Mortgage Standards Tightened

Federal regulators are casting a disapproving eye on mortgages that give borrowers low introductory rates but let them pile up more debt over the long run -- a loan feature favored by hundreds of thousands of Californians.

Starting this month, federally chartered lenders are being discouraged from qualifying buyers based on the low starter rates, when only the interest or a portion of the interest is due. Instead, they are being urged to evaluate the borrower’s ability to pay for the loan at the full rate.

Regulators are trying “to add some discipline to the lending process,” said Richard Wohl, president of Pasadena-based Indymac Bank. “Whenever you do that, you’re going to have some [borrowers] that won’t have the product available to them.”

The tougher standard was issued in the form of “guidance” from the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Reserve and other regulators. Guidance has less force than a regulation and provides no specific penalties for violation.

The regulators, however, say they will “carefully scrutinize” lenders to see whether they are following the new rules. Those who fail to do so, the guidance summary warns, “will be asked to take remedial action.”

In addition, the guidance applies only to federally chartered lenders, including Indymac, Countrywide Financial Corp., Washington Mutual Inc. and other behemoths. State-chartered banks, which are smaller but more numerous than federal banks, are not affected.

Industry observers are divided on the effect of the new guidance, which takes particular aim at loans often marketed as “option ARMs,” in which the borrower has the option of choosing how much to pay on an adjustable-rate mortgage.

In a letter to regulators last winter, Indymac said 24% of the option loans it made in 2005 would have been affected by the proposed tightening.

Last week, however, Wohl said that some of those borrowers would have been eligible for other types of loans. Indymac’s option ARM business is shrinking anyway, he said, as interest rates fall and customers move to the certainty of fixed-rate loans. Rates on 30-year fixed mortgages fell to an average of 6.30% last week, the lowest since March.

Even so, interest-only and option ARM loans accounted for more than half of first-time mortgages and refinancings in the state in July, according to data-tracking firm First American LoanPerformance.

With an interest-only loan, borrowers pay only interest for a set period -- typically three, five or 10 years. After that, the rate on the loan readjusts and the borrower has to start paying the principal as well. The longer the interest-only period, the steeper the payment once the borrower begins paying the principal.

Option ARMs give borrowers the ability to put off both the principal and much of the interest for a period ranging from one month to several years. If a borrower pays the minimum in a weak housing market, his or her debt could grow faster than the value of the house.

That’s the sort of thing regulators say they want to prevent.

Kathy Dick, deputy U.S. comptroller for credit and market risk, said interest-only loans and option ARMs originally were for a minority of savvy, well-off people whose income was variable -- the self-employed and those who worked on commission or were paid intermittently.

“Now they’re used to get someone into a home without a real analysis of their ability to pay,” Dick said. “Lenders are qualifying people for homes they can’t afford. We felt that wasn’t consistent with prudent lending principles.”

Dick demurred on offering any prediction about how the new rules would affect the housing market. Because the guidance applies only to federally chartered lenders, it raises the possibility that it would merely move some loans from one segment of the market to another.

“It’s too early to tell what the impact will be,” Dick said. “But from our vantage point, looking at national banks, we don’t see any evidence this is going to cause ... a major problem.” Others made bolder predictions.

“Just as the loosening of credit standards made the housing bubble go higher and last longer, the tightening of standards is going to make it deflate further and faster,” said Michael Calhoun, president of the Center for Responsible Lending, a research and advocacy group that fights predatory lenders. As borrowers find they qualify only for smaller loans, Calhoun predicted, sellers will have to cut their prices.

“There’s some pain coming,” he said, noting that California “is at ground zero on this.”

Allen Fishbein, director of housing and credit policy for the Consumer Federation of America, also believes the new rules will have at least a mild effect.

“There will be fewer leveraged loans of this kind, and it will depress some home prices,” Fishbein said. “Lenders that were making these loans have a responsibility to rework them into something sustainable.”

The Consumer Bankers Assn., a lobbying group whose members will be covered by the new guidance, predicted dire consequences when it was agitating against the proposals over the winter.

The restrictions are “overly paternalistic” and “largely unworkable” and would place option ARMs in particular “beyond the reach of many consumers,” counsel Steven Zeisel wrote.

His current view, now that they’re a reality, is milder.

“Regulators are trying to create a situation with strong underwriting, strong risk management and portfolio management and good disclosures, all of which we endorse in principle,” Zeisel said. “The problem is whether the detail is too strict, and that remains to be seen.”

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david.streitfeld@latimes.com