A few years ago it was commonplace in the mortgage industry for lenders to make home loans on the basis of the borrower’s stated income. You might wonder why a lender would underwrite such a risky loan. It seems like these types of loans were ripe for fraud on the part of the borrower by inflating their income and assets. At the time most lenders thought that there would never be any problem because they were certain that home values would continue to increase and therefore even if they had to foreclose on the property, they would be able to recover most if not all of the remaining amount left on the note. Of course, we all know that the gamble of these lenders turned out to constitute unbelievable pour insight into the workings of home values. Sure, as long as foreclosure rates stayed relatively low, home values could continue to increase even with a foreclosure here and there. But as home prices soared in certain parts of the country, each new loan involved higher and higher payments and therefore higher likelihood of default and foreclosure. As more and more people began to default because they either could not afford the loan from the beginning or their interest rate adjusted upward under an ARM product, the comparable home values in the area were adversely affected. Because foreclosure sales almost never return the full value of the property, each foreclosure caused the values of the homes in the surrounding area to drop. As a double whammy, banks and state legislatures began to realize that these loans were just too risky and fewer people were able to qualify for a home loan. As a result, we had an economic client that was perfectly ripe to see home values fall by significant levels.
With hundreds of thousands of homeowners facing foreclosure and banks facing the reality that they were going to take massive losses on many of these loans, the state legislatures of many states saw an immediate need to step in. One of the most common things the state legislatures are imposing on lenders is a requirement that they verify the borrower’s ability to repay. You might say, why would we need such a law? Don’t lenders always verify the borrower’s ability to repay the loan they are making? It seems like bad business to neglect to verify the ability to repay. As mentioned earlier, a number of lenders thought it was a solid business practice because they did not consider that home prices would not continue to appreciate indefinitely or that home prices could and in many areas would decline. Most of the states that require the ability to repay now specifically require that lender’s verify the borrower’s stated income and assets through past tax returns or pay stubs or through other reasonably reliable methods. As I outlined above, requiring the ability to repay is necessary to avoid the housing bubble and subsequent burst that we have experienced in the past decade. However, there are certain circumstances where verifying the borrower’s ability to repay should not necessarily involve verification of income and assets through the normal methods. Specifically, the VA and FHA streamline finances should not require the normal ability to repay.
The VA streamline is a unique product in the mortgage industry. The VA created this product to allow veterans who are already in a VA home loan to take advantage of a significant drop in interest rates with little effort or expense. The VA has done this by requiring little or no documentation on these types of loans. However, in order to qualify as a streamline refinance, the borrower’s overall payment must actually decrease. This means that streamline refinances do not present the potential for fraud and foreclosure that other low documentation or stated income loans present. This is due to the fact that the original loan was underwritten under the normal stringent VA guidelines. The borrower has a payment history on the original loan and cannot have a late payment in the last twelve months, and as mentioned before but it cannot be overstated, the borrowers overall payment must go down. In fact, these types of loans should help to reduce foreclosure rates by allowing borrowers to take advantage of lower interest rates and lower payments. The problem is that when state legislatures consider passing an ability to pay requirement, they do not know anything about the VA and FHA streamline products. Therefore, the state ends up passing an ability to pay statute but does not create an explicit exception for VA and FHA streamlines. The state of Illinois recently passed such a statute. The statute was drafted with exceptionally broad language. The Illinois statute says that the lender must verify the borrower’s ability to repay through traditional method or through other acceptable means. Clearly in the government streamline the lender could easily say that they have verified the borrower’s ability to repay through reasonable means. Even though the Illinois law has this flexibility, due to the conservative lending climate we are currently experiencing, many lenders are unwilling to do the government streamline loans without a specific statutory or regulatory exception for government streamlines in the Illinois law. There are other states such as Minnesota with similar ability to repay statutes that have provided a specific exemption for government streamlines. I would argue that the state of Illinois should enact such a specific exemption for government streamlines, and even further they are doing a disservice to their constituents if they do not enact such an exemption in the near future. For any states that may be considering adding an ability to repay statute in the future, they should ensure that their statute includes an exemption for government streamline refinance products.