The Real Impact of The OCC’s Minimum Payment “Crackdown”

As noted previously (second item of post), the Office of the Comptroller of the Currency, the alleged watchdog over national banks, is “strongly encouraging” banks to raise required minimum payments on credit card balances over the next 12-18 months from 2% of the outstanding balance to 4%. Business Week (link requires subscription to magazine) characterizes this requirement as a “crackdown” on bank practices and “Tough Love for debtors.”

No one would deny that requiring higher minimums is a GREAT idea for all NEW card accounts opened from this day forward. But it’s a lousy idea to impose it on existing balances, simply because:
– Lenders have been using the 2% threshold in making loan approval decisions.
– Lenders, especially mortgage lenders in the past year or so, have lowered their approval standards, and have made more loans to riskier customers.

The combination of these two points could be lethal for many existing borrowers, and I’ll show you why.

First, my support for relaxed lending standards has three sources, two of which are from conversations and one I can document:

• I had a conversation late last year with a loan rep from one of the major national mortgage lenders. He told me Fannie Mae and Freddie Mac (Fan and Fred), the quasi-private corporation that buys mortgages from lenders and packages them for securitization, had regprogrammed their loan underwriting programs to allow consumers with credit scores as low as 660 to get conventional loans at the best rates. Previous practice for years had been to require a credit score of 720 for the best rates (for a quick explanation of credit scores, go here).
• Last week I spoke with mortgage broker I have used a few times in the past. He told me that Fan and Fred have relaxed the underwriting standards even further–a score as low as 620 can still get you a conventional mortgage, and you can qualify for a subprime (higher-risk, higher rate) mortgage with a score as low as 550 and “debt ratios” as high as 48%-50%.
• What I can show is that subprime mortgages have exploded to a degree never previously seen in just the past year: “Subprime originations soared by 59.6 percent in 2004 according to the trade publication Inside B&C Lending (Bethesda, MD) to reach $529.9 billion. In contrast, a decline in demand for refinancings caused total 1-4 family mortgage originations to fall by 25.3 percent. Consequently, the proportion of all mortgage originations in the United States that were subprime rose sharply to 18.9 percent.”

So what are these “ratios” I referred to earlier? There are two when it comes to mortgage lending: Front-end and Back-end.

- The Front-end Ratio divides a borrower’s monthly mortgage payment, including real estate taxes and homeowner’s insurance (even if not escrowed), by the borrower’s monthly gross income. Lenders don’t want that ratio to be any higher than 25%-30%, and 28% is generally considered the norm.
- The Back-end Ratio divides ALL monthly payments, including the mortgage payment plus what is called consumer debt (credit cards, student loans, car payments, and any other loans or lines of credit) by monthly gross income. Lenders don’t want that ratio to be any higher than 35%-40%, and 36% is generally considered the norm.

So, let’s say a couple earning $90,000 annually combined, or $7,500 per month, applies for a mortgage. Let’s assume that their mortgage will have a payment of $2,100, enabling them to pass the Front-end Ratio requirement (28% x $7,500 = $2,100).

Now let’s say they also walk in with two car payments of $350 each and $9,000 in credit card balances (just below the average for Americans who owe on their credit cards). Here’s how the Back-end Ratio shakes out under the current 2% and future 4% minimum payment requirements:

2% Min.: $2,100 + $700 + $180 (2% of $9,000) = $2980 =
39.7% of Monthly Gross

4% Min.: $2,100 + $700 + $360 (4% of $9,000) = $3,160 =
42.1% of Monthly Gross

Using the current 2% minimums, this loan application probably gets approved (barely). Under the new minimums, the loan application gets rejected (or pushed into a subprime situation). Raising the minimum payment requirements after the fact will will push this couple into a situation that (as defined by the approval guidelines) they cannot afford. Many people who just barely qualified will therefore be pushed into untenable situations, especially if most of the consumer debt is credit cards and not installment loans. Late payments and foreclosures will increase. The effect on subprime borrowers who just barely qualified under subprime standards with the higher Back-end Ratios noted earlier will be even more dramatic.

This is not fair and not right. More important perhaps, even if you don’t buy into the ethical aspect of all of this, is that large numbers of foreclosures, late payments, and bankruptcies slow down new home sales, then new home construction, and then other related industries, and may eventually slow the economy down, even perhaps leading to a recession.

Of course, a reasonable response to this is that people should never allow themselves to get into situations where they can barely afford to make payments, especially if in the process they will make very little progress in paying off their credit cards (which is usually the case with 2% minimums). But the underwriting models should have considered this, should have built in 4% minimums from the very beginning, and didn’t, because generating sales and commissions was more important. For better or worse, too many borrowers assume that if the bank says they can afford it, they can. They shouldn’t think this way, but they do, and that’s reality. Many lenders in the past, when banking was built on personal relationships, would often have intervened to turn down a loan if it was clear to them that the applicant couldn’t cut it, regardless of what the ratios said; few such lenders exist any more. It doesn’t help that realtors and others encourage people to “buy as much house as possible.”

The new minimum-payment requirements should only be applied to new card accounts, because only new loan applications will be evaluated using these new minimums.