Killing Small Business Part II

Last week we discussed how the Merkley amendment kills small business by mandating caps on originator compensation. Today, I want to look at another aspect of the amendment to Senate bill 3217--the part that mandates that all loans must be underwritten to consider the borrower's ability to repay the loan.

Like so many other things that are codified into law, this sounds great on the surface. After all, we all know about the infamous "liar loans" that allowed waitresses with $10.00 an hour incomes to purchase $500,000 houses. So mandating that borrowers need to prove their incomes and be underwritten according to their incomes is actually necessary to prevent another housing meltdown. Right?

Not necessarily. To really understand what mandating that loans be underwritten based on income means, it is important to understand first that this is a moving target. Several years ago, underwriting to full income through Fannie Mae and Freddie Mac meant, for a salaried employee, one paystub and the most recent W2 from the previous year. For a self- employed person with great credit, it could mean the most recent year's tax returns. Many of the low documentation and no documentation programs were credit score driven and designed to help individuals who had the income but could not pass the underwriting litmus test. Today, underwriting standards have tilted dramatically against the small business owner and the self-employed or commissioned individual, making it harder for these people to qualify to purchase or refinance a home.

Let's look at a few examples:

Borrower # 1 has owned his own business for three years. He has exceptional credit (over 750), but when the recession started in 2007, he was one of the first to lose his job, so he took his savings and invested in setting up a business. Year # 1 he lost money. Year #2 (2008 filing period) he broke even but still got to carry forward some losses from the previous year on his income taxes. Year #3, 2009, he made a healthy profit and now six months into 2010, he is realizing a good income. His credit is strong, and he still has some savings. Now, he wants to take advantage of the lower interest rates and falling prices and purchase a new home. His neighbor Fred's sister in law is moving back to town and she needs a place to rent, so he has agreed to rent his existing home to her for 1250.00 a month. Since his escrowed house payment (principal, interest, taxes and insurance) is $1000.00 a month he will have the payment completely covered. Even though guidelines allow the underwriter to use only 75% of the rental income against the escrowed payment, he still has it covered.

Will borrower # 1 qualify? Probably not. Under current guidelines, the underwriter will have to average his income from 2009 and 2008 as reflected on his tax returns. Although he had a good year in 2009, in 2008 he broke even and he had a loss that carried forward from 2007. That will probably be enough to negate his profit in 2009. The income he is currently making won't make any difference--he will have to file his 2010 taxes in order to come up with a better average.

But let's suppose that our borrower made so much money in 2009 that even with averaging the two years together he still has enough income to qualify. Unless he has thirty percent equity in the house he is currently living in he will not be able to use the rent money from his new tenant to qualify--even if the new tenant is prepared to give him a check for the first month's rent before closing. (Some programs also require evidence of two year's experience as a landlord.) In this case, he has to qualify with the full payment on the existing house he owns now and the full payment on the new house he wants to purchase. The 30% equity rule was established about 18 months ago to prevent underwater borrowers who could not refinance from purchasing a new home at a lower interest rate and better terms and then letting the previous one go into foreclosure. But in practice, it can prevent qualified borrowers from being able to buy a home. Since the 30% equity must be established by an appraisal ordered through an appraisal management company by the lender, even if the borrower perceives that he has the equity in the house, that equity can be eaten up by something as arbitrary as a recent low-ball sale of a similar property on the same street. And the borrower, who has already paid for two appraisals, has no recourse unless he wants to start over with a different lender, pay for two more appraisals, and hope for a different outcome. So borrower # 1, who was willing to take a chance during a recession, work hard and build a new business, probably will not get his loan.

Borrower # 2 is a salaried employee, but his wife is commissioned. Together they have decent credit and not a lot of debt. She has always worked for the same company but recently she moved to a different deparment where she has greater earning potential and she went from salaried plus commissioned to purely commissioned. She is currently earning about twice as much as she did last year. They also want to take advantage of the current low rates and buy a house. Will they qualify? Maybe but maybe not. Even though the wife has worked for the same company, she is now strictly commissioned. Her commissions would have to be averaged for two years, and even though she is making much more now than she was making with her salary, the underwriter would not take the previous salary into account--just the commissions. So unless the salaried spouse's income is strong enough to carry the deal, Borrower #2 may not qualify either.

Borrower # 3 is a career federal agent. He has 15 years on his job. His credit is excellent (over 750) and he has job stability and an annual income of just over six figures. Five years ago he got a divorce, and the court awarded his ex-wife child support, which he pays on time. Early last year, he re-married. His new wife has a bankruptcy and a foreclosure resulting from her previous divorce. She owns a deli, which with her child support from her ex was barely enough to keep her alive until she married our borrower. In 2009, they filed a joint tax return and since she is a sole proprietor with a struggling business, she filed a loss on the joint return.

To me, this is the most unfair example of all. Before the new underwriting guidelines went into effect, if you had one borrower with strong credit and stable income and a spouse with terrible credit and no income, you put the spouse with the good credit and the good income on the loan. Texas is a homestead state, so the spouse who did not qualify signed onto the deed of trust as a non-purchasing spouse and had ownership interest in the property, but neither their income nor their credit was considered for a conforming conventional loan.

The current guidelines change that. Even though borrower 3 receives all of his income from his salaried job with Uncle Sam, his new wife's losses from her business must be subtracted from his income even though she is not on the loan. And if he currently owns a home, he must be able to prove that he has 30% equity in the house, or he will have to qualify with that payment also and prove that he has 6 months of principal, interest, taxes and insurance put aside so that he can make the payment on the current home. Further, a 401K or other retirement account no longer qualifies for reserves, because in order to use that money we must have proof that he has actually withdrawn the funds. So even though all three of our borrowers might have put away some money in investments, we don't get to consider that money unless they have cashed out the investment and deposited it into the bank.

The Merkley amendment may sound as though it prevents another financial meltdown, but in reality, all of these new rules overlook the fact that people are individuals with individual challenges and problems. Rather than preventing problems, amendments like this one merely keep qualified, responsible borrowers from buying houses, and slow down the recovery.