Minimal Paperwork? No Problem for Mortgages in This Deal

(Bloomberg) -- A unit of private equity firm Lone Star Funds sold more than $375 million of bonds backed by mortgages requiring minimal documentation from borrowers, a practice that before the 2008 financial crisis contributed to the creation of “liar loans.”

Over 20 percent of the loans packaged into the Lone Star bonds were made to borrowers who proved their income with just a single month’s worth of bank statements, documents tied to the deal and seen by Bloomberg show.

Those terms recall risky mortgage lending practices from the housing bubble that burst a decade ago, where borrowers could secure a loan with minimal paperwork, allowing them to inflate their monthly income and other measures of their creditworthiness. This is the biggest such deal that Lone Star unit Caliber Home Loans has done in the past year. The bond deal includes about $265 million of securities with top grades from Fitch Ratings and other firms. Christina Pretto, a spokeswoman for Lone Star, declined to comment.

In this case, the low-documentation mortgages backing the bonds, originally made by Sterling Bank & Trust, include other features that make them less risky. For example, borrowers made high down payments-- an average of about 45 percent of the purchase price. Size of down payments is often one of the strongest predictors of a mortgage’s performance, because borrowers with more of their own money invested are often reluctant to give their home up to a bank. No loans in this lending program have been delinquent since October 2011. A representative for Sterling Bank declined to comment.

Risk Rises

The bonds are the latest to be backed by low-documentation loans in the market for mortgage bonds without government backing, where investors have shown an increased willingness to take on risk in pursuit of higher yields. Most other lenders that have packaged these deals looked at more than one month of statements. For example one competitor, Invictus Capital Partners’ Verus Mortgage Capital, typically asks for 24 months of borrower history when relying on an applicant’s bank statements, while also taking steps like verifying the consumer’s assets, according to a person familiar with the lender’s policies.

The Sterling Bank home loans in the Lone Star transaction were made through a lending program that focuses on borrowers with prime credit scores, according to a report from Fitch Ratings. The bank verifies their assets and employment, the report said.

‘Good Faith’

New laws put in place after the housing bubble burst are designed to stop lenders from making some of the riskiest types of mortgages that grew popular last decade. One rule, called Ability to Repay, says that mortgages must be made to borrowers who have the means to meet their obligations. There has long been a debate in the mortgage industry around how that rule will be interpreted and enforced by regulators. One difficult-to-interpret clause requires lenders make a “reasonable and good faith determination” that the borrower can repay based on verified and documented information.

It is not clear that checking one-month’s worth of bank statements is enough to comply with that rule, said Chris Nard, president of Citizens Home Mortgage and a 25-year mortgage-industry veteran.

“If you were forced to testify, you would not be able to do so and honestly say that you proved the borrower was able to repay,” Nard said. Lenders that fail to meet the rule can be sued by the homeowner, and forced to pay up to three years of finance charges plus other damages and fees, some of which are uncapped, which can lead to big losses on the loan.

Sterling Bank has worked with regulators to comply with the Ability to Repay rule, according to the deal’s bond offering documents.

‘Reasonable Defense’

The Ability to Repay rules, written after the financial crisis by the Consumer Financial Protection Bureau, are “silent with regards to the sufficiency or adequacy” of documents proving a borrower’s “ability to repay,” according to a recent Moody’s Investors Service report. Using just a few months of bank records is riskier, and longer-term bank-statement requirements are a safer alternative, Moody’s has said. 

Fitch, which competes against Moody’s for business, said it was comfortable with the mortgages, but acknowledged there is some risk that the loans could be challenged in court. “We think Sterling’s specific program has a reasonable defense to ATR claims,” said Grant Bailey, a managing director at the firm. “We would have a different opinion if the one-month bank statement was used with a different profile of borrower, or if it was used by a lender that couldn’t show a track record with the program.” 

In documents related to its ratings on the bonds, Fitch called the loans a “concern” because “income documentation is a notable risk.” It doubled its assumptions related to potential legal claims if they are challenged under the Ability to Repay rule.

Sterling Bank has retail branch offices in California and in Michigan, where it is headquartered, according to the documents obtained by Bloomberg. Mortgages from the program in this deal are open to U.S. citizens as well as foreign nationals.