Why are so many subprime mortgage borrowers in serious delinquency and headed for foreclosure? Federal regulators believe they've identified an important contributing factor that hasn't gotten a lot of publicity: Many subprime loans originated during the years 2003-2006 came without mandatory escrow accounts.

The lack of escrows for people with poor credit histories and high household debt ratios raises the risk that borrowers will lose their houses when they fall behind on their regular monthly payments, according to regulators from the Federal Reserve, Treasury and other agencies. In new proposed federal guidelines, the agencies tell lenders to at least disclose and explain the added layer of risk to subprime loan applicants whenever they extend mortgages without escrow accounts.

Consumer advocates, meanwhile, are urging Congress to require escrows for all subprime borrowers.

"We think escrowing should be mandatory," said Mike Calhoun, president and chief operating officer of the Center for Responsible Lending, Durham, N.C. "The failure to escrow on subprime is an abusive practice."

Calhoun's organization conducted the massive study of subprime mortgages that led to the widely-quoted estimate that 2.2 million subprime homeowners will go to foreclosure in the next several years. Calhoun estimates that three of every four subprime loans closed in recent years have lacked escrows for property taxes and insurance. The reason: to cut monthly payments lower and make loans more "affordable." Yet in the prime mortgage market, where borrowers have stronger credit histories and lower household debt burdens, escrow accounts have long been virtually mandatory.

"It's an upside-down world," he said in an interview. "The people you'd think need an escrow the most are not required to have them, and the people who need them the least are forced to use them."

A mortgage broker from San Antonio, Texas, Roy Rangel of Statewide Mortgage and Lending, says the lack of escrow accounts is often "a killer" for unsophisticated first-time subprime home buyers. They "don't really understand that the payment they're making every month isn't everything they owe, and they've got to come up with $3,000 or $4,000 more to pay taxes and insurance."

When homeowners like these encounter sudden, large monthly payment hikes -- as with "2/28" and "3/27" adjustables that reset upwards -- "they're in really big trouble, they are drowning."

Rangel said he has refinanced numerous subprime borrowers who've been hit with what he calls the "double whammy" -- a 40 to 50 percent payment shock coupled with back taxes and unpaid insurance premiums -- into fixed-rate FHA loans. In one case two first-time purchasers had signed up for a 2/28 ARM at 7 percent with no escrow. They were never told that their monthly $703 payment did not cover taxes and insurance, and ultimately fell $5,000 behind. The lender force-placed new insurance at double the previous premium cost, and jacked up their payments to $1,646 a month -- far beyond their ability to pay and sending them down the path to eventual foreclosure.

All FHA borrowers are required to put money into escrows every month, in part to avoid such situations. They also typically come with fixed rates that are 3 percentage points below competing subprime loans. To Rangel, "FHA is often the only way out" for borrowers in trouble.

Published: April 2, 2007

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.