Regulators propose curbs on Non-Traditional Mortgages
By Mark Felsenthal and Kristin Roberts, Reuters

WASHINGTON — The nation's financial regulators issued proposals Tuesday that would require mortgage lenders to be more careful with innovative mortgage lending that may strain the finances of borrowers and banks as interest rates rise.

"While innovations in mortgage lending can benefit some consumers, the agencies are concerned that these practices can present unique risks that institutions must appropriately manage," bank regulators said in a statement accompanying the proposal. The guidance targets interest-only and "payment option" adjustable-rate mortgages and the practice of pairing exotic loans with second mortgages and allowing reduced documentation for borrowing. Payment-option loans give the borrower flexible payment choices, some of which add to the amount of the loan.

The proposal was issued Tuesday by the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration. The proposed guidance follows a five-year rally in the U.S. housing market that has seen home construction and sales set annual records and sent prices up more than 53% on average nationwide.

Price gains in some local markets have been even greater. In California, for example, prices have soared nearly 110% over five years, according to government data.

Regulators and some economists have been raising concerns about loose lending practices and the more aggressive use of what Federal Reserve Chairman Alan Greenspan called "exotic" mortgages that carry greater risks than traditional 30-year fixed-rate loans. Those loans have helped sustain the housing rally by giving home buyers the ability to afford pricier houses, even though household income has not risen as quickly.

Some economists now worry that as interest rates rise, so will delinquency rates, as borrowers find themselves unable to make payments. Significantly higher delinquency rates could pressure banks that offered the mortgages and investors who hold much of the risk due to their purchases of mortgage-backed securities.

Regulators propose that banks assess a borrower's ability to repay a loan at the higher rates and balances that kick in after an introductory "teaser" period. They also call on banks to be sure they have adequate capital and loan loss reserves as buffers against potential losses because such loans are untested in a "stressed environment."

The agencies further say banks should ensure borrowers fully understand loan terms and risks.

Financial institutions have two months to comment on the proposals.

Interest-only mortgages, in which the borrower pays only the interest due, and option adjustable-rate mortgages, which allow borrowers to pay less than the interest due, thus adding to the loan principal, have joined adjustable-rate mortgages as ways borrowers can reduce monthly payments when they buy a house.

Some lenders are waiving detailed documentation from borrowers to speed the loan process. Some lenders are also approving second loans simultaneously to keep the primary mortgage under the size cap for loans that can most easily be sold into secondary markets, thus ensuring a lower interest rate.

The chief economist for mortgage finance giant Fannie Mae, David Berson, Tuesday said if mortgage bankers take regulators' guidance to heart and tighten underwriting standards for riskier loans, it could hurt home sales in the priciest markets, where people have come to depend on non-traditional mortgages just to afford homes. "Certainly there has been a big shift up in the use of these products in the high-cost areas," Berson said. "It is one of the reasons why housing demand has been so strong in the high-priced areas despite affordability that's falling significantly."

Berson and other economists expect housing activity to slow in 2006 as interest rates rise and dampen demand for homes.