Michael Calhoun, president of the Center for Responsible Lending, urged policymakers to address high-risk "exploding" ARMs in the subprime market before subcommittees of the Senate Committee on Banking, Housing and Urban Affairs today.
"Nontraditional loans in the subprime market are seriously eroding the traditional benefits of homeownership," said Mr. Calhoun. "By their very nature, they pose a high risk of losing valuable home equity or foreclosure."
Hybrid ARMs and nontraditional mortgage products in the subprime market are structured to cause families to fail. Mortgage brokers and lenders use the initial low "teaser" interest rate to entice debt-strapped families into the loans. When the rate adjusts higher, homeowners are faced with the choice of another expensive and equity-stripping refinance or struggling to pay an unaffordable loan. Particularly in regions where housing prices are relatively flat, foreclosures are rising as many homeowners feel the pinch from "payment shock" – the large interest rate increases that result from most subprime ARMs.
Analysts expect payment shock to be a growing concern. As of September 2005, about 80% of subprime home loans were adjustable-rate mortgages – mostly 2/28 hybrid loans. "Exploding" loans or 2/28s operate as two-year loans that lead to another bad ARM or even foreclosure after the introductory teaser rate expires. Because subprime lenders typically qualify borrowers based on the introductory payment amount, most borrowers cannot afford to remain in these arrangements even if interest rates do not rise. According to Barron's, during the next two years homeowners can expect increased monthly payments on an estimated $600 billion of subprime mortgages.
As a typical example, consider the situation of a borrower with an annual income of $30,354 who receives a 2/28 subprime home loan for $180,000 (see attached chart). The "teaser" interest rate is 7.55 percent, giving the borrower an initial monthly payment of $1,265. However, the fully indexed rate climbs to 11.25 percent with a corresponding monthly payment of $1,726. Even more disturbing, the homeowner was placed in the loan with a debt-to-income ratio of 61 percent, meaning that well over half of the borrower's post-tax income would be spent on his mortgage. At the fully indexed rate, the debt-to-income ratio rises to 83 percent, a debt burden that is clearly unaffordable.
CRL generally supports the proposed guidance on nontraditional mortgage products issued by the federal financial regulatory agencies (FRB, FDIC, OCC, OTS and NCUA), while strongly recommending them to expand this guidance to cover subprime hybrid ARMs, and other nontraditional products made by subprime finance companies.
In addition, CRL recommends:
- Lenders should qualify borrowers based on the fully indexed rate of the loan – not the teaser rate;
- Agencies should pursue meaningful enforcement against lenders and brokers whose underwriting practices harm homeowners;
- Federal regulators should require that subprime lenders evaluate the borrower's ability to repay before making a home loan.
Download Michael Calhoun's written testimony on non-traditional mortgage products
Senate Subcommittee on Housing & Transportation and Subcommittee on Economic Policy, Sept 20 2006