Subprime loans: A failure to communicate fully

By now we’ve all heard the horror stories.

A first-time homebuyer thinks he’s secured the American dream – until his payments double or triple and he finds himself in way over his head. He didn’t realize the interest rate would change so drastically. He feels he was lied to.

It’s a common – and true – anecdote, but industry experts don’t think it tells the whole story of why so many homes in Northern Colorado and around the country are going into foreclosure. While no one denies the existence of greedy brokers who take advantage of unsuspecting buyers, people in the industry say borrowers have to accept their share of blame for getting into loans without doing their homework.

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“A lot of times the borrower just doesn’t understand the loan,” explained Ryan McMaken, community relations director for the Colorado Division of Housing. “That could be the fault of the broker for not sufficiently explaining things, or the borrower hasn’t asked enough questions. If the broker has not explained everything in excruciating detail, there’s nothing illegal there. A broker may explain all of those things in good faith, but the borrower might still not understand the loan.

“They’re excited about getting into the house. They overestimate what their future income is going to be. They assume their income is going to grow, that they’re going to do well,” he continued. “People who were satisfied they understood the loan, when they find they’re in trouble, they come to the conclusion they were deceived. That may or may not be true. They may have made a bad decision. It’s a problem of information.”

The state conducted a survey of 1,500 callers to the Colorado Foreclosure Hotline, a network of nonprofit homeownership counseling agencies, between October 2006 and March 2007. McMaken thinks the study offers insight into the types of loans people are foreclosing on, though it is a narrow sampling of people who chose to call the hotline.

Weld leads in volume

Weld County was among the six counties with the highest volume of calls to the hotline. The survey showed that 75 percent of callers were having problems with a refinanced loan. Just 7 percent had fixed-rate loans, and 26 percent didn’t know what their loan product was.

The rest were all types of subprime loans: 18 percent adjustable-rate mortgages, 13 percent option ARMs with payments so low they don’t cover interest, 16 percent interest-only loans that postpone repayment on principal, and 15 percent were 80/20 loans for which the borrower takes a second, 20 percent loan to cover the down-payment on the first.

A Colorado Bankers Association study released in March, the Colorado Foreclosure Analysis – 2006, showed a similar outcome. Looking at a random sample of 374 home loans that entered foreclosure last year, the survey firm Development Research Partners found that 77 percent of home loans in foreclosure were adjustable-rate mortgages.

Those loans, CBA pointed out, came from non-bank lenders such as mortgage and finance companies, homebuilders and private individuals. On average, the homeowners in foreclosure had taken their loans out 2.8 years earlier and paid off just 3 percent of the original loan amount.

Adjustable rate mortgages fall into the broad category of subprime lending, which generally refers to loans to borrowers who do not qualify for market interest rates because of problems with their credit history. It’s not a new phenomenon, but over the last five or six years guidelines became less stringent, allowing more people to qualify, said Bronwyn Morrissey, a national account manager with PMI Mortgage Insurance Co. in Lakewood who serves on the executive committee for the hotline.

‘I’ll get a raise’

“A lot of times I think it’s the borrower’s responsibility,” Morrissey said. “They want that house so badly they don’t think about the future. Now their payment is $900. They don’t think about when it’s going to be $1,800. A lot of people think, ‘I’ll get a raise,’ or ‘I’ll be able to sell it.’ I think borrowers were taking a lot of risks. But, there are loan officers who may not have been forthcoming.”

Charlotte O’Donnell, community resource director for the Colorado Mortgage Lenders Association, runs the organization’s consumer helpline. She’s found time and time again that consumers don’t understand their loan products. For years, she said, there have been homebuyer education classes, but they’ve been directed largely toward first-time buyers.

There was an assumption that people buying a second home or refinancing their home for the third time were knowledgeable about the loan products, but that hasn’t been the case in her experience – particularly when she saw that 75 percent of people calling the state hotline were in trouble over a refinanced home.

With rates remarkably low in recent years, the market presented an opportunity. “But not only were consumers not well-informed, they also weren’t making good money decisions,” O’Donnell said. “Yes, you can access $30,000 against your home, but it’s not a good idea if you plan to sell in a few years or you can’t afford the increased payments.”

People were making quick decisions, refinancing to get 1 or 2 percent rates and not understanding or not worrying about what would happen when that rate adjusted.

“What these loans are good for is temporary relief, a temporary solution,” O’Donnell said. “These loans are for people who can manage that and whose situations are going to improve in a short time.”

Being in the mortgage insurance business, Morrissey has seen a lot of problems with 100 percent value loans – when borrowers don’t put any money down. People who got into an adjustable rate loan because they thought they could sell the house and turn a profit before the rate adjusted found themselves in trouble, particularly in Colorado, because there wasn’t the appreciation seen on the coasts.

Perfect financial storm

Zachary Urban, director of housing counseling for Denver-based Brothers Redevelopment Inc., sees the foreclosure crisis as stemming from a perfect storm of factors: poor financial education at the high school level, increased availability of subprime loans, an industry that had yet to figure out how to use these loans, and borrowers getting into loans they didn’t read or understand.

And while he doesn’t think predatory lending is responsible for the largest share of foreclosures, Urban does acknowledge that the market in recent years created opportunities for abuse.

“In its basic element, (subprime lending) is not a bad thing because of the opportunity it gives for someone with less-than-perfect credit to obtain a mortgage,” he said.

But with those types of loans, the borrower is in a subservient position to the mortgage lender because they have less-than-perfect credit. Brokers can take advantage of that, giving inappropriate loans because they make a higher commission off them.

“Some of the activities investigators are bringing to the (Colorado State Board of Real Estate Appraisers) are directly related to appraisals,” Urban said. “Of course, the appraisal industry is being pulled on from all sides, by all the different players in a transaction, to reach the number. There’s the term ‘friendly appraiser.’ That suggests the appraiser is being friendly by reaching the number the broker suggests will get the deal done.”

When that number is inflated, the borrower is in trouble from the start – owing more than the home is worth.

Recent changes to Colorado law will make it easier for the state to crack down on illegal behavior, and even spells out for the industry what is unethical. For example, Senate Bill 85 protects appraisers from undue influence from other parties in a transaction. SB-203 requires that mortgage brokers be licensed, which means brokers will at least have to pass a background check. HB-1322, the Mortgage Fraud Prevention Act, further reiterates that all parties must provide true and accurate information.

Going forward, Urban says the hardest part of stemming foreclosures is going to be consumer education.

Wave continues to roll

For now, it doesn’t look like the wave of foreclosures will be stopping anytime soon. The Division of Housing report for the first quarter of 2007 shows that the number of filings is still increasing. With 9,254 filings thus far, a 25 percent increase is expected from last year and a 110 percent increase since 2003.

Across the state, McMaken said the worst places for foreclosures are where there’s a lot of new home building. There’s so much on the market right now that it’s difficult to sell existing houses.

Thus, counties along the Front Range – Adams, Weld, Arapahoe, Denver, and Pueblo – have the most significant foreclosure activity. In Weld County, one in 124 households are in foreclosure, a rate surpassed only by Adams County with one in 98. Larimer County posted a rate of 1 in 275.

The good news is that the Colorado Foreclosure Hotline has helped more than 8,000 homeowners avoid the word “foreclosure” being put on their credit report, though many still had to leave their homes. McMaken urges anyone getting behind on mortgage payments – or who is unsure about the terms of the loan – to contact a housing counselor right away.

In addition to counseling borrowers who call the CMLA hotline, O’Donnell contacts the companies and brokers those borrowers worked with when there are complaints so they address their communication failings. She said some loan officers have started incorporating their own checklists of information for clients to read and understand.

“It’s always good business for the lender/broker to do their best to make sure the customer is well-informed,” she said.