The following article by Jack Guttenberg may give further insight into the American sub-prime lending market and the variety of products available.
Should stated-income loans be banned?
Rising foreclosure rates warrant probe
Monday, August 20, 2007
Jack Guttenberg
A stated-income loan (SIL) qualifies a borrower using the income the borrower states, as opposed to the income the borrower can document. With an SIL, the lender agrees not to verify the income the borrower states on the application.As one might expect, SILs are priced higher than fully documented loans, and the foreclosure rate is also higher. With overall foreclosure rates reaching uncomfortably high levels, SILs have emerged as a possible weak point in the underwriting process. Regulators and legislators have been considering whether they should bar SILs or limit them in some way.Why SILs? Singling out SILs for special regulatory treatment is a little strange on the face of it, since they are only one of a spectrum of alternative forms of documentation that have developed in the marketplace. Ranked by restrictiveness, furthermore, SILs stand immediately below full documentation, and above all the others.While lenders don’t verify income on an SIL, they do verify assets and employment. On a “no ratio” loan, income is not reported at all; on a “stated income/stated assets” loan, both income and assets are stated; on a “no income/no assets” loan, neither income nor assets are reported; and on a “no doc” loan, nothing is reported, including employment.These alternative forms of documentation are priced even higher than SILs and have higher foreclosure rates, but have not attracted the same attention. No doubt, the reason is that SILs are the most common type of alternative documentation, and may account for as many loans as all the others put together. The Borrowers Protection Act of 2007, introduced in the Senate by Sen. Charles Schumer, D-N.Y., declares that “A statement provided by the borrower of the income … of the borrower, without other documentation … is not sufficient verification for … assessing the ability of the consumer to pay.” This would leave lenders free to employ less restrictive forms of documentation, including no documentation requirements at all.
Restricting SILs would be costly. The SIL was itself a response to limitations of the underwriting system. Many prospective home buyers have the income to afford a mortgage, but can’t meet the standards of full documentation.
Full documentation generally requires that applicants show that the income they claim was actually earned in each of the two prior years. This is usually done by presenting W-2s or tax returns for two years. Self-employed borrowers usually have the most trouble meeting this requirement, and stated-income loans were originally designed to deal with them, but other legitimate cases quickly emerged.
Many applicants with incomes from salaries can’t meet full-doc requirements. They may not have held their position long enough, or their latest increase in salary may not be reflected in documents covering past income.
If a married couple pools their incomes and one has a much lower credit score than the other, the full-doc rule is that the lower score is the one used. Stated income allows the partner with the higher score to claim all the income, which appears reasonable in most situations, especially in community property states where husband and wife share legal right to each other’s incomes.
Full-documentation rules are backward-looking; forecasts of future changes in income are not accepted, no matter how well grounded they may be. This means, for example, that the low-paid medical resident who, barring a catastrophe, will triple her salary in three months, can declare only her current salary with full documentation. Using a SIL, however, the resident can declare her future income.
The Rap on SILs: The valid rap on SILs is that some borrowers, without any realistic basis for expecting a rise in income, lie about their current income and take loans they cannot afford. This irrational behavior of some borrowers may be encouraged by rational behavior on the part of rapacious loan officers or brokers, who get paid only if a loan closes and have no interest in what happens afterwards.
Because borrowers with high credit scores are much less likely to be irrational in their financial affairs, lenders place a lot more weight on credit scores of SIL borrowers than of full-doc borrowers. SILs will not be available to borrowers with very low credit scores, and if they are available, the price difference between good credit and poor credit is much larger on SILs than on full-doc loans.
The federal financial regulatory agencies looked at SILs in their analysis of problems in the subprime market and concluded that they “should be accepted only if there are mitigating factors that clearly minimize the need for verification of repayment capacity.” Since the rules governing SILs are part of the mosaic of underwriting rules in which everything depends on everything else, there are always mitigating factors. In effect, the agencies elected to go through the motions but not to do any harm. Hopefully, our legislators will elect to do the same.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania.
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