Bank regulators tightened standards for mortgage lending on Friday in a bid to curtail risky practices that have been blamed for a record level of foreclosures.
Borrowers should not be penalized for refinancing out of a mortgage before a low introductory rate resets to a higher level and lenders must have evidence a borrower can repay, according to a statement of principles issued by the regulators.
The guidelines, which lenders treat as binding, also call for lenders to warn borrowers when a reset is coming and grant them at least 60 days to refinance.
This guidance ... underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect but also after the interest rate resets, Federal Reserve Board Governor Randall Kroszner said in a statement.
Many lenders relaxed underwriting standards for subprime borrowers with shaky credit during the recent housing boom. Among the most popular loans were those that offered low early payments that spiked within a few years.
As the housing market has soured, many of those borrowers fell behind in their payments and a record portion of borrowers faced losing their homes in the first three months of the year. Many of the biggest lenders to subprime borrowers have been pushed into bankruptcy.
Besides protecting borrowers from costly refinancing, the guidance discourages loans that have let borrowers inflate their income in order to qualify for a loan. So-called 'low doc' mortgages were offered to borrowers even if they could not document that they had the resources to make payments.
Lenders should only offer such loans to borrowers if there is other evidence that they can repay, according to the Friday statement.
A borrower who is refinancing a home or has a valuable asset that can be turned into cash might not need to prove all their income but low-doc loans should be the exception rather than the rule, said John Dugan, Comptroller of the Currency.
Dugan said he did not expect the standard to discourage home purchase among immigrants and others who work in a cash economy.
I don't think this precludes (low-doc loans in) some special circumstances as long as there is some way to look at the income the borrower has ... like a tax return, Dugan said in an interview with Reuters.
Some lenders had hoped regulators would leave space for subprime borrowers to get a new loan without meeting the stringent new underwriting standards.
However, Friday's principles seemed to close the door on those hopes as it stressed that borrowers should be qualified based on whether they can make payments over the life of the loan.
The guidance was issued by the Fed, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration.
While the guidelines will immediately impact banks and others who lend funds from their depositors, it does not apply to firms that lend money from investors and Wall Street. In recent years, a large share of risky subprime loans came from non-banks that are regulated by the states.
On Friday, the Conference of State Bank Supervisors said that it intended to harmonize state regulations with the federal standards.