Nontraditional mortgages: Who decides who's suitable?

Imagine that mortgages were automobiles, and you had the power to witness every sale. Every day, you would watch, dumbfounded, as pizza deliverers passed up Priuses and bought Hummers instead. You would cringe as 16-year-olds screeched off the lot in souped-up cars, destined to die young.

If mortgages were cars, you would see people making these mistakes all the time. Too often, consumers get home loans that are inappropriate or too risky.

Regulators are wrestling with the question of what to do about it. Whose job is it to decide that a particular loan is unsuitable for a specific customer?

“Who am I to tell you that you’re eligible for this kind of loan, but you’re not suitable for it?” banker Robert Broeksmit asked at a recent Federal Trade Commission workshop.

A consumer advocate retorted in an interview, “It can be boiled down to this: Don’t offer things that people can’t pay and really are rip-offs.”

The argument is about what federal regulators call “nontraditional” mortgages — home loans in which the borrower is required to pay only interest, and not principal, for the first few years. About one-quarter of new mortgages are nontraditional loans, up from a negligible market share just five years ago. These mortgages’ popularity worries regulators, because the loans are considered riskier. Some nontraditional loans, called payment-option adjustable-rate mortgages, don’t even require the borrower to pay the interest accrued: The amount owed can increase every month.

Regulators have proposed a “guidance” asking lenders to step cautiously when underwriting nontraditional loans. A guidance is a recommendation — not as binding as a regulation, but stronger than a mere suggestion. The proposed guidance says lenders should avoid loans “that may result in the borrower having to rely on the sale or refinancing of the property,” once the borrower has to start paying principal as well as interest.

In other words, don’t give a mortgage to someone who can’t afford to pay principal and interest, even if it’s an interest-only loan.

Regulatory agencies jointly proposed such guidance in December and asked for written comments. In late May in Washington, D.C., the FTC held the workshop on behalf of itself and other agencies so regulators could ask questions and get answers in a more informal setting.

Consumer advocates said lenders should subject applicants for nontraditional mortgages to a suitability test — “some duty to the borrower to make sure they’re not put in a loan that’s not appropriate,” says Stella Adams, executive director of the North Carolina Fair Housing Center. A suitability standard would be applied subjectively in a lot of cases. It would screen out egregiously risky loans.

Adams imagines a trade group coming up “with a general script that explains the differences between the products and is uniformly applied, so that people can hear an explanation. I tell you, three-page disclosures with ’wherefores’ and ’therefores’ don’t cut it.”

A suitability standard “would put some obligation on some part of mortgage lenders and mortgage brokers to not squeeze people into loans where they have no reasonable prospect of being able to repay them,” says Allen Fishbein, director of housing and credit policy for the Consumer Federation of America.

Adams and Fishbein spoke in favor of suitability tests at the FTC workshop. Bankers countered that the lending industry has built-in suitability standards. Riskier borrowers pay higher interest rates and sometimes must buy mortgage insurance. Mortgages are bundled together and sold on the secondary market to investors, who have powerful analytical tools to gauge just how risky a particular pool of loans is.

“If loans are being underwritten that will inevitably fail, there will be no buyers for those loans on the secondary market,” says Robert McKew, general counsel for the American Financial Services Association. “The secondary market acts as a regulator in addition to government regulation.”

But consumer advocates argue that the secondary market allows the mortgage industry to view foreclosures as just another cost of doing business. One foreclosure in a package of hundreds of loans is a blip on an investor’s computer screen, but it’s long-lasting trauma to the family that loses a house.

“Ultimately,” says Peter Macdonald, general counsel for LendingTree Loans, “suitability is about financial literacy. That can’t be just within the industry. The American public can and will rise to the challenge of learning how these loans work.”

Michael Williams, vice president for legislative affairs for The Bond Market Association, agrees that “you have to put the burden on the consumer to be educated.” On the other hand, he says, people don’t want to be educated. They just want the loan.