Could Risky Mortgage Lending Practices Prick the Housing Bubble?

Here's the deal: Buy your dream home and pay only interest - no principal - for the next few years. That will give you an unusually low monthly payment while you get on your feet. Or better yet, pick one of our Option mortgages, and pay even less... .

So goes the pitch for the hottest subset of the old-fashioned adjustable rate mortgage. With names like Interest-Only (I-O), OptionARM and Pick-a-Payment, these products offer borrowers far lower payments than they would face with traditional fixed- and adjustable-rate loans. According to some surveys, these especially risky products now account for half of all new mortgages being written this year, up from less than 10% in 2001.

But there's a catch: The required payment is almost certain to jump a few years down the road -- by hundreds and hundreds of dollars a month for many borrowers. In the most extreme cases, the borrower's debt can actually go up over time, rather than down.

What's driving this market? Most important: Are these loans ticking time bombs that could shock the financial markets and economy if rising interest rates or falling home values cause a rash of defaults? A flood of failed real estate loans torpedoed the Japanese economy in the early 1990s, and that country has yet to recover.

"The question is: Are we at that tipping point in the United States? And clearly we are not," says Wharton real estate professor Susan M. Wachter. Nonetheless, she says, these loans are contributing to soaring housing prices, setting the stage for a potentially rough pullback that could make the next recession far more severe than it otherwise would be. "Undoubtedly, these new instruments bring us into uncharted territory. This is unprecedented."

Some types of interest-only mortgages have been around for decades and used by wealthy borrowers who were sophisticated and disciplined enough to find profitable uses for money saved on monthly payments. But today's products are marketed to ordinary homebuyers and, in many cases, to "sub-prime" borrowers who in the past could not have qualified for standard loans.

Though terms vary, a borrower with an interest-only mortgage typically makes no principal payments during the first five, seven or 10 years. After that, the interest rate adjusts annually based on an underlying benchmark, and the principal payments begin. On a traditional 30-year, fixed-rate mortgage for $100,000 at 5.75%, payments would be about $600 per month. With an interest-only loan, the payment would be about $500, because there would be no principal payment. The lower payment requirement enables the homeowner to borrow more than he could with a traditional loan.

But while the traditional borrower starts whittling his debt with his first payment, the I-O borrower doesn't. With more debt remaining 10 years down the road, for example, the interest charges will be higher than they would be at that point with a traditional loan at the same interest rate. And the principal payments, once they begin, will be higher with the I-O loan because fewer years remain to pay off the debt.

Since the interest rate may adjust upward after the initial, interest-only period, the monthly payment can soar. The loan that started at $500 a month could easily go to $700 or more - a jump that could exceed 40%. Some borrowers may be unable to meet this burden.

Option loans are similar except that the homeowner has various payment choices every month. A full payment covers interest and principal, as with a traditional loan. The borrower can also make a bigger payment, with the extra going to the principal so that the loan can be paid off more quickly. Then there is an interest-only option.

Finally, there's a minimum-payment option, which doesn't even cover all the interest. The unpaid interest is added to the debt, boosting the interest charge. A borrower who routinely chose this "negative amortization" option would end up owing more than he would have originally borrowed. With all four options, interest rates are routinely adjusted, so the interest charges go up if rates rise.

"As interest rates have stayed low, all kinds of lenders and builders are seeking to constantly expand the scope of home ownership," says Wharton real estate professor Lynn B. Sagalyn. Exotic mortgages allow lenders to reach customers "who otherwise might be shut out of the market as home prices soar at record rates."

Lenders scrambling for business are also offering loans to people with poor credit, and borrowers can now make down payments of only 5% or 10% - and sometimes zero percent - while 20% was standard not many years ago. "The deeper we get into the pool of what we call marginally eligible borrowers, the riskier it gets" for borrowers and lenders, Sagalyn notes. "That's something of a time bomb."

Compared to I-O and option loans, the traditional adjustable-rate mortgage looks conservative. With these, the borrower typically gets a low "teaser" rate for the first 12 months. Then the rate changes annually with market conditions. Payments can therefore change every 12 months. But part of every payment goes to principal, as with a traditional fixed-rate mortgage. Because interest rates can change, standard ARMs are riskier than fixed-rate mortgages, though not as risky as the I-O and option loans. The use of ARMs is on an upswing. In the past two years, about a third of all new mortgages were ARMs, according to Todd M. Sinai, real estate professor at Wharton. "They are sort of typical right now," he says, noting that ARMs made up an unusually low 12% of the loans issued in 2001 but made up half of loans issued in the late 1980s.

Default rates on ARMs have never been a serious problem, Sinai adds. People tend to make mortgage payments their top priority. And since housing prices have tended to rise and ARM borrowers start trimming their debt with their first payments, ARM borrowers who run into financial trouble can generally sell their properties for more than they owe. "The rate of ARM usage in itself is not anything to be particularly alarmed about. I think that they are not as risky as they are perceived to be."

According to Sinai, loan defaults tend to come amid a "perfect storm" that is rare: Interest rates rise, pushing the ARM payment up; the homeowner's income fails to rise enough to cover the higher payment; housing prices fall so that the home cannot be sold for enough to cover the debt. He adds, however, that the heavy use of I-O and option loans is so new that no one knows what will happen if interest rates rise and the economy lags. "The banks really don't know what risks they are taking because these things haven't been stressed enough."

This is one of the factors that concerns Wachter. "We do not have the history to test for the likely default rate on these instruments because they are too new." In the mid-1990s, she says, lenders started using automated underwriting processes to grant or deny mortgages. These proved far more accurate at predicting defaults than the previous subjective system that relied on loan officers' judgment, allowing loans to less-credit-worthy customers and those with little down payment money. Poorer and riskier customers can now get loans, often by paying higher interest rates that offset the lenders' risks.

But, Wachter says, lenders don't have enough data to know just how high the rates need to be set to achieve that balance, and they must keep rates low to compete. The automated underwriting prices have no way of accurately forecasting the risk of I-O and option loans because there's too little history. "There is a real systemic tendency for banks to support real estate price rises - potential bubbles - when they happen."

Because home prices have soared in recent years, lenders tend to feel confident that homes will be worth enough to cover the debts of defaulting borrowers who end up in foreclosure.

But why have home prices gone up? Partly because borrowers have lots of money to spend, thanks to low interest rates. The new exotic loans have brought more borrowers into the market, contributing to the price run-up, Wachter says. She believes that contribution to be considerable.

Home pricing, she notes, is not as efficient as pricing on stocks and other securities because only the optimists participate in the market. People who think homes are overpriced sit on the sidelines, allowing the enthusiasts to outbid one another. In the stock market, in contrast, pessimists can bet prices will fall by selling short or buying put options.

In the real estate market, optimists tend to believe prices will continue to go up because they have been going up, according to Wachter. Also, open-space preservation laws enacted in recent years in a number of fast-growing states have made it harder for builders to increase the housing supply as demand grows, helping to push prices up.

Some experts argue that true home-price bubbles are rare, and usually confined to a few overheated pockets. Owners cannot sell homes with the click of a mouse, as they can stocks, so it's difficult for housing prices to cascade as stock prices do when a bubble bursts. Typically, a home-price run-up is followed by a period of flattening prices rather than a wide-ranging collapse.

But Wachter says some overheated markets in California and the Boston area did see home prices fall by 30 to 40% after the 1980s bubble burst. Prices tend to fall the most where they have previously gone up the most, and many, many markets have seen enormous gains in the past few years. Hence, many parts of the country could experience falling home prices, she argues. "We could have 30 or 40 of those areas instead of one or two." The risk of borrower defaults is clearly higher because of the heavy use of I-O and option loans, she adds.

While a rash of mortgage defaults is not likely to plunge the U.S. into a prolonged downturn like Japan's, it would cause lenders to tighten their practices enough to constrain economic growth, Wachter predicts. While it's impossible to know which lenders and investors carry the most risk because many loans are bundled into mortgage-backed securities and traded on a world-wide market, mortgage defaults could in fact cause losses in mortgage-backed securities, harming many financial institutions and investors across the globe. "If and when the business cycle turns and we are in a recession, the result of this [heavy use of exotic mortgages] is that the recession could be more severe."

This source is the Wharton Graduate School of Business at the University of Pennslyvania. One of the top Ivy League colleges. If there is any fault with this editorial, one may point to the $ 100,000 loan being used as an example. Assuming that the average ARM loan being made is about $ 218,000 yields more interesting data. In my example, the loan payment for this subprime borrow would start out at about $ 1090. Add in the required monthly payment for taxes and insurance and you are close to $ 1,600 a month. When interest rates rise about 40% (another $ 436) making the total in the example increase to about $ 2,036. Do you begin to feel the pinch yet? (Read More About Bubbles?)

I know a guy who is earning about $ 38,000 a year. He just qualified for a $ 200,000 ARM loan. What is he going to do when his payment jumps another 40%? How can he make his payments? Oh, well, not for me to worry. Nobody listens to this geezer from Oregon, anyway.

"In the stock market, in contrast, pessimists can bet prices will fall by selling short or buying put options."

Or, they could repeatedly post articles with recycled content to Free Republic, in the hopes that the drumbeat of negativity will add up to a shift in consumer sentiment to the negative.

Yes, some markets appear to be overpriced. Yes, lending standards have been relaxed, which increases risk. This has been known for several years.

Do you have any concrete evidence that a real estate doomsday is upon us? If so, I'll be the first to read it and appreciate it. Until then, it's becoming a little tedious.

I'm sure the many mortgages I have read about in the New Orleans area that were not required to carry flood insurance will help.....

I wonder how many will default on home loans down there - both voluntarily and involuntarily???? Let's see - homes with homeowner's (but it won't cover flood damage), and no flood insurance. Home is a total loss, still have that mortgage payment for a wet lot and rotted home remains..... Hmmm.... the bank can have it. I see it building already.

And then of course it will be chalked up to racist lending practices because of the high number of "African-Americans" being forclosed on....

I know a guy who is earning about $ 38,000 a year. He just qualified for a $ 200,000 ARM loan. What is he going to do when his payment jumps another 40%? How can he make his payments?

Secure a loan with the ever-growing equity?

The very lax lending practices have created this bubble in the first place...

Here's another problem. When people want to re-finance their homes, some lenders have their own appraisers, who will appraise the property at exactly the right price so that there is 80-20 loan-value on the home. This occurs regardless of what the actual price of the home is. As a result, a home that is worth about $150,000 will get appraised at $190,000, so the owner can get a loan. If the homes foreclose, banks wind up with property with no equity, and they will end up losing.

Where I live, the lenders are immediately selling their loans to local banks. When a foreclosure occurs and the bank comes looking for the money they've lost, the lenders simply make up the difference; it's a profitable scam for lenders, and since the banks are being made whole (for now), no one is saying anything. It's only a matter of time before this scam comes crashing down.

I just had a divorce client who had an appraisal done for $191,000 when he wanted to re-finance. Appraiser came from lender. Client now getting divorced and we need to value the land. Reputable appraisers hire by my client and his ex-wife showed that the actual value was $160,000. Loan originally in excess of $160,000.

I've seen a couple of threads about banks lending money to people who don't have a credit rating, social security number, or valid ID -- in other words, illegal aliens. It's just nuts. And who pays when the borrower packs up and leaves in the middle of the night on the eve of home foreclosure? John Q. Taxpayer. It's the stupidest thing ever.

"But there's a catch: The required payment is almost certain to jump a few years down the road -- by hundreds and hundreds of dollars a month for many borrowers. In the most extreme cases, the borrower's debt can actually go up over time, rather than down."

No, no, you don't get it. I'll resell at a profit before I've paid hardly anything, because "real estate always goes up."

I hear you, GreatOne. Many years ago when I was buying property in California, I had a close friend who was a realtor. He had many close buddies in the appraisal business. In two years, he bought over 50 homes and became a millionaire in 1977. Back then, there was only about a 5% gain in home prices every year. But people in the biz were making snaky deals right and left. With real estate bubbling at its current rate, (home values up 15% in the past two months) we are very near the top. The bubble may start leaking in your area tomorrow. Count your luck stars you were not caught in the same trap.

Add mortgage fraud, loan servicing scams and illegal foreclosures to your list. It's very dangerous out there. And it's going to UGLY very soon.

While ex-Texan appears to be a one "song band" on the real estate bubble, I invite you combine some of his concerns w/
> Unfunded prescription drug mandate
> Underfunded SS Ins.
> Massive fraud/ funny biz @ Fannie Mae in past 1-2 yrs w/ FOB's
> Potential huge PBGC (unfunded) obligations
> What are the "growth industries" for our new college grads ?
> Huge tort rulings against productive/necessary Corps (e.g. Dow, US Gyp)
Court permission to defraud shareholders (spell K-mart)

There's plenty to be concerned with.

only 1 block in the economy's foundation crumbling could cause a major financial catastrophy.

Please. please, please. Cast some sunshine on what, could be a very dark situation.

Me, I'm not worried 'bout da R.E. bubble. I'ts all those other things that could cause it to happen w/o warning.

When it does finally happen, we'll all probably regale ex-texan for not accurately predicting the actual timing.

" In the most extreme cases, the borrower's debt can actually go up over time, rather than down"

This is called a reverse amortisation loan, and is not a new invention. They were used in the eighties, during a period of extremely high interest rates. Guess what? Nationally, residential real estate rose in value, every year. Locally, the story varied. Houston got pounded, due to loss of employment. New England had a rough patch, again centering upon employment. Los Angeles had a period of decline for the same reason.

I'm no "perma-bull" on real estate, so the comment is misdirected. Nor am I a "perma-bear," which is equally misguided. Much of the excessive speculation seems to be cooling off in those areas with the greatest problem, which strikes me as a good thing, hardly an omen of doom.

Lending standards will prove to be an issue when we go into recession, and inevitably we will at some point, with the problem being mostly on the entry level end of the scale. There are those who have overextended themselves at every level. There will be a shake out. This, again, is nothing new, and is not exactly apocalyptic.

Barring widescale economic destruction due to multiple natural disasters or simultaneous terrorist attacks, you're not going to see prices fall to any great degree, and even that will likely be regional, not national. But, if running around screaming makes anybody feel better, have at it. It won't change a thing, though.

In Ventura County CA, this guy's $200K mortgage wouldn't buy him half of a 700 square foot, 2-bedroom, 1-bath, 40-year-old apartment/condo conversion--now selling for $420K and climbing.

And some idiot mortgage broker is going to get a loan for some 25-year-old who's had a fulltime job for 2 years, is making $50K/year (when combined with new wifey's salary), has never made a mortgage payment, and who has $25K from his in-laws to put down! And some idiot lender is going to accept that mortgage!!!

And to them, there is nothing alarming about that scenario, which is being repeated over and over again every day! It is certainly a recipe for disaster.

Granted, I am biased--I hate mortgage brokers as a rule. They (not all of them, of course but many of them) are the lowest of the low in the so-called legitimate business world, in my opinion.

Ridiculous!!!

The housing bubble has already burst, remember if it is not inflating, which it clearly is not, it is deflating.
It is still an open question of who will pay for this, after all Fannie Mae and Freddie Mac are private companies and their shareholders and bondholders, mostly pension funds and mutual funds, will bear the brunt of the meltdown.
A government bailout is not required by law as far as I can tell.
The average homeowner with 20% equity, a fixed rate and sufficient income to cover monthly payments has no need for concern.

"I'm no "perma-bull" on real estate, so the comment is misdirected."

My quote was pulled directly from the article. I had not noticed your comment (we coincidentally pulled the same sentence).

As far as real estate, I do feel we are on the edge of a real estate bubble. But I will freely admit I have a tendency toward pessimistic feelings of this sort. In 1984 I read David Stockman's book about his experiences while helping form some of the Reagan budgets. I immediately started predicting a Depression.

How are you doing? Haven't bumped into you for awhile.

I just did a re-fi of my home. I found the mortgage brokers lie about the rate they will offer, then delay matters so that the borrower becomes desparate to get the money. One offered 6% fixed and came in at 8% variable! Another one promised to compete with 6% and came in at 7.5 with points.

My home has enabled me to fix my credit and do well for the future. I wonder about the people who spend all their equity and then cannot make payments. They get loans all too easily.

The picture is even worse than I thought. From the La La Times on 9/6/2005:

California real estate buyers with ARM loans are pledging 40% - 50% of their monthly income to feed the debt monster

Fair Use Excerpt:

AMY and Bob Salessi are cutting a few corners to meet their mortgage payment, which consumes about a third of their income. They've reduced their 401(k) retirement contributions, eat out less and rely on relatives to help with child care. They're also counting on quarterly work bonuses to pay insurance and taxes.
The couple, both restaurant employees, bought a three-bedroom Glendora home in the $500,000 range three weeks ago with 100% financing.
"We'll have to struggle for a while, but it's worth it for the house," Amy said. "With the market going up, we couldn't wait any longer."
Apparently a number of Californians feel the same way.
More than 50% of state residents who bought in the last two years spent more than a third of their pretax household income on housing, the top threshold recommended by the Department of Housing and Urban Development. An additional 20% paid out more than half their earnings, according to a study released last month by the Public Policy Institute of California.

Mortgage Servicing Fraud

How Lenders Steal Your Homes

"How are you doing? Haven't bumped into you for awhile."

Pretty well, business is hot and heavy, that's why I'm on FR on a Sunday, in the office. Needed a little diversion from the work grind, LOL.

On the housing bubble thing, I've run the gamut over the past year, from being thoroughly freaked out about it, to uncertain, to feeling that, yes, there is a problem, but there would be a greater problem had we not had all this liquidity post 9-11 and that the shake out will be limited.

The main reason I went through so many gyrations on the issue is that I committed to building myself a new home on land that I bought over two years ago. My market (NC) is just climbing out of the doldrums, days on market is declining, appreciation has returned from the dead to around 5% - 10%, employment has improved. So, my initial pessimism has been tamed somewhat.

But, then again, I don't have a COFI ARM or some such to worry about. The property has appreciated enough during the course of wrangling over plans and permits that I have (or think I have) enough cushion to not take a hit if anything really hits the fan.

And yourself? What have you been up to?

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