Part Three of a Three Part Series
Testimony of Paul Leonard
California Office Director
Center for Responsible Lending
Before the California Senate Banking Committee
March 26, 2007
The crisis in subprime lending will produce record levels of foreclosures. Immediate action is needed on two fronts: 1) help for current borrowers to avoid widespread foreclosures; and 2) statutory and regulatory changes to ensure that this cycle will not be repeated when the housing market turns up again.
A. Help for Current Borrowers
We must act immediately to help those borrowers who are at risk of losing their homes right now. A key principle of any loss mitigation strategy is to assist threatened borrowers, not to bail out lenders and investors who have facilitated this debacle.
Loan Modifications and Workouts at Scale: Our highest priority should be creating a system that facilitates large-scale workouts that can help minimize foreclosures. In doing so, we must hold industry players accountable for their actions – lenders, servicers, investors and trustees should stem the tide of foreclosures by proactively modifying loans to make them sustainable. There is no longer any dispute that brokers and lenders have placed borrowers into loans that set them up for foreclosures, and the secondary market provided key support and high demand for this reckless lending. The parties who enabled this crisis should be held fully accountable for minimizing the damage today by taking a proactive role in changing the terms of 2/28s and other abusive subprime loans. Specific remedies will vary depending on the homeowner’s situation, but examples of positive actions include converting loans to fixed-rate mortgages with affordable interest rates, writing down principal loan balances, and waiving prepayment penalties.
This task is made infinitely more complex by the reality that 80 percent of subprime loans are bundled in securities, owned by investors around the world. Loan servicers, who currently collect mortgage payments, have limited flexibility in negotiating workouts on behalf of investors who own securities.
The California Housing Finance Agency may also have a role to play in shaping a workout strategy, as they could bring their expertise and, potentially, resources to bear. But action must be taken quickly, as many homeowners are facing foreclosure right now and more will be joining the ranks in the weeks and months ahead.
Unfortunately, for some borrowers, the best we can hope for is a soft landing. Due to flattening home values and prices, some borrowers will not be able to refinance and they will be forced to sell their homes. However, we should protect them from the additional misery of being liable for any outstanding debt to mortgage lenders after foreclosure.
Cracking Down on Foreclosure Rescue Scams: Another area worthy of legislative attention is to reform the Home Equity Sales Contract Act (California Civil Code § 1695) passed to address the growing problem of purported “foreclosure rescue consultants” taking advantage of homeowners whose homes were in foreclosure. HESCA recognized that homeowners in foreclosure are particularly vulnerable and susceptible to fraudulent activity and need protection. Unfortunately, the protections of HESCA are incomplete and in some ways actually provide a “roadmap” for the potential scammer. Our organization has worked with a number of consumer attorneys to develop suggested revisions to HESCA to provide homeowners facing foreclosure with added protections and to close unintended loopholes in the existing statute.
B. Establishing a Stronger Statutory and Regulatory Framework
Belatedly, California regulators are now in the process of developing new regulations to implement the federal non-traditional mortgage guidance. This guidance should be extended to the subprime hybrid ARMs which are the biggest source of problems in the subprime mortgage market. Stronger statutory actions are needed to ensure that these changes are permanently embedded in California law, with meaningful enforcement mechanisms. In order to prevent this crisis from recurring, California should adopt a number of policy recommendations, including:
Ability to Pay Standards: One of the hallmarks of the subprime market is a lack of attention to a borrower’s ability to repay the loan beyond the initial teaser rate period. Borrowers who are already stretching to pay their mortgage at the initial teaser rate will not be able to afford to make payments when their loan enters its third year and the payment rises sharply. Brokers and lenders are not required to ensure that borrowers can afford to pay at the fully-indexed—not just the teaser—rate. This must change, and ensuring that borrowers can afford to repay their loan over the life of the loan will go a great distance in preventing future foreclosures.
Additionally, brokers and lenders should be mandated to require escrow accounts for taxes and insurance, to avoid an unexpected financial squeeze for the borrowers.
We should also mandate a return to the sound underwriting principles that have guided the mortgage industry for decades by requiring income verification for all subprime loans. Currently, products exist that require little or no income verification, which means that borrowers and brokers may be tempted to inflate income.
Limitations on Prepayment Penalties: In addition to having been originated without sufficient income verification, many subprime mortgages include costly prepayment penalties, which often forces borrowers to pay thousands of dollars in penalties to refinance into a better mortgage product. Prepayment penalties—despite efforts by the states to limit their use—continue to be applied to 70 percent of all subprime mortgages. [See, e.g., David W. Berson, Challenges and Emerging Risks in the Home Mortgage Business: Characteristics of Loans Backing Private Label Subprime ABS, Presentation at the National Housing Forum, Office of Thrift Supervision (December 11, 2006)]
California should prohibit prepayment penalties on subprime loans.
At minimum, California should require a ending prepayment penalties with sufficient time to allow a borrower to refinance a loan at least 120 days before the mortgage payment resets.
Originator Duties: We must realign incentives to get the best loans for borrowers, not the best commissions for brokers. Brokers at this moment have bifurcated duties: on one hand, they are driven by yield-spread premiums (YSPs) – the kickback paid to the broker for originating loans at higher rates; on the other hand, borrowers often expect the broker to have their best interests at stake. Unfortunately, this is not your parents’ mortgage market, and brokers are currently neither lenders nor friends to borrowers—much to the surprise of many homebuyers. YSPs should be counted with other fees in determining whether a loan is a high-cost loan in California and prohibited from being combined with prepayment penalties in the same loan.
Lastly, lenders should be liable for brokers and their actions. They are in the best position to spot abusive practices, and they have at least an ethical and—ideally—a legal obligation to protect their customers.
Assignee Liability: In today’s climate, when mortgages are bundled and sold on the secondary market, determining who has ultimate responsibility for irresponsible mortgages is difficult. Establishing assignee liability means that borrowers would be allowed to pursue legal claims against the assignee when the loan transaction involved illegal or abusive terms. When liability is assigned to the purchaser of the loan, there is clear accountability. If a loan goes into foreclosure as a result of abusive or illegal practices, the borrower would be able to pursue legal action that might save his or her home. A number of states have incorporated appropriate measures to ensure that the secondary markets help to provide accountability for loan originations.
This foreclosure epidemic threatens not only individual families and homeowners in California, but entire communities, neighborhoods and local economies. Until recently, homeownership has served as a lifeline for families to gain security, financial stability and wealth, but high-risk nontraditional mortgage products and the lack of appropriate regulation and oversight of the subprime industry are seriously eroding the traditional benefits of owning a home.
It is imperative that California act affirmatively to address the foreclosure crisis and the collapse of the subprime market so that we can 1) prevent future recurrences of similar problems and 2) help current borrowers in the gravest need as soon as possible.
We can achieve the first goal by establishing statutory requirements on all subprime loans—including assessment of a borrower’s ability to repay, requiring escrow accounts for taxes and insurance and requiring income verification; realigning incentives to get borrowers the best loans and making lenders liable for the actions of brokers; limiting prepayment penalties; assigning liability to lenders and investors and crafting a meaningful enforcement framework that allows the Departments of Real Estate and Corporations to be more effective and provides adequate resources for enforcement and monitoring.
Those borrowers at risk of losing their homes can be helped by broad-scale workouts to avoid many of the 450,000 foreclosures we expect to see in California. This means a soft landing for those who are under water with no hope of refinancing, and a restructuring of current mortgages to affordable levels for those who have maintained some equity in their home.
Thank you for convening this hearing, and for giving me the opportunity to add to this very important discussion.
For more information vist the Center for Responsive Lending website. There will be more articles from different perspectives on this issue in the days and weeks to come.