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

Monday, July 24, 2006 | 11:50 AM

in Consumer Spending | Fixed Income/Interest Rates | Real Estate

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