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Risky Lending Policies Junked as Lenders Return to the Basics

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Veteran real estate agent Ray Brown welcomes the tighter mortgage underwriting standards that have been imposed on consumers following spikes in home foreclosures around the country.

The freewheeling days of risky low-doc, no-doc, interest-only and payment-option loans are over, "and that is good riddance," Brown said. "We are returning to the basics. You have to have good credit."

Money no longer is being loaned to borrowers who are at high risk of defaulting when low "teaser" interest rates adjust upward, said Brown, co-author of the "Home Buying for Dummies" real estate primer.

These days, borrowers need to have "a little skin in the game," said Ed Smith Jr., vice president of governmental affairs and industry relations for the California Association of Mortgage Brokers.

That means requiring down payments "even for customers with great credit," Smith said. "Gone are the days of 100 percent financing and very flexible credit criteria."

During the first half of the decade, when the prices of many homes were going up, lenders were eager to sell buyers mortgages with little regard to their ability to repay, said Paul Leonard, California director of the nonprofit Center for Responsible Lending.

Many adjustable-rate mortgages were made on the shaky premise that borrowers always could refinance if rising interest rates made their monthly mortgage payments unaffordable. The riskiest loans were made in 2005 and 2006, when lenders lowered standards to maintain sales volumes.

"That was the mantra: You can get in over your head, but don't worry, you always will be able to finance," Leonard said. "That was true as long as prices went up, but that isn't the nature of real estate markets. They don't go up forever."

The recent scramble by lenders to cut their losses by suspending subprime lending has helped create a national credit crunch. While borrowers with blemished credit now may find it hard to refinance, the move ultimately will benefit borrowers in the prime loan market, Brown said.

"Lenders are not taking money away from well-qualified borrowers," he stressed. "There is no reason to be fearful."

In a recent Federal Reserve survey, numerous banks reported tighter standards for prime mortgages, nontraditional mortgages such as "interest only" loans and for subprime loans. The poll's 49 responding banks included many of the nation's largest.

The lending climate was radically different a few months ago. Happy to feed Wall Street's appetite for subprime loans that could be bundled and sold to investors as mortgage-backed securities, lenders frequently overlooked bad risks. More than 50 have paid for their mistakes by being forced out of business.

Subprime loans, which are more expensive than prime products because of higher risk, originally were intended for borrowers with credit problems. During the housing boom they became a vehicle to keep people in the market as prices soared beyond their financial grasp.

September foreclosures in San Diego County increased just over 300 percent from year-ago levels, according to a report released by DataQuick Information Systems. Although defaults and foreclosures were down slightly from August, a one-month decline doesn't mean the worst is over, said analyst DataQuick John Karevoll. There were 2,157 foreclosures in the third quarter, up from 453 a year earlier.

While foreclosures affect all communities, the highest concentrations are in lower-cost areas that typically attract entry-level buyers. Smith says tighter credit standards will "bring stability back to the marketplace" as bad loans work their way through the system.

"You can't leverage like you used to," Smith said of home loans. "It's even difficult for people with good credit. You are going to have to really document your income now and your ability to repay, especially for any loan over $417,000."

That's the limit for "conforming loans" that can be purchased by government-sponsored enterprises Fannie Mae and Freddie Mac. Fannie and Freddie were created to bring liquidity to the marketplace. Their willingness to buy conforming loans has kept their interest rates lower.

About half of the buyers in San Diego County must use "jumbo" loans that exceed the $417,000 Fannie Mae and Freddie Mac limit. These loans carry slightly higher interest rates. But lending in the jumbo market has grown tighter as Wall Street has retreated from mortgages not backed by Fannie Mae or Freddie Mac.

"Wall Street is not buying the jumbo product, except for people with stellar credit, documented income and reserves in case something goes wrong," Smith said.

Gabe del Rio, homeownership director of the nonprofit Community HousingWorks, says buyers with moderate incomes should lower their expectations and use conforming loans to purchase homes that are within their means.

No longer available, the risky adjustable loans that enabled moderate-wage households to buy homes they couldn't afford were harmful, he asserted. "The stuff that has gone away has been the bad stuff."

Even so, many bad loans still are working their way through the system.

While tighter lending is a good thing, the new standards are making it harder for distressed borrowers to refinance their way out of expensive loans, Smith said. His organization is lobbying Congress to allow Fannie and Freddie to raise the conforming limit. Declaring California a high-cost housing state would place it among select regions where the conforming rate is about 150 percent higher.

Smith said thousands of recent home buyers with adjustable loans in California could be forced into foreclosure if Fannie and Freddie aren't allowed to raise their loan limit.

"We are going to have billions of dollars in adjustable-rate products that are resetting nationwide within the first quarter of 2008," Smith said. "California will take a large share of that hit."

During the recent U.S. housing boom, the Federal Housing Administration was a minor player because its lending ceiling of about $363,000 was too low for many buyers in costly markets. Some lenders are calling for the government to raise that ceiling to ease the credit crunch.

A recently proposed bill from the House Financial Services Committee seeks to help borrowers by placing new restrictions on lenders. In part, it would bar lenders from lending to borrowers who don't have the ability to repay; prohibit lenders from steering homeowners into unnecessary refinancing; and punish Wall Street banks that violate lending laws. Lawmakers are debating whether such action would help stabilize the market or simply make it more difficult to borrow money.

Brown holds that the market will take care of itself.

"This isn't the first frenzied market we've had," Brown said. "You have to visualize a pendulum. Slowly but surely it gets to the center."

Staff Writer Roger Showley contributed to this report.
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