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Unintended Consequences To Government Legislation

Below, I've cut/paste the beginning impetus for the whole sub-prime lending industry. Lenders were under pressure from the government to make more loans to low income individuals, so the Fed came out with the following guidelines for mortgage lenders to follow that lowered the underwriting standards in making loans.

This was from 1993 report issued by the Boston Fed.

Initially, this was an effort to get everyone into a home of their own. A very noble and caring hope. But even noble legislation can have unintended consequences – like our current financial meltdown.

The far reaching power within the TARP legislation (troubled asset relief program) currently being debated in congress will undoubtedly cause problems that no one is currently envisioning. The government needs to act to shore up our financial system, unfortunately we will be paying for this (in dollars and maybe otherwise) for generations to come.

Even the most determined lending institution will have difficulty
cultivating business from minority customers if its underwriting standards
contain arbitrary or unreasonable measures of creditworthiness.
Consistency in evaluating loan applications is also critical to ensuring
fair treatment. Since many mortgage applicants who are approved do not
meet every underwriting guideline, lending policies should have mechanisms
that define and monitor the use of compensating factors to ensure
that they are applied consistently, without regard to race or ethnicity.

The Board of Directors should establish a policy to detect and
eliminate biases in underwriting standards and practices. As part of this
policy, management should be directed to review existing underwriting
standards and practices to ensure that they are valid predictors of risk.
Special care should be taken to ensure that standards are appropriate to
the economic culture of urban, lower–income, and nontraditional
consumers. The Board should require management to define acceptable
compensating factors and to monitor their use by loan production staff.

The Board may also wish to establish a written policy on equal
opportunity lending, in which its underwriting guidelines are explained.
This policy can describe the institution’s commitment to the community
and to minority and lower–income consumers and explain how its
products can meet homebuyers’ needs.

Management should review both underwriting standards
and practices. (See also the sections on Second Review
Policies and Testing Fairness in Lending Practices.)

Underwriting Standards
Property Standards and Minimum Loan Amounts:
These standards should be checked for arbitrary rules as to
the age, location, condition, or size of the property. Such
standards could negatively affect applicants who wish to purchase
two– to four–family homes, older properties, or homes
in less expensive areas.

Obligation Ratios: Special consideration could be
given to applicants with relatively high obligation ratios who
have demonstrated an ability to cover high housing expenses
in the past. Many lower–income households are accustomed
to allocating a large percentage of their income toward rent. While it is
important to ensure that the borrower is not assuming an unreasonable
level of debt, it should be noted that the secondary market is willing to
consider ratios above the standard 28/36.

Down Payment and Closing Costs: Accumulating enough savings
to cover the various costs associated with a mortgage loan is often
a significant barrier to homeownership by lower–income applicants.
Lenders may wish to allow gifts, grants, or loans from relatives, nonprofit
organizations, or municipal agencies to cover part of these costs. Cash–
on–hand could also be an acceptable means of payment if borrowers
can document its source and demonstrate that they normally pay their
bills in cash.

Credit History: Policies regarding applicants with no credit history
or problem credit history should be reviewed. Lack of credit history should
not be seen as a negative factor. Certain cultures encourage people to “pay
as you go” and avoid debt. Willingness to pay debt promptly can be
determined through review of utility, rent, telephone, insurance, and
medical bill payments. In reviewing past credit problems, lenders should
be willing to consider extenuating circumstances. For lower–income
applicants in particular, unforeseen expenses can have a disproportionate
effect on an otherwise positive credit record. In these instances, paying off
past bad debts or establishing a regular repayment schedule with creditors
may demonstrate a willingness and ability to resolve debts.

Successful participation in credit counseling or buyer education
programs is another way that applicants can demonstrate an ability to
manage their debts responsibly. (See the section on Buyer Education.)
Property Appraisal/Neighborhood Analysis: Terms like “desirable
area,” “homogeneous neighborhood,” and “remaining economic life” are
highly subjective and allow room for racial bias and bias against urban
areas. The same holds true when lenders evaluate properties based on
their market appeal or compatibility with the rest of the neighborhood.
(See the section on Third Party Involvement in the Loan Process.)
It should be noted that the Federal Home Loan Mortgage Corporation
(Freddie Mac) has stated that neighborhoods undergoing revitalization
should be assessed on their potential as well as their existing condition.
Also, the Federal National Mortgage Association (Fannie Mae) will
accept block–by–block underwriting analyses in urban neighborhoods
being rehabilitated.

Employment History: It is important to distinguish between
length of employment and employment stability. Many lower–income
people work in sectors of the economy where job changes are frequent.
Lenders should focus on the applicant’s ability to maintain or increase his
or her income level, and not solely on the length of stay in a particular job.

Sources of Income: In addition to primary employment income,
Fannie Mae and Freddie Mac will accept the following as valid income
sources: overtime and part–time work, second jobs (including seasonal
work), retirement and Social Security income, alimony, child support,
Veterans Administration (VA) benefits, welfare payments, and unemployment

Underwriting Practices
Review and monitoring of the mortgage origination and underwriting
process will help determine whether the institution is treating all
potential and actual applicants fairly, and whether it is communicating
its lending policies clearly to the public.

To ensure fair treatment, it is important that the lending
institution document its policies and practices regarding acceptable
compensating factors. If an institution permits flexibility in applying
underwriting standards, it must do so consistently. Management should
consider developing a checklist for loan production staff to ensure that
all allowable compensating factors are requested of the borrower (such
as explanations of late debt payments or a demonstrated ability to carry
high housing costs). The checklist will also make loan production staff
aware of the institution’s commitment to serving borrowers who may not
meet traditional underwriting standards.

One way to help ensure that compensating factors are applied
consistently among racial and ethnic groups is to document and monitor
their use. Debt–to–income ratios and credit history are two areas in
which lenders frequently allow for compensating factors.
Informed borrowers are more likely to ask
loan production staff
about ways to enhance their applications. Thus, another way to encourage
consistent treatment is by clearly communicating the institution’s lending
policies and underwriting standards to the public. The lender’s commitment
to the community and to minority and lower–income consumers
can be described in mortgage–related documents, including marketing
materials, pre–qualification worksheets, and applications. These documents
could also explain the institution’s credit evaluation and underwriting

Loan Production Staff must review their practices to ensure
that they use compensating factors consistently. If a formal checklist
does not exist, loan production staff should have a mental checklist
of compensating factors that they should request from borrowers.
Loan production staff can also draw on their experience with minority
applicants, particularly lower–income or first–time homebuyers, to help
determine how the institution can improve its loan products. They may
wish to note which compensating factors they frequently record during the
application process. They can also inform management of any vague or
unclear wording in loan application documents that could present a
stumbling block for first–time mortgage loan applicants.