New, More Stringent Rules on Option ARMs and Interest-only Loans

On Saturday, we mentioned Alan Abelson quoting of Don Tomnitz, CEO of the No. 1 home builder, D.R. Horton.

If you stopped reading after that section, you might have missed something intriguing from Ed Hyman’s ISI Group (via Abelson) on upcoming bank regulations:

"We got to musing on the extraordinary deliberateness
… while reading a recent "policy report" put out by
Ed Hyman’s ISI Group. [Bank regulators] who,
as it happens, months ago were to issue new regulations to curb the
abuses of such mortgage exotica as option ARMs and interest-only loans.

Which bears on our conviction that Mr. Bernanke is
wrong on how severe the housing skid is apt to prove and is wrong as
well on his relatively benign expectation for its impact on the
economy. The folks at ISI say that, despite its tardiness, the new,
more stringent rules, chances are, will be issued by the end of the
summer. And when they finally see the light of day, contrary to the
conventional wisdom on the Street, they’ll have an impact, and a
substantial one. And that impact will consist of cutting already shaky
demand for housing and putting further pressure on home prices.

That prediction, the authors of the report assert,
is based not on idle speculation, but rather on conversations with the
. The latter believe that "many financial institutions will
have to change their underwriting standards significantly to comply
with the new rules
." Alas, ISI doesn’t tell us exactly what has held up
issuance of the regulations. Maybe it’s nothing more sinister than
typical bureaucratic lag. (We’d prefer, of course, to think it was
something more sinister.)

What could magnify the effects of the harsher rules
is the very fact that investors seem fairly confident that the rules
won’t have much of an effect at all (those investors, that is, who are
even aware that the regulations haven’t been put to a peaceful rest in
somebody’s drawer).

The rules, ISI explains, focus on three issues: underwriting standards, portfolio management and consumer disclosure.

The first is easily the most important and holds the potential to do the most damage to housing.

What the regulators are aiming at, pure and simple,
says ISI, is to discourage banks from layering risks by writing option
ARMs and IO loans to borrowers with high loan-to-value, high
debt-to-income and low credit scores. In other words, from piling
dubious debt on impecunious or unreliable borrowers

On that score, the regulations would also require
banks when peddling "nontraditional mortgage products" to make some
reasonable effort to determine whether the wannabe borrower will ever
be able to repay the loan.
Now, the notion that banks are supposed to
worry about getting their money back strikes us as almost un-American." (emphasis added).

That’s a pretty straight forward, factual approach. It wouldn’t be an Abelson column if its wasn’t rich with snark and dripping with sarcasm:

"It also strikes us that the regulatory timing is
truly exquisite. For had the rules been issued on schedule, as last
year was calling it quits, when housing was still aboil and home
builders were reporting strong earnings, they might not have been all
that much of a big deal as an investment depressant. Come the end of
the summer, though, with housing likely awash in bad news and the
economy listing, it could be another, much uglier story."

Actually, by December ’05 the housing market was already 4 or 5 months past its peak. But the point that the regulatory impact will be more pronounced art this phase of the cycle is well taken . . .


Eyes Wide Shut
Barron’s MONDAY, JULY 24, 2006

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What's been said:

Discussions found on the web:
  1. Bob A commented on Jul 24

    A ponzi scheme with the chairman of the fed at the pinnacle of the pyramid… What a novel idea for a sci-fi thriller.

  2. Robert Cote commented on Jul 24

    Mr. R,
    Yes, the regulation(s) are too little too late and likely to exacerbate rather than ameliorate the conditions they are intended to address. My question is what regulation in your experience hasn’t been?

    Regardless, the last bit escaped your keen analysis; “…and consumer disclosure.” Transparencies at the retail and commercial levels would be really all that are necessary and thus are least likely to be implemented. As a strong (but weakly held) believer that there is nowhere near enough risk premium built into mortgage backed securities I’d dearly love to know which investment products are most exposed but there is no transparency.

  3. jw commented on Jul 24

    regarding the delay (implementing the regs), my guess would be one simply needs to check in with bank lobbyists, not to mention the home builders themselves, for a good explanation.

    witness: most home builders have been offering financing packages using super low teaser rates (with rather high APR’s buried in the detail).

    witness, part II: got a call from a buddy that filed bankruptcy two years ago. he’s been approved for a mortgage up to $300,000. he got suspicious and called me to get my take (“they know I’ve filed, how can I qualify for so much at such a low rate?”). once again, low teaser rate for first year followed by huge jump year 2-30.

    think about that in the context of everything we’ve learned about the housing bubble… then think about that in the context of high tech vendor financing so prominent when the Y2K bubble popped.

    you can’t make this stuff up.

  4. Lord commented on Jul 24

    to determine whether the wannabe borrower will ever be able to repay the loan

    Such archaic thinking! Haven’t they realized these are never meant to be repaid, only perpetually refinanced?

  5. Gary Anderson commented on Jul 25

    It is interesting to note that some who received adjustable loans in the early years of the upswing have refinanced into adjustable loans to buy more time, hoping that the fed will lower rates soon. Given some deflationary trends in wages and such, this is a possibility. But it is a gamble, as inflation is still a threat, and this declining of interest rates is not certain to occur.

    When it becomes a bet on the economy and on the fed whether to buy a house or what loan to use we are in one heck of a mess.

  6. Shawn H commented on Jul 30

    I believe these regulations will only apply to depository institutions. The real culprits of this mess will, as they have, continue to lend with reckless abandon *UNTIL*, as Bob A pointed out, the proper risk premium is priced into MBSs such that they cannot offload these time bombs. Of course they will follow the lead of Accredited Home Lending (LEND) and securitize the mortgages while keeping them off the books, then sell the few they can while keeping the trash on the books.

    This will work for a few quarters. Then either Helicopter Ben devalues the dollar by easing or defends the dollar while driving LEND and their cohorts to chapter 11. The answer was telegraphed for us when the U.S. stopped reporting M3 in January.

  7. Shawn H commented on Jul 30

    Sorry, I meant to say “keeping them *ON* the books”

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