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Regulators call for caution on subprime loans

Federal bank regulators, worried about a surge in defaults on high-risk home mortgages, on Friday called on lenders to exercise caution in making subprime loans and strictly evaluate borrowers’ ability to repay them.
/ Source: The Associated Press

Federal bank regulators, worried about a surge in defaults on high-risk home mortgages, on Friday called on lenders to exercise caution in making subprime loans and strictly evaluate borrowers’ ability to repay them.

The proposed guidance issued by the Federal Reserve and the other four federal agencies that regulate banks, thrifts and credit unions, comes in an increasingly troubled market for subprime mortgage loans. Home-mortgage delinquencies and foreclosures are spiking, especially for people who took out subprime mortgages — higher-interest loans for those with blemished credit records or low incomes who are considered higher risk — during the sizzling housing boom that waned in the second half of 2005.

The regulators said the guidelines, if formally adopted by the agencies and followed by lending institutions, could result in fewer borrowers qualifying for subprime loans. The mortgage industry had hoped for less stringent guidelines.

John Robbins, chairman of the Mortgage Bankers Association, said the group was concerned that the guidelines “may restrict credit to many consumers in high-cost areas and deny credit to many deserving low-income, minority and first-time home buyers.”

In their notice issuing the guidance for public comment, the banking regulators noted that borrowers “may not fully understand the risks and consequences” of taking out subprime mortgages, and that the mortgages “may pose an elevated credit risk to financial institutions.”

Adjustable-rate mortgages are especially prevalent in the subprime market. They are considered higher-risk loans because they typically draw borrowers in with an initial low, or “teaser” interest rate, which can rise markedly over time. The proposed guidelines direct banks to base their lending decisions on borrowers’ ability to repay home loans at the full final rate, as opposed to the teaser rate.

In addition, the guidelines say that banks should provide consumers “clear and balanced information about the relative benefits and risks” of subprime mortgages.

Fed Chairman Ben Bernanke has said the central bank is concerned about the rise in delinquencies. Several financial companies that specialize in subprime mortgages have seen their shares plummet in recent weeks, roiling the industry sector. The weakness in the subprime market was seen as a factor in this week’s tumultuous decline on Wall Street.

“The federal agencies are proposing practices and principles to limit risks to both the borrower and the lending institution,” Fed Gov. Randall Kroszner said in a statement Friday.

Senate Banking Committee Chairman Christopher Dodd, D-Conn., and Rep. Barney Frank, D-Mass., head of the House Financial Services Committee, lauded the regulators’ move.

“I hope everyone in the market will quickly embrace these new guidelines, so we can move forward and work together to address the looming foreclosure problems that may lie ahead,” Dodd said.

The entire mortgage industry has been feeling the pressure in recent months from slumping home sales. And rising delinquencies on subprime mortgages have forced an array of lenders, large and small, to set aside more reserves against potential loan losses.

Mortgage payments that are 30 or more days past due are considered delinquent.

The market for subprime mortgages has exploded during the housing boom, from fewer than 5 percent of all new mortgage loans in 1994 to an estimated 20 percent currently, or $600 billion.

On Tuesday, Freddie Mac, the nation’s second-largest financer of home loans, said it will stop buying those subprime mortgages that it deems most vulnerable to default or foreclosure.

Write-offs of home mortgage loans by banks and thrifts reached a three-year high in the fourth quarter last year, according to the Federal Deposit Insurance Corp.

In addition to the Fed, the agencies issuing the proposed guidance are the FDIC, the National Credit Union Administration, and the Treasury Department’s Office of the Comptroller of the Currency and Office of Thrift Supervision. The guidelines could be formally adopted sometime after the 60-day public comment period.