Proposed Regulation of Subprime ARMs
by Dan Stephens, November 25, 2008
(If you like this plan, please recommend it to your U.S. Senators and U.S. House Representative, and consider contributing to us to support our fight for meaningful mortgage reform and economic rescue for Main Street.)
Remember the subprime ARM crisis? It has gotten lost in the general financial and credit crisis. The fact is, now there are virtually no subprime ARMs loans available for new lending, since most subprime lenders are out of business, and the few remaining have rates that are so high they aren't worth mentioning, or only offer fixed rates. But there are still a lot of borrowers stuck in subprime ARMs, and those should be modified by government fiat. Lawmakers and regulators have totally neglected the most important action that needs to be taken, which is to regulate the most dangerous terms of the subprime ARMs that are the original and main source of the foreclosure problem, the loans that have fixed rates for only two or three years, and then quickly adjust to high rates that borrowers can't afford, the so-called 2/27 and 2/28 ARMs that previously prevailed in subprime lending.
Since early 2006 there has been an incredible level of regulatory and legislative action regarding mortgage origination, but almost none of it addresses what everybody seems to recognize as the original cause of the mortgage crisis, and still a major problem, the dangerous terms of subprime ARMs themselves. The big push has been to to regulate broker licensing, broker registration, compel rigid restrictive underwriting standards, regulate advertising, limit broker income (ban YSP's), impose fiduciary duty on brokers to borrowers, provide better disclosures, register loan officers. If all of this were to be enacted, most of the remaining brokers and wholesale lenders will be out of business and only the banks will be left to lend. Maybe that's the real intent. But, whoever is left in the market, there will still be the existing 2/27 and 2/28 ARMs with the most dangerous features still intact, because none of the government or regulatory action addressed the true source of the problem. The most urgent priority should be to enact perfectly reasonable and simple restrictions on the most dangerous terms of ARMs, both subprime and prime, that will almost completely solve the problem, and they're suggested below.
(If you like this plan, please recommend it to your U.S. Senators and U.S. House Representative, and consider contributing to us to support our fight for meaningful mortgage reform and economic rescue for Main Street.)
Remember the subprime ARM crisis? It has gotten lost in the general financial and credit crisis. The fact is, now there are virtually no subprime ARMs loans available for new lending, since most subprime lenders are out of business, and the few remaining have rates that are so high they aren't worth mentioning, or only offer fixed rates. But there are still a lot of borrowers stuck in subprime ARMs, and those should be modified by government fiat. Lawmakers and regulators have totally neglected the most important action that needs to be taken, which is to regulate the most dangerous terms of the subprime ARMs that are the original and main source of the foreclosure problem, the loans that have fixed rates for only two or three years, and then quickly adjust to high rates that borrowers can't afford, the so-called 2/27 and 2/28 ARMs that previously prevailed in subprime lending.
Since early 2006 there has been an incredible level of regulatory and legislative action regarding mortgage origination, but almost none of it addresses what everybody seems to recognize as the original cause of the mortgage crisis, and still a major problem, the dangerous terms of subprime ARMs themselves. The big push has been to to regulate broker licensing, broker registration, compel rigid restrictive underwriting standards, regulate advertising, limit broker income (ban YSP's), impose fiduciary duty on brokers to borrowers, provide better disclosures, register loan officers. If all of this were to be enacted, most of the remaining brokers and wholesale lenders will be out of business and only the banks will be left to lend. Maybe that's the real intent. But, whoever is left in the market, there will still be the existing 2/27 and 2/28 ARMs with the most dangerous features still intact, because none of the government or regulatory action addressed the true source of the problem. The most urgent priority should be to enact perfectly reasonable and simple restrictions on the most dangerous terms of ARMs, both subprime and prime, that will almost completely solve the problem, and they're suggested below.
Following are the terms of the traditional subprime ARMs as they have been traditionally constituted that have proven themselves very dangerous due to several factors:
(a) the shortness of the fixed rate period, most often two years, doesn't give the property owner a good enough chance to achieve the improvements needed to be able to
refinance out of the loan into a much better one before payment shock occurs (i.e. some combination of improved credit score and history, or significant appreciation in the property, or an increase in income, or a decrease in debt);
refinance out of the loan into a much better one before payment shock occurs (i.e. some combination of improved credit score and history, or significant appreciation in the property, or an increase in income, or a decrease in debt);
(b) the terms of the loan guarantee a rapid and unbearably large increases in the interest rate and minimum payments as soon as the fixed rate period ends (a high limit for the first adjustment, usually 3% to 6%), frequent adjustments (almost always every six months), very high margins (typically 6% to 9%), and the high lifetime adjustment cap (usually 6%);
(c) the existence of prepayment penalties that make it difficult to refinance or very expensive to do so during the penalty period;
(d) the fact that prepayment penalties expire either coincident with the first interest reset or even later.
To regulate those dangerous features in a reasonable manner we recommend the following legislation applicable to all ARM loans regardless of origination source:
Definition of a Subprime ARM ("higher-priced loan" in the proposed Reg Z amendments, and "high cost" loan in S2452, when referring to subprime ARMs):
Any adjustable rate mortgage that has a fixed rate period of ten years or less that is followed by adjustment of the interest rate to equal an interest rate index plus a margin rate (the "fully indexed rate"), and has any one of the following features:
a) a margin greater than 3%
b) a start rate greater than the fully indexed rate
c) a lifetime adjustment cap greater than 6%, unless the loan has no lifetime adjustment cap
d) if the loan has no lifetime adjustment cap, a lifetime maximum rate greater than 12%
e) an index using an interest rate security having a maturity greater than one year
(Please note that items c and d were constructed so as to avoid inadvertent inclusion of the 1-month LIBOR ARMs, 6-month LIBOR ARMs, and prime option ARMs, that have been typically originated for borrowers with excellent credit.)
We propose the following restrictions on subprime ARMs:
(a) No subprime ARM loan shall have a fixed rate period less than three years, if it adjusts more frequently than once per year;
(b) No subprime ARM loan shall have a fixed rate period less than two years;
(c) No subprime ARM loan shall adjust more frequently than once every six months;
(d) If a subprime ARM loan adjusts at intervals of less than one year, the initial and periodic adjustments are limited to 1%;
(e) No subprime ARM shall have a life adjustment cap greater than 5%;
(f) No subprime ARM loan having a fixed rate term of less than five years shall allow payment of interest only for any period.
(g) No subprime ARM loan shall allow payment of interest only for a period longer than five years.
In addition we propose the following restrictions which are vitally necessary for subprime ARMs, but are recommended for all ARMs, since there is a definite possibility that the current default trend will spread among the alt-A and prime ARM borrowers starting in 2009 at the latest, especially if the various proposed restrictions on underwriting become law:
(h) No ARM loan shall have an initial rate adjustment of more than 2%;
(i) Nor ARM loan shall have periodic adjustments of more than 1%;
(j) No ARM loan shall have a margin greater than 4%;
(k) No ARM index shall have a maturity of more than one year;
Finally, to address the issue of prepayment penalties, which has been a major headache to borrowers, brokers and lenders, we propose the following as a uniform national standard for all prepayment penalties to supercede the existing patchwork quilt of varied state laws that make interstate commerce in mortgages much more difficult:
.
(m) No mortgage loan shall have a prepayment penalty period longer than two years; (l) No mortgage loan shall have a prepayment penalty period that expires less than 120 days before the first rate adjustment (this ensures that a borrower has time to get competitive quotes and to take advantage of possible beneficial changes in rates); and
(n) A prepayment penalty shall be limited to 60 days interest on 80% of the unpaid balance.
(n) A prepayment penalty shall be limited to 60 days interest on 80% of the unpaid balance.
The foregoing would have the effect of limiting the choices of subprime ARMs to the following menu:
1) a 2-year fixed rate with 1-year adjustments, initial and periodic adjustments of no more than 1%, a lifetime adjustment of no more than 5%, and fully amortizing payments; or
2) a 3-year fixed rate with 6-month adjustments, initial adjustment of no more than 2%, periodic adjustments of 1%, a lifetime adjustment of 5%, and fully amortizing payments;
3) a 3-year fixed rate with 1-year adjustments, initial adjustment of no more than 2%, periodic adjustments of no more than 1%, a lifetime adjustment of no more than 5%, and fully amortizing payments; or
4) a 5-year fixed rate with 6-month adjustments, initial adjustment of no more than 2%, periodic adjustments of no more than 1%, a lifetime adjustment of no more than 5%, and either fully amortizing payments or interest-only payments for no more than five years; or
5) a 5-year fixed rate with 1-year adjustments, initial adjustment of no more than 2%, periodic adjustments of no more than 1%, a lifetime adjustment of no more than 5%, and either fully amortizing payments or interest-only payments for no more than five years.
Similar loans could be constructed for 7-year and 10-year fixed rates, but it's unlikely that such products would ever by instituted for the subprime market.
The newly regulated subprime ARMs would pose greatly reduced dangers of default than the existing typical 2/27 and 3/28 ARMs that werre originated in the period of 2002 through 2007. As a concrete example, compare the typical subprime 2/27 originated in June, 2005 having a start rate of 5%, an initial adjustment limit of 3% (that's being generous since many had 6% limits), 6-month adjustments, a lifetime adjustment cap of 6%, a margin of 5% and using the 6-month LIBOR index, which was over 5% at the time of first adjustment in June, 2007. That loan adjusted to 8% in June, 2007, 9% by December, 2007, then dripped to 8.125% in June, 2008. Compare that to the proposed newly regulated 2-year subprime ARM, item 1 above, with one year adjustments, and a margin of 4% maximum, which perhaps would have had a little higher start rate than the more dangerous 2/27, say at 5.25%. It would have adjusted to 6.25% in June, 2007, 7.25% in December, 2007, and 7.125% in June, 2008. The fully-indexed rate would currently be about 7.875%, and could never be higher than 10% due to the new limitation of 5% margins for all ARMs. The borrower would have had more time to adjust budgets to meet smaller payments, and the prepayment penalty would have expired in January, 2007 so there would have been 120 days to try to refinance before the first adjustment.
Another example using the 3-year ARM under the proposed new limits would have only adjusted once, to 7.125% in June, 2008. The prepayment penalty would have expired in June, 2007 so the borrower could have been shopping for a new conforming or FHA or MyCommunity loan at a rate potentially significantly better rate than 7.125%, depending on the borrower's current equity and personal credit parameters. Even if the borrower were to have been unable to refinance until now, the next adjusted rate in December, 2008 would likely be a reasonable 6.625% until June, 2009 (based on a margin of 4
% max plus the current index of 2.6%).
As you can see, the newly regulated ARMs would give borrowers a much better chance to survive their initial loan. I find it easy to imagine that, if the proposed newly-regulated ARMs had been available in 2004, the subprime crisis would have been much less severe, borrowers' equities might not have shrunk as much today, if at all, and the subprime lending market might still exist on Wall Street. If legislators want to have a major positive effect on the current subprime mortgage crisis, impose the above restrictions retroactively on all the outstanding subprime ARMs (see my post on government-mandated modification of subprime ARMs). That would have a good chance to bring back the CMOs and MBSs from the dead and unlock the seized up mortgage credit coffers. It would also be a more attractive alternative to lenders than simply rolling back ARMs to their initial rates, since lenders could at least get some reasonable and workable increases in their rates on those loans. That could make the emerging economic recession shorter than it otherwise will be. -END-
Another example using the 3-year ARM under the proposed new limits would have only adjusted once, to 7.125% in June, 2008. The prepayment penalty would have expired in June, 2007 so the borrower could have been shopping for a new conforming or FHA or MyCommunity loan at a rate potentially significantly better rate than 7.125%, depending on the borrower's current equity and personal credit parameters. Even if the borrower were to have been unable to refinance until now, the next adjusted rate in December, 2008 would likely be a reasonable 6.625% until June, 2009 (based on a margin of 4
% max plus the current index of 2.6%).
As you can see, the newly regulated ARMs would give borrowers a much better chance to survive their initial loan. I find it easy to imagine that, if the proposed newly-regulated ARMs had been available in 2004, the subprime crisis would have been much less severe, borrowers' equities might not have shrunk as much today, if at all, and the subprime lending market might still exist on Wall Street. If legislators want to have a major positive effect on the current subprime mortgage crisis, impose the above restrictions retroactively on all the outstanding subprime ARMs (see my post on government-mandated modification of subprime ARMs). That would have a good chance to bring back the CMOs and MBSs from the dead and unlock the seized up mortgage credit coffers. It would also be a more attractive alternative to lenders than simply rolling back ARMs to their initial rates, since lenders could at least get some reasonable and workable increases in their rates on those loans. That could make the emerging economic recession shorter than it otherwise will be. -END-
Posted by The Mortgage News at 11/25/2008 5:09 PM 
Categories: Housing Values,Credit Crisis,foreclosures,foreclosure crisis,mortgage crisis,Subprime Loans,mortgage delinquencies,mortgage modification,Main Street bailout,Mortgage Legislation
Categories: Housing Values,Credit Crisis,foreclosures,foreclosure crisis,mortgage crisis,Subprime Loans,mortgage delinquencies,mortgage modification,Main Street bailout,Mortgage Legislation
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