A Hands-Off Policy on Mortgage Loans

By EDMUND L. ANDREWS - NYTimes.com

WASHINGTON - For two months now, federal banking regulators have signaled their discomfort about the explosive rise in risky mortgage loans.

First they issued new "guidance" to banks about home-equity loans, warning against letting homeowners borrow too much against their houses. Then they expressed worry about the surge in no-money-down mortgages, interest-only loans and "liar's loans" that require no proof of a borrower's income.

The impact so far? Almost nil.

"It's as easy to get these loans now as it was two months ago," said Michael Menatian, president of Sanborn Mortgage, a mortgage broker in West Hartford, Conn. "If anything, people are offering them even more than before."

The reason is that federal banking regulators, from the Federal Reserve to the Office of the Comptroller of the Currency, have been reluctant to back up their words with specific actions. For even as they urge caution, officials here are loath to stand in the way of new methods of extending credit.

"We don't want to stifle financial innovation," said Steve Fritts, associate director for risk management policy at the Federal Deposit Insurance Corporation. "We have the most vibrant housing and housing-finance market in the world, and there is a lot of innovation. Normally, we think that if consumers have a lot of choice, that's a good thing."

At the Federal Reserve, officials face issues similar to those posed by the stock market bubble of the late 1990's. Alan Greenspan, the chairman of the Federal Reserve, warned about "irrational exuberance" in the stock market but did not try to pop the bubble.

Today, Mr. Greenspan acknowledges that housing prices in some areas are "frothy," but he and other top regulators do not think it is their job to push them back down.

The main issue for regulators is whether banks and other lenders are properly managing their own risk, and the lenders are looking good.

They have hedged their risks by bundling mortgages into securities that are then sold to investors around the world. And if interest rates go higher, they have shifted much of the risk onto consumers because a growing share of home buyers have taken on adjustable-rate mortgages. At the same time, they have built sturdier financial institutions through mergers and the breakdown of barriers to interstate banking.

Bert Ely, an independent banking analyst who was among the first to recognize the crisis at savings and loan institutions in the 1980's, said the banks are far sounder today. "It's a night-and-day difference," Mr. Ely said. "No comparison."

But consumers - and perhaps the broader economy - are taking on more risk. About 60 percent of mortgages last year had adjustable interest rates, many with artificially low teaser rates that expire after the first few years. If a mortgage rate jumps from 4 percent to 6 percent, just slightly above current levels, the monthly payment can jump by roughly 30 percent when the teaser rates come to an end.

The jolt can be higher for people with interest-only loans. In addition to facing higher rates, borrowers also have to start paying down the amount they owe after about five years. People who put no money down face a different risk: if housing prices decline, even slightly, owners who need to sell their homes may have to come up with thousands of dollars beyond the sale price to pay off their loans.

Indeed, because the main risks are to consumers rather than to financial institutions, some critics say regulators have been too timid. "The prevailing attitude is that if you're taking on a risky mortgage, you're an adult and you're taking on the risk yourself," said Representative Barney Frank, Democrat of Massachusetts and a co-sponsor of a bill that would impose tougher rules against so-called predatory lending practices.

"If you are the comptroller of the currency or the Federal Reserve, you're looking out for the system of the world," Mr. Frank added. "You're making macroeconomic policy. It's much more fun than looking out for consumers."

Even as federal regulators try to reinforce what they say are standard practices for proper underwriting, a growing number of state banking regulators worry that more may be necessary.

"The issue is suitability," said Joseph A. Smith Jr., the state banking commissioner of North Carolina. "If you are a stockbroker, you don't put grandma into a hot tech stock. In the mortgage market, you may have a product that is perfectly O.K. for a thoracic surgeon or a professional basketball player, but is not appropriate for a nurse at Baptist Hospital in Winston-Salem."

Betting on RatesUnconventional mortgages have soared in popularity in recent years. About a third of home buyers in the last 18 months did not put any money down, according to a recent survey of home purchasers by the National Association of Realtors.

Over 25 percent of all new mortgages in the last year have been interest-only loans, which allow buyers to postpone principal payments for three to five years but which become much more expensive afterward.

Perhaps the hottest new loan is the so-called option adjustable-rate mortgage, or option ARM, which gives borrowers the choice of paying interest and principal, interest only, or even less than the normal interest. If the home buyer picks the lowest possible payment, the mortgage debt goes up rather than down.

Despite their hands-off approach, some regulators are worried that banks and other mortgage lenders may not have properly judged the risks to themselves. They warn that speculative buying has increased, with many people hoping to quickly resell houses and condominiums before the construction is even finished.

"There is a lot of pressure on banks to build market share, and consumers are looking for a quick response," said Barbara J. Grunkemeyer, deputy comptroller for credit risk at the Office of the Comptroller of the Currency. "With respect to these new mortgage products, they are new and have taken off rapidly. We are still in the process of understanding the risk-management systems that surround them."

Led by the comptroller's office, which oversees nationally chartered banks, federal banking regulators published guidance in May that gave lenders more detailed instructions on how to evaluate the risks in home-equity loans.

The move was a warning shot to lenders. The value of home-equity loans shot up 40 percent in 2004, to $398 billion. Almost all of those loans are at adjustable interest rates, which could rise sharply, and many were extended to people who had just borrowed money to buy a house.

Regulators say they plan to raise many of the same concerns this fall that they have already raised about home-equity loans. The areas they find worrisome include granting loans equal to 100 percent of the value of the homes; granting large loans without due attention to the likelihood of higher monthly payments in the future; and granting "no-doc" (no documentation) or "low-doc" loans that require little or no proof of income or assets.

Such "guidance" is part of a joint effort by the federal regulators involved with banks and savings and loans: the Office of the Comptroller, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration.

Ms. Grunkemeyer said she would push for better assessment of a potential buyer's capacity to repay a loan. Even if the applicant qualifies for a loan based on a teaser rate of 4.25 percent, for example, banks will be asked to judge whether that borrower will be able to make payments if the rate jumped to 6 percent.

Regulators also want to take a tougher stance toward no-documentation loans. "You have to ask yourself, why would he be willing to pay a quarter-percent more when he could have gotten a lower rate by giving a copy of his pay stub and a W-2 form," Ms. Grunkemeyer said. "There's a reason they've been called 'liar's loans.' "

The guidance is tougher than it sounds, because bank examiners use it when they scrutinize an institution's loan portfolio and underwriting practices.

But even advocates of stricter scrutiny, like Susan Bies, a governor of the Federal Reserve, say regulators are merely telling banks what most of them already know.

"We're not trying to set off alarms that we see broad issues," Ms. Bies said in a recent interview. "We are seeing examples of practices that need to be tightened down a bit."

Most regulators, including Mr. Smith in North Carolina, are against issuing edicts against particular kinds of loans, even relatively risky ones, if both home buyers and lenders are eager to have them.

But many state regulators want to go further than the federal government. State banking regulators are locked in a long-running power struggle with Washington over so-called predatory lending: deceptive mortgage loans that have extremely high fees and are usually offered to people with poor credit.

Complaints about predatory lending are heavily concentrated among subprime borrowers, or people with spotty credit records and erratic incomes who probably could not have obtained a mortgage 10 years ago.

The volume of subprime mortgages has soared from about $35 billion in 1994 to about $530 billion in 2004 - more than 20 percent of all new mortgages last year. That growth helped propel the homeownership rate to a record 69 percent in 2004. The foreclosure rate on subprime mortgages remains modest, only 3.5 percent in the first quarter of 2005, but that is nine times the rate for prime borrowers.

The Bush administration and Republican lawmakers in Congress are seeking to pre-empt state laws on predatory lending, saying that consumers and lenders need a coherent set of national rules.

But many states, including New York and North Carolina, contend that the federal guidelines are weaker than their own and that federal agencies are not equipped to handle consumer complaints from 50 states.

"When I started out, the biggest complaints were about denial of credit," Mr. Smith of North Carolina said. "Today, none of our complaints are about denial of credit. They are all about what happened after the credit was given."