As interest rates rise, as homes get more expensive and as more and more buyers seek high-leverage, higher-risk mortgages, instead of tightening credit, lenders are taking steps to keep the easy money easy.

Federal regulators now fear that lenders are attempting to maintain profit levels by easing lending standards at a time when they should be tightening them.

The practices threaten borrowers with the potential for defaults on loans they couldn't really afford and, if too many borrowers default, lenders could also face collapse, according to John M. Reich, director of the Office of Thrift Supervision, speaking recently before the New York Bankers Association.

The office and other federal agencies are stepping up examination of lenders' portfolios and could come down hard on lenders making loans without regard to risk.

"I am concerned that there has been an overall slippage in underwriting due to increased competition in certain markets segments and areas. Specifically, my examiners have noted examples where loan pricing misaligns with credit risk solely due to competition and the desire for loan volume. We are also seeing an increased liberalization of terms by some institutions in order to maintain their loan volume. This is particularly troubling as institutions are effectively taking on greater risks with less vigilance regarding their overall program requirements," Reich said.

The questionable mortgage lending practices appear to be in continued defiance of federal regulatory agencies coaxing lenders to, well, behave themselves when it comes to writing risky mortgages.

Reich failed to mention that some lenders in California and likely other high-cost markets have indeed tightened underwriting standards, nor did he indicate the percentage of lenders who continue to make it easier to qualify for mortgages.

In his speech Reich pointed primarily to interest-only and payment-option mortgages, but other "nontraditional" mortgages have raised the ire of federal regulators in recent years.

Piggy-back, no-, low-down payment loans and adjustable rate mortgages (ARMs) in general have this decade become de rigueur -- especially in high-cost housing markets -- because the "traditional" 20-percent-down, fixed-rate, 30-year mortgage just doesn't cut it.

Non-traditional loans, as a group, make up the bulk of purchase mortgages in some markets, because they give buyers more financial leverage and the ability to buy a home they might not otherwise afford. The loans have also been used to help historically under served socioeconomic and ethnic segments of the population buy homes.

However, because the loans give buyers more financial leverage to buy, they begin with a small, if any, equity stake in the home. In one scenario, if market-based equity growth hits the brakes as higher interest rates force home owners to shell out more and more each month, some home owners could reach the point of no return and find themselves unable to make the larger payment.

Small equity stakes and "upside down mortgages" -- loan balances higher than home values -- make it easy for home owners to simply walk away from the loss instead of struggling financially. Too many defaults however, could impact lenders' business and ultimately the economy, given the economy's large stake in the housing market.

Published in the Federal Register on Dec. 29, 2005, "Interagency Guidance on Nontraditional Mortgage Products" to corral nontraditional loans is not unlike "Credit Risk Management Guidance For Home Equity Lending" which the same federal agencies released earlier in 2005 to target equity loans.

But months after the Office of the Comptroller of the Currency (OCC); the Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation (FDIC); Office of Thrift Supervision (OTS); and the National Credit Union Administration (NCUA), issued the guidance for home equity lending the Federal Reserve Board's "October 2005 Senior Loan Officer Opinion Survey on Bank Lending Practices", revealed mortgage lending business as usual -- underwriting actually eased.

After proposed guidance on nontraditional mortgages was issued, lenders asked for more time in the public comment period to examine the complex proposal.

The comment period closed at the end of March, and firm guidance is expected within weeks, but lenders apparently used that time not to roll back the red carpet, but to pump up the volume and keep the party going.

"In an effort to continue feeding their current loan volume, some institutions are purchasing loan participations. The concern that I have, however, is that some of these purchases are occurring despite the fact that the packages lack complete documentation. Moreover, I am told that some sellers are telling buyers that if they insist on complete documentation then other buyers will take their place. This practice is unacceptable and will be scrutinized by our examiners ... . Incomplete documentation that obstructs the ability to understand the credit risk of any loan product or participation is a practice that can lead to significant problems and should not be tolerated by bank management," said Reich

Reich says the Feds don't want to end the use of mortgage products that are clearly in demand, especially when some lenders have a track record of managing the loans' inherent risks.

Instead the Feds seek to corral use of the loans and prevent them from falling into the hands of less sophisticated borrowers and others with weaker credit profiles.

To that end Reich said regulatory examiners are now "digging deeper" into loan portfolios to learn the level of risk lenders are facing. Examiners will scrutinize loan documentation, pricing, loan-to-value ratios, and overall underwriting standards.

"We continue to monitor overall operational costs, again, with close attention paid to costs attributable to prior build-ups in mortgage lending operations. In addition to our ongoing monitoring of interest rate risk, we are looking at credit risks, particularly with respect to nontraditional mortgage lending products," Reich said.

Published: April 11, 2006

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Broderick Perkins parlayed a career in old-school journalism into a contemporary digital news service that really hits home. The award-winning consumer journalist, originally from Wilmington, DE, is founder, publisher and executive editor of the bootstrap DeadlineNews Group, a Silicon Valley-based editorial content and consulting service specializing in residential real estate, consumer news and related editorial consulting services. The DeadlineNews Group includes the website, DeadlineNews.com, offering real estate editorial content and consulting services, and its back shop, the Deadline Newsroom, an open house on news that really hits home. Perkins obtained his formal journalism education from University of Delaware and a journalism boot camp, the Institute of Journalism Education at the University of California-Berkeley. He went on to 20 years of service as a daily newspaper journalist at the Wilmington, DE News Journal and San Jose, CA Mercury News. Perkins covered housing on the San Jose Mercury News reporting team which earned a General News Reporting Pulitzer Prize in 1989 for coverage of the Loma Prieta earthquake. He has also produced real estate, consumer and small business content for the Wall Street Journal, Los Angeles Times, RealtyTimes.com, Nolo.com, Better Homes and Gardens, the National Association of Realtors, Homestore/Move and Intuit/Quicken among more than three dozen publications. In addition to managing the DeadlineNews Group, Perkins most recently served as chief editorial consultant for Nolo's Essential Guide To Buying Your First Home, Nolo, and writes real estate television scripts for RealtyTimes.com.