Cheap mortgages draw needed regulatory fire


YOU'VE SEEN the home loan pitches - possibly ad nauseam: "Refinance now!! 1 percent mortgages!! Save thousands of $$$$$ per year with our 1 percent option ARM!!"

Given the seductions of 1 percent money, you might not be surprised to learn that this form of financing has quintupled its national market share in the past 12 months. But two developments - one that took effect Aug. 1, another due this fall - could reduce the number of promotions you see for cut-rate option adjustable rate mortgages.

Also known as payment-option adjustables, option ARMs give borrowers a choice of several monthly payment alternatives, ranging from full amortization of principal and interest to minimum payments as low as 1 percent. Borrowers who opt for the minimum payment rack up additional debt since the principal and interest they are not paying get tacked onto the balance they owe the lender.

That feature is known as negative amortization. Some option ARMs allow borrowers to accumulate 10 percent to 25 percent of additional debt beyond the original balance. Option ARMs also come with periodic conversion or reset rules that adjust monthly payments to higher levels at fixed points in time. The post-conversion monthly payments can be sharply higher - sometimes 70 percent to 90 percent higher - forcing borrowers to find a cheaper alternative, cough up the extra cash, or default on the loan.

Borrowers who have higher loan balances than when they closed the mortgage face especially tough choices. The squeeze gets even more painful if they had minimal equity in the house to start and home values have softened since their purchase. They may find themselves underwater - sitting with mortgage debt that exceeds the resale value of their house.

Enter Wall Street's new rules for option ARMs. Though some lenders retain option ARMs in their own portfolios, many pool and sell them for repackaging into Wall Street mortgage-backed bonds. (Consumers might assume that their lender supplies the money for their home loan, but the fact is that trillions of dollars raised in the global capital markets actually finance America's home purchases through mortgage-backed bonds.)

Investors look to ratings agencies to tell them how risky the bonds are, based on the default probabilities of the underlying loans. The dominant rating agency for so-called nonconforming, jumbo and "alternative" home loans is Standard & Poor's. Think of Standard & Poor's as a kind of gatekeeper: If a lender's loans adhere to S&P;'s criteria, they get into the bond pool with no extra charges. But if they carry features that Standard & Poor's considers risky, they get hit with penalties known as credit enhancements.

The net effect of the penalties is to make the loans costlier and less attractive for the lenders who offer them to the public. If the penalties are steep enough, lenders make fewer loans or follow the rating agency's rules.

On Aug. 1, Standard & Poor's blew the whistle on option ARMs. After an intensive study of recent mortgage-backed bonds, it concluded that lenders are allowing credit standards to slip too far. And too many of the borrowers using option ARMs are paying the minimum amounts per month, thereby accumulating potentially toxic levels of debt - especially in markets where home values are likely to soften.

"We wanted to jump in before this got any worse," said Standard & Poor's mortgage bond director Michael Stack. By "any worse," he meant that if credit standards continued to decline, there would be a rising probability of defaults on option ARMs - something unacceptable to bond investors.

A second development potentially affecting option ARMs is under way at the federal financial regulatory agencies. A task force headed by Deputy Comptroller of the Currency Barbara Grunkemeyer is preparing new underwriting and credit risk guidelines on option ARMs, interest-only mortgages and reduced-documentation loans offered by the nation's lenders. In an interview, Grunkemeyer said the new guidelines could be out "by early fall," but there is no specific target date.

She said that financial regulators have "noticed that these products have taken off in the past six months." The goal of the guidelines will not be to eliminate any particular loan type, she emphasized, but "to make sure banks are offering [interest-only and option ARMs] in a safe and sound manner and doing so in a way that allows consumers to understand the risks."

Bottom line: It's probably sayonara to 125 percent mortgages at 1 percent to buyers with marginal credit, insufficient incomes, minimal down payments and no clue about the potential payment-shock monsters lurking over the near horizon.

Ken Harney's e-mail address is

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