Mortgage Lending: The Debatable Facts

The market for “nontraditional” mortgage products has increased enormously in the past few years, growth which raises a question: Are interest-only and option adjustable rate loans behind the foreclosure rash seen nationwide in 2006? Could they be responsible for the looming foreclosure glut expected in 2007 and beyond?

Nontraditional loans, after all, are different. They allow borrowers to purchase homes with small monthly payments. If you want to borrow $150,000 over 30 years at 6.25 percent you’ll pay $924 a month for principal and interest with fixed-rate financing.

With an interest-only loan, assuming the interest rate is fixed for the life of the loan, your monthly payment during the five-year start period would be just $781. With an option ARM you could pay as little as $500 a month.

The problem with these comparisons is that they’re tilted. Most interest-only loans, in fact, are adjustable-loan products. As to option ARMs, that low monthly payment upfront is possible only because unpaid interest is being added to the loan balance. By month 61, our option ARM borrower will owe $163,930 and the monthly payment will increase to $1,076 — assuming, of course, that interest levels do not rise above 6.25 percent.

But interest rates do change. A household which can afford monthly mortgage costs of $500 a month may well fear foreclosure if payments double. And if rates go up, then for many households all bets are off.

So do nontraditional mortgage formats mean more risk in the marketplace?

According to a 2007 fact sheet from the Mortgage Bankers Association, the answer is a solid no. “There is no evidence,” according to the association, “that the increased delinquency and foreclosure rates are the result of hybrid ARMs or nontraditional products, such as interest-only and payment-option mortgages.”

Actually, there is such evidence.

HSBC Holdings — one of the largest banks in the world and one of the biggest sources of subprime funding in the U.S. — just announced that 2006 subprime lending in the U.S. would produce a loss of $1.8 billion. Why did this happen?

“The impact of slowing house price growth,” said HSBC, “is being reflected in accelerated delinquency trends across the U.S. sub-prime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable rate mortgages reset over the next few years from their original lower rates.”

First American Real Estate Solutions maintains transaction and ownership information regarding more than 100 million properties. In February 2006, a report by Christopher L. Cagan, Ph.D., the company’s director of research and analytics, found that 7.7 million ARMs worth $1.88 trillion had been issued in 2004 and 2005. Of this number, Cagan determined more than 1.1 million loans were likely to fail during the coming five years.

In other words, the failure rate projected by Cagan is roughly 14 percent. In comparison, the MBA says “about 1 percent of all loans are in the foreclosure process, well within historical norms, despite the record number of homes sold in the last 3–5 years.”

Not all of the homes in the “process” of foreclosure are actually lost, however.

“Three out of every four loans that enter the foreclosure process,” according to the MBA fact sheet, “do not wind up as a foreclosure sale, either through the homeowner curing the delinquency, a workout between the lender and borrower, a refinance or a voluntary sale of the home.”

In rough terms, if three out of four homeowners can avoid a sale on the courthouse steps, then the real foreclosure rate is about .25 percent. That means Cagan’s projected foreclosure rate is roughly 56 times greater than current levels, an astonishing increase.

Logically — if nontraditional loans do not represent additional risk — there would be no need to toughen underwriting standards. However, exactly the opposite has happened. Prodded by federal and state regulators lenders are beginning to harden the loan-approval process. As the MBA reports, “the marketplace is working. The volumes on many nontraditional products have not been this high before. As a result, investors, rating agencies and lenders have tightened underwriting standards.”

The market is obviously not working for everyone. For 2005, reported 885,468 foreclosures nationwide, a number that grew to 1,259,118 in 2006 — a 42 percent jump. Would investors, ratings agencies and lenders tighten underwriting standards if the old guidelines are working?

“The number one cause of delinquencies and foreclosures,” says the MBA, “is job related, as we can see in the Midwest, which has seen a significant number of manufacturing jobs lost.”

But in 2006 the states with the highest foreclosure rates were Colorado, Nevada and Georgia — states not in the Midwest and states not associated with a significant loss of manufacturing jobs. Moreover, job losses hardly explain the situation in Dallas — in November the Dallas Morning News reported that more than a quarter of all existing homes available for sale were foreclosed properties.

The MBA says that 35 percent of homeowners own their home outright; 47 percent are in fixed rate loans. That leaves 18 percent of homeowners with adjustable rate products. Only 6 percent of homeowners are nonprime borrowers with adjustable rate loans.

In other words, one-third of those who use ARMs are nonprime borrowers — the very borrowers with the worst credit standing. But is that the whole story?

“ARM products,” says the MBA, “have a long and successful history and nontraditional products have allowed many first-time homebuyers to own their homes.”

It’s true that to date the borrower experience with ARMs has largely been positive. Because they have more liberal qualification standards than fixed-rate loans, many buyers have been able to borrow more with ARM financing. Negative amortization, a feature found in many adjustable loan products, has generally not been an issue because during the period from 1990 through 2003 interest rates generally fell and home prices generally rose.

However the marketplace today is different. Rates are higher today than in 2003 — though not high by historic standards. This means that rather than lower costs, many borrowers will face steeper monthly payments as loans reset.

“John Tuccillo, formerly chief economist for the National Association of Realtors, said that with more than $1 trillion in adjustable-rate mortgages set to reprice upward this year, homeowners are looking at a 25% rise in the amount of house payments unless they refinance,” according to the The Milwaukee Journal Sentinel. (See: “Mortgage rate may play into spending,” January 9, 2007)

“A number of lenders — especially those who offer subprime second loans — have already seen the impact of reset rates and changing market conditions,” says Jim Saccacio, Chairman and CEO. of, the nation’s largest source of foreclosure data. “The news is filled with subprime lender losses, buy-backs and closings. The central issue at this point is whether mainstream lenders will face such problems to a similar degree.”

Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 90 newspapers.

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