Regulators Wary of 'Risk Layering' on Alternative Products

Federal regulators stuck to their guns in issuing tough final guidance on interest-only and payment-option lending, but opinions are divided over the impact it will have. But few think the new guidance will cause volumes to plummet.

The Mortgage Bankers Association accused the regulators of overreaching and forcing lenders into a "one-size-fits-all underwriting standard that will unnecessarily choke industry innovation and diminish consumer choice."

Many expect the guidance will force federally insured banks and thrifts to tighten their underwriting standards, giving independent mortgage banks and Wall Street conduits a competitive advantage.

It could also force some banks to exit the business, which would reduce originations and buyers for these loans.

But Rudy Orman, a subprime industry veteran who joined Goldman two years ago from Countrywide Home Loans, said over the past two months he has seen scores of lenders rolling out their own version of payment-option ARMs.

Still, some believe the guidance could slow originations of exotics as depositories implement the new, detailed guidance, assuring that their mortgage brokers and correspondents are complying with the new underwriting standards.

"As anticipated, the guidance is very tough and includes no 'out' for sales to the secondary market," according to Federal Financial Analytics managing partner Basil Petrou.

Mr. Petrou expects many banks and thrifts will return to more conventional lending, which will be a "boon" for Fannie Mae and Freddie Mac.

Mortgage banking consultant Howard Glaser said the guidance will substantially reduce the "proliferation of these products." Fannie, Freddie and the Federal Housing Administration "all emerge as potential winners as products, which have driven mega-originator profits, fade from the market," the Washington consultant said.

But a Friedman Billings Ramsey analyst expects the guidance will not "materially alter the option ARM landscape" and the larger lenders will be able to adjust.

"We believe the smaller more aggressive players in the option ARM space will feel the biggest impact, while the traditional option ARM lenders and the larger, more diversified mortgage companies are well equipped to conform to the rules," FBR analyst Paul Miller said.

One mortgage company executive noted that the guidance requires lenders to qualify borrowers at the fully indexed rate and to include potential negative amortization in the loan amount for underwriting purposes. However, the guidance is silent on debt-to-income ratios.

That allows lenders to increase DTI qualifying ratios to accommodate the higher loan amounts, according to the executive who did not want to be identified. In his research report, Mr. Miller also noted that the guidance does not address DTI levels.

The banking regulators stress that the focus of the guidance is sound underwriting practices and managing risks, not the product itself.

"Institutions with sound underwriting, adequate risk management and acceptable portfolio performance will be not be subject to criticism merely for offering such products," the guidance says.

Paul Muolo also contributed to this report. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com