E-Z Credit Under Fire

Submitted by Rich Toscano on November 29, 2005 - 10:59am

John Dugan, the new-ish head of OCC (Office of the Comptroller of the Currency—a federal banking regulator), isn't a big fan of "exotic mortgages."

Those with some free time can read a recent speech that Dugan delivered regarding "non-traditional mortgages." The executive summary: they have their legitimate uses, but these legitimate uses don't include helping people stretch financially to buy more house than they could afford otherwise. Here's a snippet on everyone's new favorite, the option-ARM:

Recent studies show that a significant number of borrowers are frequently choosing to pay the minimum amount possible, a payment amount that typically falls short of the interest accruing on the loan. Even more disturbing, this choice does not seem limited to high quality, affluent borrowers who may be using the product as a payment flexibility tool. The research indicates that borrowers at both ends of the FICO spectrum make this choice, with riskier borrowers resorting to it most frequently. Because such minimum payments fall considerably short of the total interest accruing each month, the unpaid interest is added to the loan principal, and negative amortization occurs. Thus, it should come as no surprise that, of the least creditworthy holders of payment-option ARMs, nearly 50 percent have current balances above their original loan amount.

Dugan then goes on to explain that sudden payment increases of 50-100% are a very real possibility for many option-ARM holders, and that he considers this far too risky a situation. The OCC will be issuing new guidelines on non-traditional mortgage products at the beginning of 2006. In the meantime, Dugan's message to the lenders is clear: start cleaning up your act now.

We don't know yet how strict these guidelines will be, but one this is for sure: this is a very negative development for California real estate. Exotic mortgages are nothing less than the lifeblood of the SoCal real estate market. With affordability ratings as low as 9% in San Diego, and not much better elsewhere, non-traditional loans are the only way the vast majority of people can afford to buy. And now we come to learn that one of the nation's top banking regulators wants to reign them in. This can't be good for the housing market, and, depending on what the guidelines look like, it could be very bad.

A philly.com article on this topic exposes an interesting twist to this whole story: none other than David Lereah, NAR chief economist and one of the nation's most strident housing cheerleaders, is lobbying for stricter regulation of exotic mortgages. What's he up to? Says Lereah:

"I'd like to see more guidelines on the percentage of these loans that can be issued, even if it slows home sales, to ensure a soft landing for the market."

Sorry, Dave, but you're about two years late to this particular party. Years of risky lending has driven prices to heights that can only be sustained via even riskier lending. Once that E-Z credit starts to tighten, we will head for a landing—but I highly doubt it will be soft.

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