Risky ‘Exotic’ Loans Fostering a Refi Cycle

Craig Wolynez is the kind of homeowner stoking fears about a housing bubble.

Even though he had no steady income, the 33-year-old computer consultant and his wife were able to purchase a $416,000 house in the San Fernando Valley two years ago using an “interest-only” mortgage that guarantees low monthly payments for the first five years. After that, Wolynez’s payments could rise sharply -- making him a prime candidate for default or, even worse, foreclosure.

But like many financially stretched home buyers, Wolynez has a way out: He plans to refinance before his payments balloon. He’s now shopping for a new interest-only mortgage that will keep his payments manageable longer.

“There’s an urgency,” he said. “We know we have to refinance.”

Countless home buyers like the Wolynezes sign up for risky mortgages knowing full well they plan to refinance them -- or sell their homes -- before the payments go up.

The mortgage industry not only grasps this refinancing game, it aggressively markets new loans to these borrowers, raking in additional profits from fees and other charges. And lenders continue to devise more creative loans that reduce payments further and extend purchasing power in pricey markets such as California.

“Lenders are putting people into loans where they are almost guaranteed to be refinanced,” said George Yacik, vice president of SMR Research Corp., a Hackettstown, N.J.-based financial research firm.

For many recent home buyers, it’s become a nerve-racking fact of life knowing that their term for paying a reasonable monthly payment will be short-lived -- unless they change loans.

Brian Kite of West Los Angeles suffers from what he calls “interest-only angst.” The 36-year-old local theater director figures if he doesn’t sell his house in the next few years, he will have to refinance his mortgage, which exceeds $360,000, regardless of going interest rates. If he doesn’t, the mandated principal and interest payments could become too onerous.

“Hopefully, rates won’t move that fast,” he said.

The necessity to refinance complicates the calculus of whether Southern California’s housing market is vulnerable to a downturn. Federal Reserve Chairman Alan Greenspan warned last month that “exotic” loans could subject borrowers and lenders to “significant losses” if home prices fell.

Over time, repeated refinancings could increase the risks of a more severe slump. Already, many fear that homeowners with interest-only mortgages will find themselves “underwater” -- owing more than their homes are worth -- if prices soften. For the borrower who has refinanced repeatedly, the amount of the debt is likely to be even greater, particularly for those who converted their equity into cash with each new loan or who have paid little or no principal.

Homeowners’ ability to continually swap interest-only mortgages not only keeps their payments low for a longer period, it delays the day of reckoning when principal becomes due. As long as home values keep rising, borrowers are protected from becoming overextended.

“So far it’s worked out well because they’ve been able to refinance their way out of trouble,” said Keith Gumbinger, vice president of mortgage information publisher HSH Associates.

Saul Lopez already has refinanced one interest-only loan since he bought his home in Sylmar a year ago. With the new loan, he carries the same amount of mortgage debt -- $479,000 -- but he has the option of paying even less than the interest due.

“This program is not good for everyone, but it’s the ideal program for me,” said Lopez, a Glendale mortgage broker who intends to sell his house in a year.

But lately, interest rates have ticked higher and there are indications that lenders are starting to tighten requirements, which would make it more difficult for highly indebted homeowners to refinance. Homeowners feeling pressure to find new loans may have no choice but to do so on less favorable terms.

“I don’t think refinancing is something people should be doing frequently,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “In a falling interest-rate environment you may be saving enough to make it worthwhile. But the mortgage could go bad in the future and, in a higher-rate environment, there may not be a loan to bail you out.”

To be sure, borrowers have gotten comfortable with frequent refinancing. Until recently, most households refinanced simply to get a lower rate. Such activity hit a peak in 2003, when mortgage rates started to reach generational lows. Nearly three-quarters of the $4 trillion in new mortgages then were refinances.

Since then, refinances have declined to about a third of all new mortgages. There are no numbers to tell how many refinances are by borrowers swapping one interest-only mortgage for another.

But the trend is expected to pick up, given that nearly one of every four new mortgages in the U.S. -- and more in California -- is an interest-only loan. More than $1 trillion of such loans will hit their reset date by 2007.

“This could result in a significant uptick in refinance activity in that year, and may have implications for delinquency levels as well,” according to an analysis by the Mortgage Bankers Assn., the industry’s chief trade group. Historically, delinquency rates on adjustable-rate loans -- which interest-only mortgages are -- have been higher than those on fixed-rate loans, regardless of the level of interest rates.

For now at least, many lenders are quite happy to feed the refinancing cycle.

At Countrywide Financial Corp., the nation’s biggest mortgage lender, fees collected through refinancings are a key source of revenue. To encourage refinancings, the lender keeps in touch with borrowers to alert them to changes, such as when the rate on an interest-only mortgage is about to be reset at a higher, adjustable rate.

“These mortgages will adjust ... and that gives companies like Countrywide the opportunity to be their lender” again, said Joe Anderson, head of the Calabasas-based lender’s consumer markets division.

Homeowner Wolynez doesn’t see himself as a weak link that could help undo the housing market. Since he bought his home in 2003, his computer consulting business has picked up, as has his side career as a musician.

Refinancing, he said, would be another positive step. “I don’t see myself living in this house for more than five, 10 years,” he said. “By then, I hope to be at a point where I can trade up.”