By Holden Lewis • Bankrate.com

Lenders have abruptly stopped offering the most popular type of subprime mortgage. Credit-challenged borrowers suddenly have fewer options.

“Many borrowers are not going to be able to refinance,” says Deborah Goldstein, executive vice president of the Center for Responsible Lending. The consumer watchdog group has criticized loose standards for subprime mortgages, which are home loans for people with problem credit — generally, with credit scores below 620.

Over the past few years, the most common type of subprime loan has been an adjustable-rate mortgage known as the 2/28 ARM. Since mid-July, five of the six biggest subprime mortgage lenders stopped offering 2/28 ARMs. Suddenly, there’s a shortage of the type of mortgage preferred by about 60 percent of subprime borrowers.

“We think it’s a good thing for consumers,” Goldstein says, because too many 2/28 ARMs were underwritten without regard to whether borrowers could afford to repay them. “So we think it’s positive that lenders are going to stop offering that product. It doesn’t mean they’ll stop offering subprime loans.”

A 2/28 subprime ARM has a low initial rate that lasts two years. After that, the loan resets, which means that the rate is adjusted upward or downward. At the first jump, the rate can conceivably climb 2 to 6 percentage points, causing monthly payments to skyrocket. (In practice, the first rate jump is usually on the smaller end of that scale, but it can keep rising every six or 12 months after that.)

What’s a refi customer to do?
Mortgage brokers and loan officers say borrowers who need to refinance their subprime mortgages still have options — just not as many. Some lenders might still offer 2/28 and 3/27 ARMs, although the rates might be high — possibly into the double digits.

And some lenders offer 5/25 ARMs and 30- and 40-year fixed-rate subprime mortgages. In addition to that, there are “expanded approval” loan programs, which allow lenders to offer Fannie Mae-approved loans to people with blemished credit — but borrowers have to document their incomes, pay principal as well as interest, and, in most cases, pay mortgage insurance.

“It’s old-school again,” one mortgage banker sums up.

Federal Housing Administration-insured loans are another option, as long as the borrower has at least 3 percent equity in the house. Veterans Administration-insured loans don’t require a down payment.

What about homeowners who face an impending rate reset that will send their payments to unaffordable levels, but can’t qualify for a refinanced loan — either because of insufficient payment history and income, or because they owe more than the house is worth?

“Some families are going to have to make ugly decisions,” a banker says, by cutting back on spending or, in the worst case, losing the home in foreclosure.

Cause and effect of easy borrowing
Underwriting for subprime ARMs was so lax in 2005 and 2006 that hundreds of thousands of borrowers fell behind during the initial two-year period, before their loans reset and the payments jumped.

At the end of March, almost 16 percent of subprime ARMs were at least 30 days past due, according to the Mortgage Bankers Association. That’s high, and the default rate is bound to get even worse as subprime ARMs reset over the next couple of years.

Too risky
Wall Street and Capitol Hill were surprised by the high default rates, and pressure from both places led to this month’s sudden scarcity of the 2/28 subprime ARM.

On Wall Street, investors’ demand for bonds backed by 2/28 ARMs abruptly dried up because the loans were perceived as too risky. Unable to sell the loans on the secondary market, lenders stopped offering them to consumers.

That was the explanation offered by Countrywide, the largest mortgage lender (both prime and subprime): “Due to the current market environment for subprime collateral, Countrywide is no longer able to offer subprime 2/28s,” the company said in a terse statement. “The decision reflects substantial tightening of secondary market demand for this product.”

HSBC Finance was the nation’s second-biggest subprime lender at the beginning of 2007. An HSBC spokeswoman says the company still offers 2/28s, and “we are always evaluating if and how we will offer this product going forward.”

The next four largest subprime lenders — Option One, First Franklin, Wells Fargo and Washington Mutual — withdrew 2/28 ARMs in the last few days. First Franklin and Washington Mutual eliminated 3/27 ARMs, too.

Some options remain
The only lender that was willing to talk at length about the decision was Washington Mutual. David Schneider, president of WaMu’s home loans division, says the lender will continue to offer 5/25 subprime loans, in which the introductory rate lasts five years. When WaMu pulled the plug on 2/28s and 3/27s, the introductory rate on 5/25 subprime loans was one-eighth of a percentage point higher than on the 2/28.

“The difference in rate is fairly small,” Schneider says. “We think it also gives borrowers more time with stability of payments versus having shorter-term loans with the possibility of rate increases.”

WaMu announced other changes in the way it underwrites subprime mortgages. All subprime borrowers will have to document their income instead of merely stating it without providing proof, and taxes and insurance must be included in their monthly payments. Every borrower will be contacted by someone from Washington Mutual, even if the loan was originated indirectly through a broker. WaMu describes these commonsense standards as “industry-leading,” with justification, which goes to show how reckless subprime underwriting became in the last two years.

The withdrawal of 2/28 ARMs, plus tighter underwriting standards such as the ones that WaMu implemented, follow months of pressure by federal regulators. At the end of June, the agencies issued guidelines telling lenders to qualify borrowers based on their ability to repay subprime ARMs after they have reset to higher rates.

The regulators told lenders that they should require subprime borrowers to document their income because doing so “is critical to conducting a credible analysis of borrowers’ repayment capacity, particularly in connection with loans to subprime borrowers.”

Yes, federal regulators actually had to tell lenders to verify the incomes of credit-challenged customers who want to borrow hundreds of thousands of dollars.