borrowers to make their payments at the initial interest rate, which is artificially low. When the rate increases, the payment also increases and may become unaffordable.

I will use the 2/28 ARM, the most widely-used instrument in the sub-prime market, to illustrate. The rate is fixed for 2 years, after which it is adjusted every 6 months to equal the value of the rate index at the time of the adjustment, plus a margin which is fixed for the life of the loan. Any rate increase may be limited by a rate adjustment cap.

For example, assume the initial rate is 6%, the index is one-year Libor which currently is about 5.4%, the margin is 6%, and the adjustment cap is 3%. If the index remains unchanged, the rate after two years will rise to 9%, the maximum permitted by the cap, and 6 months later to 11.4%. Assuming a 30-year mortgage, the payment will increase by 32.7% in month 25, and by another 21.3% in month 31. The borrower may not be able to manage such formidable increases.

The affordability proponents propose that lenders should be required to qualify borrowers at the fully indexed rate (FIR), which is the current value of the index plus the margin, rather than the initial rate. In the example, the FIR is 6% + 5.4% = 11.4%. The logic is that borrowers who at the outset can meet the payment calculated at the FIR will find it affordable 24 or 30 months later when the rate increases.

The ARM Affordability Rule Is Easily Evaded

The requirement, however, will have little impact because it can be so easily (and legally) evaded. This may be a good thing because the consequences of an effective rule might well be unacceptable.

Borrowers are qualified using maximum ratios of mortgage payment plus other housing expenses to income. Assume the maximum ratio is 36% and that the borrower taking out the 2/28 ARM described above barely qualifies – his ratio is 36% -- when the payment is calculated at 6%. Calculating the payment at the FIR of 11.4% would push the ratio to 51%, making the borrower ineligible.

The maximum ratio, however, remains within the lender’s discretion. This means that a lender who wants to make the loan has only to increase the maximum ratio to 51% and, presto, the borrower qualifies at the FIR. This would be a completely legal evasion. In the sub-prime market, ratios of 50-55% are not uncommon.

In principle, Government could close this escape valve by freezing the qualification ratio, and 25 years ago this might have been possible. Ratios of 36% and 28%, measured with and without non-mortgage debt service, were then more or less the norm. As underwriting systems have evolved, however, maximum ratios have proliferated. They now vary from one loan program to another, and with other factors that affect risk, such as credit score, down payment, type of property, and loan purpose. Government intrusion into this very complex process in order to make the FIR rule effective would be a disaster, and nobody has suggested it.

Evasion May Be Better Than Enforcement

Proponents of the FIR rule either don’t realize how easily the rule can be evaded, or are satisfied to go through the motions. If the rule was effective, they might be forced to confront a really thorny issue.

Any Government underwriting rule that is more restrictive than those selected by lenders, and which cannot be evaded, will reduce the number of households who qualify for loans. Of this group that is cut from the market, some would lose their homes through default and foreclosure had they received loans. This is the intended benefit of the more restrictive rule. A larger number, however, would have become successful homeowners under the previous rules and are now denied this opportunity. This is the unintended but inescapable cost of the restrictive rule.

To prevent one foreclosure by tightening standards, we prevent a larger number of successful loans. I don’t know what that number is, or what society should view as an acceptable number. These questions have been studiously avoided.

Some Unaffordable Loans Are in the Interests of Borrowers

Another shortcoming of the “all loans should be affordable” idea is that some unaffordable loans are clearly in the interests of borrowers. Reverse mortgages are an obvious example, but there are many others that are not so obvious. The following examples are based on letters from my mailbox.

Need to Stay in House: Mary M. is a widow who owns a house worth $2 million with no mortgage. Her income, however, dropped precipitously when her husband died and is now barely enough to pay the property taxes. She plans to live with her children starting in 5 years, and wants to remain in her house until then.

To accomplish this, Mary takes out an interest-only 30-year fixed rate mortgage for $1 million at 8%, which costs her $6,666 a month. She immediately invests the $1 million in a pay-out annuity that yields 5% over 5 years, generating cash flow of $18,793 a month. ($16,667 of this is the repayment of her $1 million). Net of the mortgage interest, her cash flow is $12,127 per month for 5 years, which meets her needs. At the end of 5 years, she sells the house and pays off the loan.

This loan is unaffordable, but it is a perfectly sound loan for the lender to make, and it allows the borrower to maintain her life style.

Financial Emergency: Chuck T. learns he is going to be laid off in two weeks and will have no income for 4 to 10 weeks. His financial reserves are not large enough to pay his mortgage during this period, but he has equity in his house, which is a type of financial reserve. He uses it to take out a second mortgage in the form of a home equity line of credit (HELOC), which allows him to stay current on his first mortgage.

Chuck can’t afford the HELOC when he gets it because he has no income. Nonetheless, it is well-secured by his house, and it is paid off along with the first mortgage when Chuck finds a new position.

Confidence in Rising Income: John M. is a young physician with two years remaining on his residency. His annual income now is $50,000 but in two years it will be at least $150,000. Instead of buying a small house now and then upgrading in two years, which is extremely costly, he wants to buy the larger house now based on his income in two years.

Underwriters will not qualify a borrower using expected future income, no matter how well grounded the expectation is. John’s current income is too small to qualify for a loan large enough to purchase the house he wants using any of the standard mortgages. However, he can qualify with his current income using an option ARM on which the initial minimum payment can be calculated at a rate as low as 1%. While the payment rises slowly over time and may jump sharply after 5 years, John will be well prepared for it.

In all these cases, lenders made good loans that were well secured. The first two were unaffordable by the borrower at the time they were made. The third would have been unaffordable if the lender had been barred from qualifying the borrower at the very low interest rate in month one, as the bank regulators have proposed.

If the affordability police force institutional lenders to reject loans of these types, the loans will gravitate to “hard-money lenders”. These are mainly individuals who base loan decisions strictly on the collateral, care not a fig about affordability, are outside the reach of any affordability rules, and charge very high rates. The prospect that Government will require that institutions make only affordable loans makes them drool.