Superintendent Neiman Testifies on “Subprime Lending Practices” Before NYS Assembly Committees on Banks, Consumer Affairs and Protection, Housing, and Judiciary Oversight, Analysis & Investigation
May 29, 2007
Good morning. Chairman Towns, Chairwoman Weinstein, Chairwoman Pheffer, Chairman Lopez, Chairman Espaillat and distinguished members of the Committees.
I am Richard H. Neiman, and as Superintendent of the New York State Banking Department, I appreciate this opportunity to address you today. The Department shares your concern around mortgage abuse and ensuring that all residents of our state have equal access to sound credit products.
I especially appreciate being asked to speak first among the day’s witnesses. I hope to provide you with a balanced perspective for you to evaluate the opinions of the various stakeholders who will testify today.
I am also pleased to be sharing this panel with Priscilla Almodovar, the President and CEO of the Housing Finance Agency and SONYMA. Priscilla’s testimony will provide the Committees with invaluable mortgage market expertise. I would like to point out that in addition to being co-panelists at the hearing this morning, we also work together on the Governor’s subprime mortgage task force, which I will discuss in detail later in my remarks.
In the limited time that I have with you this morning, I will address 4 areas:
- First – An overview of the trends that have led to the subprime mortgage crisis;
- Second - A preliminary assessment of the potential impact of the subprime problem, with special emphasis on the challenges facing New Yorkers;
- Third - An outline of the initial response from the Governor’s Interagency Task Force; and
- Fourth – Proposed recommendations for developing an appropriate regulatory and legislative response.
Before I get into the details of the subprime problem, I would first like to mention that we do not deny that there is a legitimate and beneficial role for lending to borrowers with impaired credit history through risk-based pricing. Such subprime lending can be successful when proper guidelines are followed to ensure that consumers receive products that are appropriate for their financial circumstances. However, the problem we face today was not created simply by the existence of subprime lending; rather, the problem was created by a complex web of market forces that encouraged undisciplined growth within vast segments of the subprime sector.
I believe the origins of the problem in large measure stem from increased institutional demand for higher yielding subprime investments. As stock values fell earlier in the decade, real estate became an appealing investment alternative and property values increased in response to renewed investor appetite. As a result there was a significant increase in institutional investor demand for higher risk subprime mortgage securities that generate a higher yield.
Lenders were quick to respond to this investor interest through the development and marketing of alternative mortgage products. These alternative products contained unique risks, such as the potential for negative amortization and risk of payment shock as adjustable-rate loans with low initial rates reset. These inherent product risks were combined with underwriting risks, such as 100% loan-to-value financing, no income verification and reduced documentation.
These products and underwriting techniques were then applied to consumers with impaired credit histories. Preliminary evaluations also indicate that minority borrowers and minority communities are being disproportionately affected as a result of subprime mortgages that are often offered with insufficient regard for the borrowers’ ability to repay.
Though it is difficult to assess the full impact at the moment, I anticipate that the extent of the subprime problem will become clearer over the next 12 to 18 months as a large segment of adjustable rate mortgages originated in 2005 and 2006 will reset in waves. Overburdened consumers may be unable to withstand the payment shock.
In just one year, from the end of 2005 to the end of 2006, the rate of homeowners entering the foreclosure process has increased by approximately 42% nationwide. This is a dramatic spike in such a short time period, and New York has not been spared. The statewide increase in initiated foreclosures is at 40% and in step with the national trend.
This percentage translates into an estimated 50,000 New York households in some stage of foreclosure in New York in 2006 alone. And, it is important to remember that behind each one of those 50,000 filings there is a family with a variety of increased social services needs.
While there is some reassurance in the fact that the situation for New York statewide is not worse than the national average, significant challenges remain.
And the foreclosure numbers only begin to tell the story. There are many more delinquent accounts that are hovering on the brink of foreclosure. The incidence of delinquency tends to be geographically concentrated, which suggests that pockets of the state may be impacted more acutely than others. For example, it has been reported that Nassau and Suffolk counties as well as the Glens Falls and Jamestown communities upstate all have escalating default rates. In New York City, neighborhoods with high minority populations, such as Bedford Stuyvesant, Bushwick and East New York in Brooklyn, and Belmont and East Tremont in the Bronx have high levels of subprime lending and risk becoming destabilized.
III. Government Response
As these issues and statistics surfaced, it was clear that decisive government action was needed. In response, Governor Spitzer has created an interagency Task Force to bring together all of the state agencies and departments that relate to mortgage issues. The HALT Task Force, as it is known, is charged with the mission to “Halt Abusive Lending Transactions.”
As Chair of the Task Force, I am proud to say that we have already identified and are in the process of addressing six core initiatives:
- We are analyzing foreclosure and lending data to identify borrowers and communities most at risk.
- We are developing loan and refinance programs -- in conjunction with SONYMA -- to help homeowners whose current loans are inappropriate for their financial circumstances.
- We are creating statewide outreach and educational campaigns to assist the state’s most vulnerable borrowers.
- We are considering various legislative and regulatory changes to enhance compliance and expand consumer protections.
- We are working with the Division of Human Rights in evaluating examination and complaint files to identify potential patterns of discriminatory lending behavior.
- And finally - in coordination with law enforcement agencies, we will be pursuing enforcement actions against those engaging in wrongful conduct and in fact have recently established a Mortgage Fraud Unit that will focus specifically on issues related to the mortgage industry. This unit works in conjunction with the Secretary of State, as well as other law enforcement agencies.
The Task Force has also begun to reach out to the community and industry through a series of day-long HALT summits. The first of these was held in Manhattan on April 11, and a second summit is being planned for Buffalo on June 28. These events reach down to the grassroots level, which I believe is a crucial first step in identifying and responding to the regional challenges facing New Yorkers.
IV. Proposals for regulatory and legislative action
As I stated above, one of the core goals of the Task Force is to pool our expertise in developing recommendations for a potential regulatory and legislative response.
The first step is to consider whether new laws or changes in existing law are appropriate. While noting both the importance of vigilant enforcement, particularly in cases of suspected mortgage fraud, and the hopeful signs of an initial market self-correction, I believe that a legislative response will be necessary. But as much as I believe the problems of subprime lending require immediate attention and consideration, I also believe that the complexities of the subprime problem necessitate a legislative response that is measured and proportional.
What is certain is that any successful legislative response needs to address the misaligned interests of the borrower, the broker, the lender and the investor. Consumers rely on mortgage professionals for assistance with what may be the largest financial transaction of their lifetime. And yet, the mortgage origination process is rife with the potential for conflicts of interest at multiple levels. It is with this fact uppermost in my mind, therefore, that I will address my comments to three important segments of the mortgage industry: brokers, lenders, and servicers.
A. The Mortgage Brokers
Mortgage brokers provide a valuable service when they arrange financing for their customers. They can expedite the approval process by collecting and processing credit documents, and by managing communications with the lender. Brokers may even be able to obtain the loan at a more favorable wholesale interest rate than the consumer would otherwise receive through the retail channel. But in spite of these potential benefits, the Department continues to receive numerous consumer complaints about the brokerage industry. These complaints are a sign that further review of broker practices is warranted.
Many of these complaints reflect a fundamental misunderstanding on the part of consumers as to the true nature of the broker’s role in the mortgage transaction. Consumers tend to assume- and it is a natural and understandable assumption- that when they engage the services of a mortgage broker, the broker is then acting exclusively in their best interest. But the fact is, brokers have an unavoidable financial self-interest in choosing which of the multiple financing options they offer to their customers.
Thus, a serious conflict of interest is present any time the broker’s legitimate business considerations become transformed into an incentive to place the consumer into a product that is inappropriate for their credit profile. This conflict becomes more serious if the consumer is unaware of the broker’s incentives and, even worse, if the consumer thinks that the broker is operating solely in his best interest.
Three suggestions to better align the interests of the broker and borrower include:
- Duty of Care – First it is critical to review the standard of care owed by the broker to the customer. Some have suggested that this may be accomplished by establishing a “fiduciary,” “suitability,” or “agency” relationship, all terms with specific legal meanings and implications. There may be other means as well, but however such safeguards are achieved, certainly we can all agree that brokers have a duty to deal fairly and in good faith with their customers. Effective disclosure to assure that the customer clearly understands the broker’s role and duty is also vital.
- Broker compensation – Second it is important to develop sufficient safeguards to ensure that the compensation systems for mortgage originators do not provide incentives to steer consumers into higher-cost or other inappropriate loan choices.
- Description of Loan Alternatives – Third, consideration should also be given to requiring brokers to provide consumers with a list of available financing options and terms prior to placing the application with a particular lender.
B. The Mortgage Lenders
The progressive abandonment of traditional underwriting norms has contributed greatly to the current subprime crisis. Traditional standards included a three-part test that evaluated the borrowers based on the “three c’s”:
- past credit history;
- capacity to repay the debt; and
- the adequacy of the collateral offered.
It is the second prong of this test, the borrower’s capacity to repay the loan, which has been particularly disregarded through the prevalence of stated income loans where the borrower’s income is unverified or only partially verified. The OCC has estimated that nearly 50% of all subprime loans rely on stated income. This practice tempts consumers to shop beyond their means. In addition, it provides an incentive for lenders to promote these loans as a time-saving option to consumers who could otherwise document their income and thus be eligible for a lower interest rate. With housing values falling in many areas, borrowers who are unable to service their debts based on their income alone may find that refinancing to access equity is no longer an available stop-gap measure.
This situation requires decisive action at both the state and federal levels:
First at the State level, we already have progressive consumer protection laws here in New York. However, the loan amount thresholds contained in these laws may have become outdated, reducing the effect of the law’s original intent. I therefore believe changes are warranted in Section 6-l of the Banking Law dealing with high cost home loans.
Second at the Federal Level - I support the establishment of National Standards
As I mentioned above, the lack of disciplined underwriting standards in assessing a borrower’s ability to pay is at the root of much of the current trouble with subprime mortgages. The practice of routinely relying on stated income, instead of on verified income, is a particularly troubling practice. Therefore, national standards should focus on evaluating borrower payment capacity. There are a variety of ways in which this could be accomplished:
- Income should be fully documented for the vast majority of borrowers. Exceptions could be developed to address the more unique situations, such as self-employed borrowers or those with commission-based income.
- Residual income tests should be considered as part of any underwriting standard. Residual, or disposable, income looks at the dollar amount of cash that borrowers have remaining after making their debt payments.
- For adjustable rate loans, they should be underwritten to the fully indexed rate to amortize the loan.
- When consumers are quoted monthly payments and when qualification ratios are calculated, a projected amount of escrow for taxes and insurance should be included in the total monthly payment.
In order to protect the competitiveness of the New York State charter, I support a national standard. In my role as Superintendent I have already begun to engage with Congressional members and staff as well as with federal regulators. Though my preference is that the national standard be a floor, permitting states to adopt additional protections as needed, I suspect that the issue of preemption will be part of the Congressional debate.
C. The Mortgage Servicers
The positive changes in sales and underwriting practices that I have just outlined would benefit consumers who are still shopping for a mortgage. However, we also need a response that is targeted to help existing borrowers who may be overextended. Many of these subprime loans have entered the secondary market and are not being serviced by the original lender. The company that currently has the servicing rights, therefore, is also an important player in the market and effective solutions to the subprime problem require the cooperation of the servicing industry.
But even when servicers are willing to consider modifications, there are obstacles that may make it difficult to offer workout arrangements on existing loans that have been securitized, for example:
- The customary 5% cap on the amount of loans in the pool that may be modified
- Tax consequences
- Qualifying sale treatment status
Another complication is that it is not always permissible under the contract terms to offer early intervention. Workout arrangements should be available before the stage of serious delinquency is reached, to help protect the consumer’s credit history and prevent unpaid interest from accruing.
There needs to be a broader discussion on this topic that includes investment banks, the securities industry, and representatives of the Financial Accounting Standards Board (FASB). It is in everyone’s interest find ways to help existing borrowers avoid entering foreclosure. The effects of foreclosure are always devastating: it is a personal tragedy, a community challenge, and a business loss.
We know that the issues facing mortgage consumers concern all of us and require a coordinated response. We look forward to working with the Assembly and all other interested parties in the months ahead on developing and implementing solutions for protecting our residents from abusive lending practices.
I can assure you that the Banking Department and the Governor’s Task Force take these concerns very seriously, and that our efforts to protect the most vulnerable are at the heart of the new Administration’s mission.
I hope to be able to remain during the entire hearing, and I am eager to hear the testimony that will be presented by the other witnesses. This hearing marks an important step toward addressing the subprime issues facing our state and I appreciate being included.Thank you very much.