Bankers' Worries Mount About Mortgage Risks

By RUTH SIMON
& THE WALL STREET JOURNAL

In the latest sign of how frothy the housing market has become, new data show the degree to which people are stretching to buy homes in a hot housing market.

The data, from the Mortgage Bankers Association, show that adjustable-rate and interest-only mortgages accounted for nearly two-thirds of mortgage originations in the second half of last year. Both types of loans have helped fuel the strong housing market since they carry lower initial monthly payments than do fixed-rate loans, enabling borrowers to purchase more-expensive homes.

With such loans accounting for an increasing portion of consumer borrowing, some mortgage analysts worry that the growth of these loans could cause problems for the housing market and broader economy. “The situation with interest-only ARMs is just one of several very scary things going on in the mortgage industry,” says Stu Feldstein, president of SMR Research Corp., a market-research firm in Hackettstown, N.J. The rise of interest-only loans, combined with other factors such as higher debt levels and changing bankruptcy laws, are likely to cause foreclosures to rise, he says, “possibly dramatically.”

Though it has been clear that borrowers in high-priced markets have been gravitating to products that make homes more affordable, the shift has been greater than expected. In California, where home-price growth has been sizzling, interest-only loans accounted for 61 percent of the mortgages taken out to buy homes in the first two months of this year, up from 47.1 percent in 2004 and less than 2 percent in 2002, according to an analysis prepared for The Wall Street Journal by San Francisco researchers LoanPerformance, a unit of First American Corp. Just 18 percent of California households can afford to buy a median-price house using a conventional 30-year fixed-rate mortgage, according to a report issued this month by the California Association of Realtors.

In another report issued this month, mortgage strategists at UBS AG called the shift to ARMs and nontraditional mortgage products such as interest-only loans “symptomatic of ...the end of the housing cycle. The thing that all of these loans have in common is that they allow homeowners to buy a more expensive home than they could have qualified for with a ‘traditional' loan.”

The Mortgage Bankers Association conducted the survey of the interest-only and ARM share of mortgage originations in an effort to provide more accurate information about the housing market. The group's survey found that interest-only mortgages accounted for 17 percent of loans originated in the second half of 2004. And 46 percent of loans were adjustable-rate loans that don't carry an interest-only feature. The data reflect dollars lent, not the number of mortgages.

This is the first time the group has measured the share of interest-only loans, in which borrowers lower their monthly outlay by paying interest and no principal in the loan's early years. It also is the first time it has looked at loans actually granted, not merely applications.

The findings are the latest evidence that borrowers have moved decisively away from traditional 30-year fixed-rate mortgages and have embraced ARMs and, in particular, interest-only loans, which used to be a niche product. Though borrowers take out these loans for many reasons, the shifts come at a time when both home prices and competition among mortgage lenders has climbed. The MBA's weekly surveys — which look only at application volume, not loans that are actually made — had put the share of ARMs, including interest-only loans, at roughly 40 percent to 50 percent this year. That is up from as little as 18 percent of application volume in early 2003.

The surge in ARMs and interest-only loans is particularly notable because rates on 30-year fixed-rate mortgages remain below 6 percent, still low by historical standards. Borrowers typically turn to ARMs as interest rates climb, but so far the increase in rates has been modest. Many economists see the current popularity of ARMs and interest-only loans as the latest sign of how borrowers are stretching to buy homes they couldn't otherwise afford — and of how lenders are more than willing to accommodate them.

Partly because of these products, mortgage originations are expected to total nearly $2.5 trillion this year, according to the MBA, down slightly from $2.6 trillion in 2004.

Products such as interest-only mortgages can be riskier than fixed-rate mortgages, particularly when interest rates are rising. If home prices fall as rates rise, some borrowers with interest-only loans could wind up owing more than the value of their home. Even if the growth in home prices simply flattens or slows, some borrowers could be squeezed by rising mortgage payments.

In another sign that worries about lending practices are increasing, federal banking regulators Monday issued new guidance for lenders making home-equity loans and lines of credit. The guidelines require banks to do a more in-depth analysis of borrowers' income and debt levels and their ability to repay the loan — instead of relying simply on credit scores.

Initially aimed at sophisticated borrowers who wanted to free up cash for other purposes, such as investing in the stock market, interest-only loans have come to dominate some segments of the mortgage market. A report issued in January by UBS found that the interest-only share of jumbo loans — currently, loans exceeding $359,650 — had tripled since the end of 2003.

Michael Menatian, a mortgage banker in West Hartford, Conn., says he is seeing some borrowers opt for interest-only loans over mortgages that carry a lower interest rate but result in a higher monthly payment.

If home prices continue to surge, affordability could this year reach its worst-ever levels in hot markets such as Los Angeles, Boston and Miami, according to recent report by Goldman Sachs Group Inc. senior economist Jan Hatzius.

The MBA survey highlights other changes in the mortgage market that may increase risks to borrowers and lenders. More than half of the adjustable-rate loans were “traditional” ARMs, meaning the initial interest rate is fixed for less than three years. Borrowers who opt for these loans typically get a lower initial interest rate in exchange for giving up protection from future rate increases.

Until recently, so-called hybrid ARMs had been a more popular choice. These loans typically carry a higher initial interest rate, but are considered a more-conservative option because the interest rate is fixed for the first three, five, seven or 10 years. That makes it more likely that the borrowers will move or see their incomes increase before they face higher payments.

The shift to short-term ARMs has occurred even as the difference between rates on ARMs and fixed-rate loans has narrowed, reducing the attractiveness of adjustables. “To have a lower initial monthly payment, people have gone for shorter-term ARMs,” says Fannie Mae Chief Economist David Berson.

As the use of more novel lending programs becomes commonplace, some mortgage analysts worry that borrowers are adding to the risks by combining a number of features _ using, for instance, 100 percent financing and an interest-only mortgage or a no- or low-documentation loan to buy a property for investment. “These things layer on each other,” says Mark Milner, senior vice president and chief risk officer of PMI Mortgage Insurance Co., a unit of PMI Group Inc. During the past year, PMI has increased its charges for insuring riskier loans, Mr. Milner says.

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If you borrow $350,000 with an interest-only mortgage that carries a fixed rate of roughly 4.8 percent for the first five years, here's what you will pay:

• The monthly payment on the loan would be $1,403 during the initial period.
• Even if interest rates don't rise, the monthly payment would jump to $2,008 after five years.
• If rates jump by two percentage points instead, the monthly payment would jump by 73 percent to nearly $2,500.

Source: Dominion Bond Rating Service