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Tuesday, October 03, 2006

Bank Regulators and Negative Am Loans

From Value Discipline

Negative amortization occurs when the monthly payments on a loan are insufficient to pay the interest accruing on the principal. The additional interest expense is added to the loan balance...the increased loan balance results in higher interest expense and again, an increasing loan balance. The homeowner essentially digs himself in deeper and deeper to cover the interest on the loan.

If the loan term ends without sufficient amortization, the remaining mortgage owned can be larger than the original mortgage.

Financial institution regulators just announced on September 29th the final guidance for non-traditional mortgages to clarify their stance on guidelines originally issued in December 2005. The goal to ensure more prudent underwriting standards is noble. The effect may considerably reduce volumes of such non-traditional mortgages issued. The guidelines will make it more difficult to originate loans to subprime borrowers, flippers, and borrowers who are stretching to afford a larger house. The offset is that credit quality for banks will improve.

A major change in the quality of mortgage underwriting is proposed. Before the guidance, some lenders underwrote loans assuming they would be outstanding a short period of time, but with loans having 30-year terms. The lender was assuming the property would be sold or the mortgage refinanced before the payment shock would occur. That game has just ended. The new guidelines now indicate the loan must be underwritten to assume collectibility over the life of the loan and a sale or refinance cannot enter into the decision making.

The new guidelines indicate that all or some portion of the negative amortization must be included in the initial calculation of loan to value. The amount of negative amortization included will depend on the spread between the payment rate and the accrue rate and how much negative amortization would be generated over the first payment period (usually five years). Again, this should discourage the more aggressive lenders and restrict their assumptions and enhance overall credit quality.

Finally, regulators want consumers to understand both the positives and negatives of nontraditional mortgages. Lenders are now required to make more balanced presentations regarding nontraditional mortgages and monthly statements will clearly indicate what each payment option will have on the loan balance. Good news for consumers...bad news for flippers and gamers who wanted to maximize cash flow.

It is encouraging to see a higher standard of underwriting, a higher standard of risk management and a higher standard of consumer disclosure. Unfortunately, it seems to me to be locking the barn door after the horse has bolted. After some years of overheated housing market activity and questionable loan practice, what took so long?

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