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Bruce and
Gina, a young couple from Olympia, Washington, bought
their first home in April 2006 and recently contacted
me to help them refinance their mortgage and obtain
a lower mortgage payment. Because of their dismal credit
and high debt load, I knew pretty quickly there would
be nothing I could do for them but I was curious to
know how they managed to buy their house in the first
place. Bruce was working as a technical support analyst
for a computer firm and Gina had a job as a teacher’s
assistant at a local school. Combined, the couple grossed
$50,000 per year. Because they didn’t have the savings
to make a down payment, they financed the entire purchase
price of $210,000 and took on a mortgage payment of
$1850 with taxes and insurance – a payment much too
high for their combined income and debt load. Bruce’s
credit rating was terrible, far below the bare minimum
required to qualify for even a subprime home loan, so
the original purchase loan had been underwritten under
Gina’s name only, using just her income and credit (which
wasn’t that great either). Knowing that Gina grossed
just over $1300 per month, I wondered how it was possible
for her to obtain a loan with a monthly payment of $1850.
As it turned out, the answer was
a fraudulent
mortgage application and loose lending practices. I
confirmed with Bruce that Gina had “qualified” by obtaining
a stated income loan – a loan that requires only that
income be declared and not proven. Originally intended
for those who can’t truly document their income (such
as the self-employed and those who get tip income),
today’s promiscuous lending environment has made stated
income loans a common vehicle to “qualify” borrowers
who don’t make enough to qualify by fully documenting
their income. As the refinance boom unfolded over recent
years, lenders loosened underwriting guidelines in an
effort to qualify a greater number of borrowers and
capture a larger share of the mortgage lending market.
Stated income loans were increasingly made available
to borrowers previously considered high risk. It is
hard to say who actually did the income “stating” in
this scenario, but the most likely culprit was the mortgage
broker. To make the numbers work, I figured that he
probably had to declare Gina’s income on the mortgage
application to be about $70,000 per year for her to
“qualify” with her debt load at the time. Though income
is not verified, stated income lending guidelines typically
require verification of employment. Because no reasonable
person would believe that a teacher’s assistant makes
$70,000 per year, it is likely that the loan underwriter
either didn’t verify Gina’s position at all or chose
to disregard that her declared income was unreasonable
for her position. Even worse, Bruce and Gina elected
to obtain an adjustable-rate mortgage with a 2-year
teaser rate. Known as 2/28s, such loans have a fixed
rate for the first two years of the term and an adjustable
rate for the remaining twenty-eight years. Once the
2-year fixed period is over, Bruce and Gina will likely
be hit with an increase in their payment of at least
several hundred dollars as their rate adjusts to prevailing
market conditions. Selling is not an option either.
Home prices are stagnant or falling and because they
didn’t put any money down, they will likely have no
equity with which to pay for selling costs. This financial
disaster in the making will likely end in foreclosure,
resulting in shattered dreams of home ownership and
a loss for the mortgage bank. And all of it could have
been prevented with more prudent lending guidelines
and practices.
Incredibly, the
headlines are proving that Bruce and Gina’s story is
not an isolated case. HSBC recently announced that losses
due to subprime loans in 2007 were going to be “about
$1.8 billion higher than expected (emphasis mine)"
1
Irvine, CA-based New Century Financial, one of the largest
subprime mortgage banks in the country, announced it
would have to restate 2006 earnings “to account for
losses on defaulted loans it would be required to repurchase.”
2
New Century is also facing class action lawsuits, regulatory
investigation, and possible bankruptcy due to the bad
loans it has made. According to RealtyTrac, foreclosures
are running 25% higher than last year:
We don't have high
unemployment, high interest rates or a slowing economy,
but we're seeing the number of foreclosure filings
pushed above historic averages," says Rick Sharga,
a marketing exec for RealtyTrac. "You can't underestimate
the effect of higher risk loans."
3
Loans for borrowers with
good credit ratings appear to be performing well, so
clearly the problem is in the subprime underwriting
practices and guidelines. The bottom line is that banks
are lending to people who are bad credit risks and the
day of reckoning has arrived.
Few would probably disagree that things obtained
easily and cheaply are seldom valued. That certainly
has been the case over the last few years as the Federal
Reserve, by lowering interest rates to record lows,
has made credit so cheap and abundant that just about
anybody can get it. The party was fun while it lasted,
but now it’s time to clean up the mess.
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