Cheap Loans Are Under Fire
Mortgage lenders have reaped huge profits in the last few years financing Americans’ voracious demand for home loans.
But as concerns rise that the housing boom has become a dangerous bubble, mortgage companies are facing a growing chorus of critics who say that the industry has been irresponsible in its lending practices and that it has set the scene for a potential financial crisis.
Nationwide, mortgage debt has ballooned by about 70% since 1999 to nearly $8 trillion as lenders have relaxed credit standards. They have offered ever more appealing terms so that borrowers can get home loans even if they have little or no money for a down payment and can’t document their income.
The new loans -- some with initial “teaser” interest rates as low as 1% -- have allowed millions of Americans to buy houses or take equity out of their homes.
But bank regulators, industry analysts and consumer advocates increasingly fear that a large number of recent borrowers won’t be able to keep up with their payments when introductory rates end and monthly loan costs automatically shoot up.
By some estimates, a record $1 trillion in outstanding adjustable-rate mortgages could face payment increases in 2007, up from $83 billion this year.
“An adjustable-rate loan made to a family which can barely afford the initial monthly payments represents a ticking time bomb,” said Stephen Brobeck, executive director of the Consumer Federation of America in Washington.
The criticism has placed lenders on the defensive. Many in the industry assert that warnings of a financial disaster stemming from the borrowing wave are overblown.
What’s more, they say, the loans they’ve promoted in the last two years represent important strides in the history of finance, and it demeans consumers to suggest they shouldn’t be offered new mortgage choices.
A report last month by the Mortgage Bankers Assn. declared that “the mortgage market is fundamentally working: Lenders are innovatively creating mortgage products that meet the needs of borrowers, while taking appropriate measures to manage risk.”
But some industry veterans say they’re worried. Herb Sandler, who pioneered alternative kinds of mortgages 25 years ago as a co-founder of Golden West Financial Corp. in Oakland, says the white-hot competition to write new loans has made mortgages too easy to get.
“All of us should be higher than we are,” Sandler said of teaser loan rates. “What’s going on certainly bothers us.”
Mortgages other than the conventional fixed-rate type accounted for an unprecedented 63% of the dollar volume of all loans made in the second half of 2004, according to the mortgage bankers association.
“Mortgage bankers are volume junkies,” said Richard Eckert, who tracks home finance companies for investment firm Roth Capital Partners in Los Angeles. “All of these loans are designed to keep the party going.”
New kinds of adjustable-rate loans have appeared in tandem with a general easing of credit standards at many mortgage companies, amid a heated battle for market share.
An annual survey of major banks by the Office of the Comptroller of the Currency, the primary regulator of national banks, found that in the 12 months ended in March, more than 4 lenders loosened home loan credit standards for every 1 that tightened them.
That occurred even as the Federal Reserve was raising short-term interest rates, which normally is a signal for banks to be more cautious.
Chris Canfora, a mortgage broker with two decades of experience in Nevada and California, said she left the field in 2002 to travel. When she returned to the business in 2004 in Orange County, she said, “I thought the whole world had gone crazy.”
Lenders had sharply lowered credit standards to keep loan production humming and fee income up, she contends. Up and down the real estate food chain -- from builders to real estate agents to appraisers to independent mortgage brokers to major banks -- “everybody’s getting pressure from someone else” to close deals, Canfora said.
Rocketing home prices have made it impossible for many would-be home buyers to qualify for 30-year fixed-rate loans or even many standard adjustable-rate mortgages, or ARMs. High prices also have made it impossible for many buyers to meet the old standard requirement of a 20% down payment.
Lenders’ answer has been the “option ARM,” a type of adjustable-rate loan that was rare before 2004. These are the loans behind the unsolicited offers of low-money-down, 1% interest rate mortgages that stuff consumers’ mailboxes every day.
They’re called option ARMs because borrowers -- home buyers or homeowners seeking to refinance -- can choose among several monthly payment options, including making a minimum payment based on an initial interest rate as low as 1%.
For a $200,000 mortgage, a 1% starting rate would mean a monthly principal-and-interest payment of $643. By contrast, a 30-year loan that size at a fixed rate of 6% would require a payment of $1,199.
What happens with the 1% option ARM, however, is that the initial payments aren’t enough to cover the interest and principal actually owed on the loan. That shortfall gets added to the loan amount.
The option-ARM borrower therefore can face not only a higher minimum payment as the teaser loan rate is adjusted in each of the first few years, but also a much larger payment shock thereafter because he or she has gone deeper into debt instead of paying off the loan.
At IndyMac Bank in Pasadena, where option ARMs have accounted for as much as 40% of recent loan volume, President Richard Wohl said his company wasn’t naive about the potential pitfalls of the mortgages.
“We certainly are alert to the risks. You couldn’t run a sound business without being alert,” said Wohl, a graduate of Stanford University and Harvard Law School.
But he said detractors of the mortgages failed to appreciate the flexibility the loans provided borrowers beyond solving the home affordability problem. Because they can raise or lower their monthly payments at will, homeowners with option ARMs have the ability to pay less, without triggering a default notice from their lender, if, say, a large medical bill temporarily leaves them short of cash, Wohl said.
“Credit standards have been loosening for 200 years,” giving consumers more financial freedom, he said. “Is this the logical next step? I would say it is.”
Some major lenders, including San Francisco-based Wells Fargo & Co., have shied away from option ARMs. But Wells, like much of the industry, offers another kind of loan with low initial costs: the interest-only loan, on which the borrower need pay only interest each month, forgoing principal repayment for a set number of years.
As with the option ARM, borrowers who use interest-only loans can face steep payment increases as the loan ages.
“We think they’re good for borrowers as long as they know what they’re getting into,” said Brad Blackwell, an executive vice president at Wells Fargo.
But some experts worry that lenders’ eagerness to make the novel loans gives borrowers a false sense of security about their ability to handle the debt.
“I think that’s what’s fooling a lot of people,” said Allen Fishbein, director of housing and credit policy for the consumer federation. “They’re expecting the lender to be the gatekeeper. That’s not happening anymore.”
Credit-rating firm Standard & Poor’s, which on behalf of investors keeps watch over mortgage issuers’ practices, said in a July report on option ARMs that the loans historically had been made mainly to “sophisticated or wealthier borrowers.”
Now the target audience has been widely expanded, the firm said. Yet “some of the borrowers may not have the financial wherewithal or the financial savvy to absorb or plan for sudden jumps in monthly payments,” it said.
Historically, adjustable-rate-loan borrowers consistently have had more trouble keeping up with payments than have fixed-rate loan borrowers -- even before the new crop of cut-rate adjustable-rate mortgages. The percentage of adjustable-rate loans that were past due averaged 5.1% in the first quarter of this year, compared with 3.5% for fixed-rate loans, according to Mortgage Bankers Assn. data.
Many lenders insist that they are maintaining high standards in qualifying borrowers for the new breed of home loans. But they shake their heads at what they say competitors are doing -- such as “NINA” lending (meaning the customer has “no income, no assets” verified).
“We are lending to probably the top 10% of the economic strata,” said Larry Goldstone, president of Santa Fe, N.M.-based Thornburg Mortgage Inc., which has been making interest-only home loans since 1997.
Of some of his rivals, however, he said, “They’re clearly standing on the railroad tracks, and there’s a train coming.”
Sandler of Golden West said the industry should be raising interest rates to close the door on the most marginal of borrowers. He said his bank’s basic rate for option ARMs, at 1.95%, would be going up at least a quarter of a point this month.
Calabasas-based Countrywide Financial Corp., which according to Inside Alternative Mortgages newsletter ranked as the largest lender of alternative mortgages in the first half of this year, with $61 billion in such loans issued, declined to discuss its rates or loan programs.
Regulators now are stepping in. The comptroller of the currency, the Federal Reserve and other bank oversight agencies expect to issue guidelines for the new mortgages this fall, said Barbara Grunkemeyer, a deputy in the comptroller’s office.
She said regulators know that “the payment shock could be pretty sizable” on the loans. “We want to lay out how banks can offer these in a safe and sound manner and treat consumers fairly.”
The worst-case scenario for borrowers who have overstretched is that the economy goes into recession in 2006 or 2007 and home prices begin to fall. That could leave many homeowners with little or no equity in their property even as their payments are rising. In a falling market, homeowners who had hoped to sell their house to get out from under their loan might find they couldn’t.
Financial markets probably would react well before a significant pickup in loan defaults. Lenders that hold a lot of questionable loans would see their stocks hammered and could have trouble finding financing to stay afloat, analysts say.
Lenders are “sowing the seeds of their own demise” by extending credit so boldly, said Roth Capital’s Eckert.
In the late 1990s, a number of lenders that had targeted so-called sub-prime borrowers -- people with questionable credit histories -- folded as Wall Street cut off their funding because of mounting losses.
This time, analysts believe that the problems would stretch into the prime-lending arena because borrowers who are granted option ARMs and interest-only loans often are classified as good credit risks.
Because many home loans are packaged and sold to investors via mortgage-backed bonds, a surprising jump in loan defaults also could filter through the financial system worldwide.
Of course, if borrowers were to stumble because the economy was sinking, long-term interest rates also would be expected to fall -- giving struggling homeowners the chance to refinance their loans at potentially more favorable rates. But analysts say refinance rates still might be well above the rock-bottom teaser rates on many new loans.
In its August report, the Mortgage Bankers Assn. cautioned against overstating the risk of widespread loan defaults. Even if estimates are accurate that $1.33 trillion in adjustable-rate mortgages face their first payment adjustment in 2006 and 2007, that amounts to less than 20% of all mortgage debt.
And under almost any scenario, the vast majority of borrowers would probably find a way to make their payments and keep their homes, experts say.
The question is how much larger the minority of troubled borrowers will be in the future compared with the past, as lenders have aggressively fought for market share in recent years.
Jay Brinkmann, vice president for research and economics at the Mortgage Bankers Assn., said that even if loan foreclosure rates ultimately were higher with the new loans, the trade-off would be that the mortgages had afforded many more people the ability to own a home than would otherwise have been the case.
“Will we eventually be better off because these loans were made? My gut feeling is yes,” he said.
But Fishbein, of the consumer federation, said the industry had no historical precedent for the easy mortgage lending of this decade. “They’re in uncharted waters,” he said.
