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Special section Subprime mortgage industry meltdown

As the federal government reviews ways to avoid future problems in subprime lending, one thing is clear: There's plenty of blame to go around for today's woes.

Federal debate

Fixing subprime mortgage lending isn't easy

Stop giving risky mortgages to people who won't be able to afford the payments in two or three years, federal regulators are telling lenders.

At issue: so-called 2/28 and 3/27 subprime mortgages. These hybrid adjustable-rate mortgages are intended for people with flawed credit. They have interest rates that can jump sharply after two or three years. House Democrats call them "high-risk 'payment shock' loans." Defenders call them "credit improvement vehicles" that allow people to become homeowners while they clean up their personal finances.

Subprime ARMs have introductory interest rates that last for two years (on 2/28 loans) or three years (on the less-common 3/27s). After that, the interest rate is adjusted upward or downward every six or 12 months. It's possible for monthly payments to skyrocket by 50 percent or more.

Terms of a hypothetical subprime hybrid ARM
  Interest rate Monthly principal and interest
First two years 7 $1,331
Third year 11.5 $1,956
Source: Federal Reserve

In this hypothetical 2/28 ARM, the introductory rate is 7 percent. The fully indexed rate is the London Interbank Offered Rate (LIBOR) plus 6 percent. If the LIBOR is 5.5 percent at the end of the loan's second year, the rate would rise to 11.5 percent -- and the monthly principal and interest charges would rise 47 percent.

Regulators say lenders should qualify borrowers at the highest possible rate. That way, there's more certainty that the borrower can afford the maximum possible monthly payment, making foreclosure less likely. The proposal says the agencies "are concerned that subprime borrowers may not fully understand the risks and consequences of obtaining certain adjustable-rate mortgage (ARM) products." They recommend better disclosures to consumers.

The proposed guidelines please consumer advocacy groups, including the Center for Responsible Lending, which said in a statement: "The devastating reign of 'exploding' adjustable-rate mortgages (ARMs) in the subprime market may soon be over. Today federal banking and credit union regulators proposed to clamp down on these risky loans by requiring depository institutions to do more careful assessments before approving these loans for credit-strapped consumers."

Critics say the regulators are focusing on the wrong problem, are taking action too late and might harm more people than they help. And anyway, some big mortgage lenders are free to ignore the federal guidelines if they want.

Subprime mortgages are home loans to people with flawed credit. Generally, the line is drawn at a credit score of 620 or 660. Between 15 percent and 20 percent of mortgage borrowers got subprime loans last year. A lot of those 2006 subprime customers fell behind on their payments within the first three months. That threw the subprime industry into turmoil, with major lenders going out of business or seeking bankruptcy protection in the last four months.

Sharp-eyed readers will notice that the feds aren't addressing the current problem. Borrowers are falling behind on their payments immediately and the regulators are taking steps to ensure that they don't fall behind in two or three years. It's like trying to lower the infant mortality rate by improving health care for the elderly.

-- Posted: April 18, 2007
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