A top federal banking regulator said Wednesday new guidance now being drafted for subprime lenders should address the widespread use of stated-income loans, which present “a temptation for misrepresentation” and “outright fraud.”
Comptroller of the Currency John C. Dugan, speaking to members of the Neighborhood Housing Services in New York, outlined his concerns that the misuse of stated-income loans helped drive an increase in delinquencies and foreclosures among subprime loans.
Last year, Dugan said, nearly 50 percent of all subprime loans relied on stated-income applications. Considering that stated-income loans carry higher interest rates, and most subprime borrowers are wage earners who can easily produce copies of their W-2 forms, it’s worth pondering why the loans are so popular.
“Two reasons jump to mind, neither of them reassuring,” Dugan said. Borrowers may not understand how much more they pay for the convenience of not providing income verification, and that makes them “a tempting target for brokers who typically have a financial incentive to skip the verification process and get the loan approved at a higher interest rate.”
But Dugan said an even more troubling explanation is that borrowers inflate their incomes in order to qualify for larger mortgages.
When the Mortgage Asset Research Institute examined a sample of stated-income loans, it found 90 percent of borrowers reported incomes higher than those found in IRS files, Dugan said. Almost 60 percent exaggerated their incomes by more than 50 percent.
Those are realities that mortgage brokers may be able to put up with, since they earn higher fees for bigger loans, Dugan said. But why would the lenders and investors in mortgage-backed securities who bear the risk if the loans go bad be willing to make so many risky loans?
Some lenders say income is not as good a predictor of default as credit scores and loan-to-value ratios, and that they can offset the risk involved in stated-income loans by charging higher interest rates.
Dugan said there’s another factor. Lenders know that as long as home prices are rising, borrowers can keep current on their loans by refinancing them — a process that generates another round of fees for brokers and lenders.
The rapid price appreciation during the housing boom “was the perfect petri dish to incubate the widespread practice of stated-income loans,” Dugan said.
When home-price appreciation slows or reverses, the consequences are plain to see, Dugan said, in the form of increased delinquencies and foreclosures that have serious costs for families and communities.
“It is not a safe and sound underwriting practice to make mortgage loans that substitute future house-price appreciation for borrower income as a key source of repayment,” he said.
Stated-income loans should be “the exception and not the rule in subprime lending,” the comptroller said, rather than a way for lenders to ease debt-to-income ratios, “without disclosing that fact to investors or regulators — or without disclosing how much easing has taken place.”
The OCC is one of several federal banking regulators working on guidance for lenders to follow in making subprime loans.
While the use of stated-income loans is covered in guidance for home equity loans and nontraditional “exotic” mortgages, Dugan said its time to decide whether to address lenders’ practices in funding stated-income loans “even more strongly” in the forthcoming guidance for subprime mortgage lending.
“I believe we should, although how we do so and the extent to which we do it are of course decisions that should only be made after careful consideration of the comments we have received,” Dugan said.
Generally speaking, it “is not the job of bank regulators to set underwriting standards like appropriate levels of down payments, or debt-to-income ratios or interest-rate levels,” Dugan said. “Lenders and markets do that. Our job as regulators is to make sure that the institutions we supervise understand and are capable of managing the risks associated with particular underwriting choices, and that customers are treated fairly.”