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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 regulators. 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 . . .

>

Source:
Eyes Wide Shut
UP AND DOWN WALL STREET 
ALAN ABELSON
Barron's MONDAY, JULY 24, 2006   
http://online.barrons.com/article/SB115352330540314175.html

Monday, July 24, 2006 | 11:50 AM | Permalink | Comments (8) | TrackBack (0)
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Comments

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

Posted by: Bob A | Jul 24, 2006 12:17:07 PM

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.

Posted by: Robert Cote | Jul 24, 2006 12:19:52 PM

Expect to see more stories like this about the time the new underwriting guidelines go into effect:
http://www.chieftain.com/business/1153204428/2

Posted by: fred hooper | Jul 24, 2006 12:20:53 PM

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.
jw

Posted by: jw | Jul 24, 2006 3:04:33 PM

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?

Posted by: Lord | Jul 24, 2006 6:48:41 PM

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.

Posted by: Gary Anderson | Jul 25, 2006 12:30:58 PM

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.

http://biz.yahoo.com/ap/060629/accredited_securitization.html?.v=1

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.

Posted by: Shawn H | Jul 30, 2006 8:09:13 PM

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

Posted by: Shawn H | Jul 30, 2006 8:10:06 PM