The United States Treasury Department, along with several other federal financial regulatory agencies, released a Statement on Subprime Mortgage Lending in June 2007. This sizeable document (it is 31 pages long) is aimed at people involved in borrowing and lending for mortgages at subprime rates. Of particular concern to the authors are adjustable rate mortgages (ARMs). The Statement provides guidelines that will ensure more appropriate practices regarding ARMs. The agencies are concerned that lenders persuade borrowers to take out ARM loans by giving them an extremely low rate of interest (called a “teaser rate”) for the first few months. Unfortunately, this rate adjusts upward very soon to a formula based on and exceeding the prime rate. Now the loan is no longer within the means of the person who is classified as a subprime borrower, and it will cause extreme financial hardship. Other issues covered by the Statement are below.

Adequate documentation of income for subprime borrowers is not always required by lenders. This practice is of concern to the agencies because it leads to so-called “liar loans.” A borrower can put whatever inflated number he chooses on the application form, knowing there will be no effort to verify that this is truly the amount of his income. These loans greatly increase the chance that the borrower will default, which is a problem for the lender as well.

The agencies also address the problem of the introductory rate period. Most ARM loans include significant penalties for early prepayment, and the penalties extend well past the initial period. In addition, borrowers are not always given full information about additional monthly payments that will be required, such as taxes and homeowners insurance. This failure to disclose such information leaves the borrower at an enormous disadvantage, and will no longer be permitted.

It is interesting and unusual that, three months before releasing the Statement on Subprime Mortgage Lending, the agencies involved in creating it requested comment from the public, from members of Congress, and from financial institutions that engaged in mortgage lending. From the industry came the comment, over and over, that they are opposed to disclosing to borrowers all the details of ARM fees and rates. They think that would result in “overloading the consumer with information”! This is of great concern to the agencies, and to the author of this article as well. We don’t think the average consumer requires the protection of subprime lending agencies from information overload. Consumers can handle information just fine! Failure to disclose costs and fees for which the borrower will be responsible is nothing short of deception.

Virtually all comments reflected uneasiness that there was no adequate definition of the term “subprime” within the Statement. When the final revision appeared in June, readers were requested to refer back to the definition of a subprime borrower contained in the earlier guidelines document Expanded Guidance for Subprime Lending (2001). All the pertinent characteristic are listed there, and can be used in determining whether a particular borrower should be classified as subprime.

The Statement also requires that every borrower be given a full repayment schedule, including information on amortization, and an estimate of the amount of insurance and taxes that will be applicable. This must be done whether or not the extra costs are escrowed and are included in the loan. The extra charges must be part of a mandatory and accurate calculation of the borrower’s debt ratio.

The Statement on Subprime Mortgage Lending is a valuable effort to remedy some of the ailments of the current housing market, and insure that subprime borrowers as well as subprime lenders are not left with a financial disaster on their hands because of imperfect communication between them.

In June 2007, the United States Treasury Department, along with other federal financial regulatory agencies, issued the Statement on Subprime Mortgage Lending. This document incorporates the Statement on Working with Borrowers published by the agencies two months previously, and is intended to supplement the recent Interagency Guidance on Nontraditional Mortgage Products. The agencies specifically targeted lenders who use adjustable rate mortgages (ARMs), addressing the necessity for appropriate guidelines in this area. One main concern for financial institutions using ARMs is the offer of a “teaser rate”. This brings in a borrower at a very low rate of interest for a brief period; however, within a few months this adjusts up to a much higher rate, based on prime plus a formulary percentage. Thus an ARM is changed very quickly from an affordable product to one that subprime borrowers cannot carry without undue financial hardship. Here are some other concerns expressed by the agencies in their Statement.

A second practice of concern to agencies and addressed in the Statement on Subprime Mortgage Lending is failure to disclose fully to the borrower how these ARMs will affect future payments. In addition, so-called “liar loans” are being underwritten by some less scrupulous subprime lenders. These loans are more politely referred to as “statement of income” loans: a potential borrower simply states on an application form how much money he makes. No verification of this income is required, nor is any attempted by the lender. Such total lack of due diligence and documentation of the borrower’s repay ability means that the lender assumes greater risk of default, while the borrower is more likely to fail to meet the financial responsibility. “Statement of income” loans were originally intended for people who are self-employed, and would be unable to produce pay stubs or a W2 form to substantiate their income claims. Liar loans are a clear abuse of this intention.

A third concern described in the Statement on Subprime Mortgage Lending refers to penalties for early prepayment extending far into the term of the loan. Such penalties are usually quite substantial, and are not always fully explained in advance to the borrower. Moreover, subprime borrowers are not always informed about additional monthly payments, like insurance, taxes, and closing costs that accompany the purchase of property but are not part of the loan itself.

Three months before releasing the final Statement, the agencies released it for comment from the public, as well as from members of Congress and various financial institutions. It is interesting that the lending industry’s most repeated comments were in opposition to the requirement of full disclosure of rates and fees relating to ARMs. Such full disclosure was described as “information overload.” We find it difficult to understand how non-disclosure of all costs connected with a loan could be considered anything other than deceptive lending practices. It is only when subprime lenders offer full disclosure and open discussion to borrowers that they will be thought of as reputable entities. To fight mandatory disclosure of costs and fees seems to indicate that they have something to hide.

Most comments on the Statement also pointed out the need for a better, more inclusive definition of the term “subprime.” The final 2007 Statement references the Expanded Guidance (2001) for full criteria for considering a borrower “subprime”.

The 2007 Statement recommends that the borrower be given a full schedule for repayment of the loan, including an informed estimate of associated closing costs, insurance, and taxes. This should be provided by the lender at the time the loan originates. The document also recommends that these extra charges be calculated into the borrower’s debt-ratio status.

All in all, the 2007 Statement on Subprime Mortgage Lending provides excellent guidance for the many questionable practices that seem to have become intrinsic to subprime lending. It is inclusive of other earlier such statements, and refers the reader to the earlier 2001 Expanded Guidance document when necessary.