Riskier types of loans triple

Overstretched borrowers may face mortgage `shock'

Fitch, S&P to tighten criteria

Payments on some ARMs could soar 40% to 120%

July 03, 2005|By Mary Umberger | Mary Umberger,CHICAGO TRIBUNE

As "payment shock" works its way into the nation's housing lexicon, the financial sector is starting to build more internal controls into some riskier mortgages.

Two bond-rating services, Standard & Poors and Fitch Ratings, have begun to tighten their criteria for assessing adjustable-rate home loans called "option ARMs" that are bundled into mortgage-backed securities and sold to investors.

The tougher standards "bring more certainty to the marketplace," said Mark Douglass, one of the Fitch analysts who studied risk patterns for 65,000 such loans, which have surged in popularity in the last few years.

Option ARMs aren't new, though recently they've become wildly popular among homebuyers who are stretching to make monthly payments, particularly on the East and West coasts, where housing costs have skyrocketed.

The complex loans offer borrowers a smorgasbord of monthly repayment options that include paying just the interest, paying the rate for 15- or 30-year amortization or making just a minimum payment. In the latter arrangement, the unpaid interest is added on the balance of the loan, resulting in what's known as "negative amortization." In those cases, the borrower ends up owing more than he started out with.

Fitch analyst Suzanne Mistretta estimates that in 2004, 73 percent of all mortgage originations had adjustable rates. "Of those, 7.4 percent were negative-amortization products. Prior to that, we were looking at 2 percent. That's a very, very big jump."

Concern about the loans is growing in some quarters because of the potential for borrowers to find themselves with unmanageable monthly bills at the end of a set period. Such "payment shock" usually sets in at five years, when the loan terms change and interest rates may have risen significantly.

In some forms of option adjustable rate mortgages, monthly payments could spike 40 percent to 120 percent or more, the Fitch study said.

"If you're a self-employed person and you have variable income, these loans give you more flexibility to manage monthly payments, and it's a great product," for borrowers who know what the risks are, Mistretta said.

"But borrowers who are looking at the teaser introductory rate and saying, `Now I can get that $800,000 house instead of a $500,000 house,' those borrowers are going to get in trouble. They're not focusing on their exposure in a rising interest-rate risk environment. Those borrowers are likely to face a higher payment shock."

She said that the guideline changes are likely to result in lenders scrutinizing the borrowers more carefully, though the change isn't likely to be readily noticed by consumers.

The changes come amid constant discussion of the existence of a housing bubble, where high home prices no longer can be sustained.

Housing industry analysts have begun to question whether such loans are propelling housing prices out of control in some markets and are calling for tighter regulation.

"The Federal Reserve absolutely has to slap selective credit controls on housing finance," said David Seiders, chief economist of the National Association of Home Builders.

"We need to know to what degree inappropriate, unwise financing is over-fueling demand," Seiders said at a housing industry conference in Washington last month. "The regulators should put out guidelines on interest-only and negative-amortization loans."

Others say such loans serve a need.

"I'm a believer in this product for a ton of folks," says Robert D. Walters, chief economist for Quicken Loans, who says more regulation is unnecessary. "One thing that's of comfort is the way clients are qualified for option ARMs. They're qualified at the higher rate, and they have to be able to make the payment at the higher rate in order to get such a loan."

The mortgages aren't universally used by buyers to try to squeak into a home purchase, lenders say.

"There are a lot of borrowers that use an ARM, whether an option ARM or otherwise, to preserve their capital for other investments. They're sophisticated, and many of them are using it as a way to stretch their money," said Dan Hanson, managing director of Countrywide Home Loans, one of the leading lenders of option ARMs. "It's not just for buying power."

The mortgage industry is divided over the risks, according to John Bancroft, managing editor of Inside Mortgage Finance, a trade journal. "Some people think, `What's the big deal?' The loans are adequately underwritten. I've seen studies that such borrowers have generally higher credit scores and lower loan-to-value ratios.

"On the other hand, people say, `Yikes!' They're concerned about negative amortization in these structures."

Credit expert Robert D. Manning sees the loans as a sign that the housing market is out of control in some regions.

"With negative amortization, you're just deferring financial stress that you assume is going to be gone in two or three years. It's an irrational assumption," says Manning, a finance professor at the Rochester (N.Y.) Institute of Technology and the author of two books on debt.

The Chicago Tribune is a Tribune Publishing newspaper.

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