New, More Stringent Rules on Option ARMs and Interest-only Loans

On Saturday, we mentioned Alan Abelson quoting of Don Tomnitz, CEO of the No. 1 home builder, D.R. Horton.

If you stopped reading after that section, you might have missed something intriguing from Ed Hyman’s ISI Group (via Abelson) on upcoming bank regulations:

"We got to musing on the extraordinary deliberateness
… while reading a recent "policy report" put out by
Ed Hyman’s ISI Group. [Bank regulators] who,
as it happens, months ago were to issue new regulations to curb the
abuses of such mortgage exotica as option ARMs and interest-only loans.

Which bears on our conviction that Mr. Bernanke is
wrong on how severe the housing skid is apt to prove and is wrong as
well on his relatively benign expectation for its impact on the
economy. The folks at ISI say that, despite its tardiness, the new,
more stringent rules, chances are, will be issued by the end of the
summer. And when they finally see the light of day, contrary to the
conventional wisdom on the Street, they’ll have an impact, and a
substantial one. And that impact will consist of cutting already shaky
demand for housing and putting further pressure on home prices.

That prediction, the authors of the report assert,
is based not on idle speculation, but rather on conversations with the
. The latter believe that "many financial institutions will
have to change their underwriting standards significantly to comply
with the new rules
." Alas, ISI doesn’t tell us exactly what has held up
issuance of the regulations. Maybe it’s nothing more sinister than
typical bureaucratic lag. (We’d prefer, of course, to think it was
something more sinister.)

What could magnify the effects of the harsher rules
is the very fact that investors seem fairly confident that the rules
won’t have much of an effect at all (those investors, that is, who are
even aware that the regulations haven’t been put to a peaceful rest in
somebody’s drawer).

The rules, ISI explains, focus on three issues: underwriting standards, portfolio management and consumer disclosure.

The first is easily the most important and holds the potential to do the most damage to housing.

What the regulators are aiming at, pure and simple,
says ISI, is to discourage banks from layering risks by writing option
ARMs and IO loans to borrowers with high loan-to-value, high
debt-to-income and low credit scores. In other words, from piling
dubious debt on impecunious or unreliable borrowers

On that score, the regulations would also require
banks when peddling "nontraditional mortgage products" to make some
reasonable effort to determine whether the wannabe borrower will ever
be able to repay the loan.
Now, the notion that banks are supposed to
worry about getting their money back strikes us as almost un-American." (emphasis added).

That’s a pretty straight forward, factual approach. It wouldn’t be an Abelson column if its wasn’t rich with snark and dripping with sarcasm:

"It also strikes us that the regulatory timing is
truly exquisite. For had the rules been issued on schedule, as last
year was calling it quits, when housing was still aboil and home
builders were reporting strong earnings, they might not have been all
that much of a big deal as an investment depressant. Come the end of
the summer, though, with housing likely awash in bad news and the
economy listing, it could be another, much uglier story."

Actually, by December ’05 the housing market was already 4 or 5 months past its peak. But the point that the regulatory impact will be more pronounced art this phase of the cycle is well taken . . .


Eyes Wide Shut
Barron’s MONDAY, JULY 24, 2006

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