The federal financial regulatory agencies (Department of the Treasury, Federal Reserve System, Federal Insurance Deposit Corporation, and the National Credit Union Association) issued a final statement aimed at toughening subprime lending standards late last week. Subprime mortgage loans are loans made to borrowers unable to qualify for prime loans due to a limited or blemished credit history.

The new standards call for documented evidence of income rather than stated income. In addition, the guidance calls for clear disclosures of mortgage terms and at least 60 days to refinance a loan, without penalty, that is about to reset to a higher rate.

The interagency efforts are in response to a record number of foreclosures in 2006 and 2007 and the bankruptcies of numerous lenders offering subprime mortgages. Any mortgage lender who is under the umbrella of the federal financial regulatory agencies is expected to follow the new standards. Sanctions for not following the guidelines are unclear but the statement says that "the [federal financial regulatory] agencies will take action against institutions that exhibit predatory lending practices, violate consumer protection laws or fair lending laws, engage in unfair or deceptive acts or practices, or otherwise engage in unsafe or unsound lending practices."

Other guidelines included in the statement:

  • Lenders need to show that a borrower can repay at the highest possible rate, not just the initial low rate;
  • Banks will not be penalized for trying to restructure loans when a borrower falls behind;
  • Rate resets, balloon payments and, borrower responsibility for tax and insurance costs should be included in consumer disclosures.

"This guidance ... underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect but also after the interest rate resets," Federal Reserve Board Governor Randall Kroszner said in a statement.
The U.S. Senate Committee on Banking, Housing and Urban Affairs Chairman Christopher J. Dodd (D-CT), says "regulators have taken an important step in the right direction."

"I applaud the regulators for this guidance. It establishes, once and for all, the principle that lenders must seriously and fully consider a borrower's ability to pay a loan back, at the fully indexed rate, before making a mortgage loan," Dodd said in a released statement. "Had regulators enforced such a standard over the past several years, and had lenders abided by it, many of the problems that homeowners and the markets are experiencing today would have been avoided."

The combined efforts of the federal financial regulatory agencies augment and reinforce an April 17 interagency statement that encouraged institutions to work constructively with residential borrowers who are financially unable to meet their contractual payment obligations on their home loans.

Subprime woes have dominated industry news in the past few months. According to an April report from the Joint Economic Committee of Congress, the areas expected to be hardest hit by foreclosures include Atlanta, Indianapolis, Denver, Dallas, and Detroit. In the same time frame, it was suggested by Congressional Democrats led by Charles Schumer (D-N.Y.), that the government bail out the more than one million subprime borrowers to the tune of $120 billion.

John M. Robbins, chairman of the Mortgage Bankers Association (MBA) says the new standards "will help curb abuses, but will likely also constrain consumer credit choices."

The National Association of Realtors (NAR) says they welcome the new guidelines and will adopt the standards in the interest of preventing "abusive lending with strong underwriting and other pro-consumer lending standards."

Learn more about markets featured in this article: Atlanta, GA.