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2007-03-29 08:05:00

Tough New Rules Limit Refinancing Options

Imagine driving along the highway. You run over some glass and a tire goes flat. It's no problem because there's a spare in the trunk.

For the past several years real estate buyers have had a financial spare tire, a back-up system that was always there if times got tough. But now that spare tire is about to disappear, a vanishing act that will surprise some borrowers and bankrupt others.

What happened?

The "smart" play in real estate between 2001 and 2006 was to buy as much property as possible, finance with little or nothing down and then make the smallest allowable monthly payments.

Such a strategy made sense in a world where home values "always" rose and lenders provided ideal forms of financing, loans where initial monthly payments equaled no more than the cost of interest and sometimes less.

But now the game has changed. Freddie Mac -- a major buyer and packager of mortgages -- has announced that starting in September it will substantially change the way it purchases subprime adjustable-rate mortgages (ARMs). From this point forward loans with little down and tiny payments up front are going to be much tougher to get.

Freddie Mac will not buy subprime loans unless the borrower is qualified to pay for the loan at its fully-indexed and fully-amortizing rate and not merely an upfront and low-ball "teaser" rate.

Freddie Mac will require stronger proof of financial capacity. For most borrowers this will mean showing tax returns and W-2 forms.

Freddie Mac wants subprime lenders to collect money each month to assure that property taxes and insurance are being paid.

"Right now," says Jim Saccacio, chairman and CEO at, the leading online marketplace for foreclosure properties, "the new Freddie Mac standards apply only to subprime loans, mortgages used to finance borrowers with high-risk credit records. However, the potential for excess risk also exists for loans for more-qualified borrowers. The result is that borrowers in every credit category would be smart to assume that mortgage standards are about to tighten throughout the marketplace."

Freddie Mac's rules are important because they create big profits for lenders. Freddie Mac buys loans from lenders -- lots of loans. According to The New York Times the company has purchased subprime loans worth $184 billion. (See: Freddie Mac Tightens Standards, February 28, 2007)

The catch is that Freddie Mac only wants loans which meet its standards. If you're a lender you want to meet the requirements of Freddie Mac and other mortgage buyers because then your loans can then be quickly sold. Once sold, the cash you receive can be used to create new loans, new fees and new profits.

While the new Freddie Mac standards will plainly impact new borrowers, the real marketplace worry concerns those who now have loans but will need to refinance in the next few years.

Between 2001 and 2006 millions of properties were financed with interest-only and option ARM financing, loans which allowed borrowers to make low monthly payments during initial start periods, the first few years of the loan. Borrowers with such financing know -- or should know -- that once initial start periods end the loans can only be continued with far higher monthly payments, in some cases payments that will double.

Despite the potentially bankrupting impact of such larger monthly payments most borrowers did not worry and with some reason: As start periods ended properties could be refinanced so borrowers could get another few years of low monthly payments.

Now, however, the ground rules have changed.

First, if the original loan was obtained with a "stated income" mortgage application that contained -- shall we say, "generous" and unchecked income estimates -- new applications will demand verifications and proof. Without evidence of real income, borrowers will be unable to refinance.

Second, if the original loan application was obtained with a full-documentation application that had every number checked and verified, the borrower will still have to meet new and tougher qualification standards to refinance.

In practical terms, suppose buyer Dixon qualified to borrow $200,000 in 2005. He now has the same income and credit, he can document everything, but his loan application will be judged on his ability to pay the real monthly cost of the loan and not just a payment based on an up-front teaser rate. The result? It may be that he can only borrow $175,000 in 2007.

This means Dixon cannot refinance unless he can also pay down a substantial chunk of his existing debt in cash -- $25,000 in this example. Without the additional cash Dixon is effectively locked into his existing loan -- the very loan that he doesn't want to pay or perhaps can't afford to pay once the "start" period ends.

For some borrowers the new rules mean existing loans -- especially recent loans -- cannot be refinanced. Unfortunately the alternatives to refinancing may also be unworkable because larger payments may be unaffordable; in slowing markets homes may not sell at a profit and rents may be insufficient to cover monthly mortgage costs. For too many borrowers, it will no longer be possible to delay mortgage problems by refinancing, an option that could have prevented foreclosure and bankruptcy.

Are the new standards too harsh? Did Freddie Mac do the right thing?

"Freddie Mac," says RealtyTrac's Saccacio, "deserves credit for being the first to make a terribly tough choice. It's the right decision, one that will be painful now but a strategy which will ultimately result in far fewer foreclosures, a reduced number of lender failures and smaller investor losses."

(Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 90 newspapers.)

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