Regulators target mortgage bankers

Top federal regulators directed banks to tighten their mortgage lending practices, warning that interest-only loans and other nontraditional mortgages pose a risk to the banking system and the economy.

The banking directive is expected to have a big effect on Washington and other hot real estate markets where more than one-third of home buyers have been using such deferred-payment loans, often because that’s the only way they can qualify to purchase houses whose prices have doubled or tripled in recent years.

Feeding what some analysts think is a “bubble” in the housing market, lenders increasingly are offering the loans to novice buyers and those with shaky credit to keep their buying prospects alive while circumventing the sharply higher interest rates engineered by the Federal Reserve in the past 1 years.

“[We are] concerned that these products and practices are being offered to a wider spectrum of borrowers, including subprime borrowers and others who may not otherwise qualify for more traditional mortgage loans or who may not fully understand the associated risks,” said the Federal Reserve, Federal Deposit Insurance Corp., Office of Thrift Supervision and two other regulators in a joint statement.

The monthly cost of the deferred-payment loans can increase astronomically beyond a borrower’s ability to pay once the principal comes due or interest payments rise, typically within two to three years of purchase.

Often the extremely lenient terms are offered as part of an “introductory rate.” Although some borrowers are financially able to withstand the payment shock when the temporary rate expires, others are not and are at risk of default.

In a new requirement that could constrict the availability of mortgages in some markets, the regulators said banks should determine before granting credit whether borrowers are able to afford the loans when the sharply higher payments come due.

The regulators said they also are “concerned” that banks are offering the risky loans in conjunction with liberal no-documentation requirements and second mortgages that eliminate any equity ownership in the property, increasing the likelihood of default.

The regulators said banks must disclose the risky terms of the loans to borrowers.

The regulators’ action comes on the heels of warnings this year by Fed Chairman Alan Greenspan about the hazards posed by the frenzy of home buying fueled by lenient lending in recent years.

A financial crisis could occur if numerous buyers purchase inflated properties using no-equity and deferred-payment loans, only to see the prices plunge as the housing market cools, driving the value of their properties below the value of their outstanding loans.

In a scenario feared by some financial analysts, buyers would be unable to pay loans as principal comes due and interest rates increase, causing a rash of defaults and collapse in the housing market.

That would reverberate through the banking system and the economy, causing an economic decline.

Banks should keep in mind, the regulators said, that unlike 30-year loans and conventional adjustable mortgages, the “innovative” loans that have mushroomed this decade never have been tested in “stressed” economic conditions in which loan losses typically rise.

The regulators suggested that banks set aside reserves in the event of higher defaults on such loans.

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