All Posts Tagged With: "risk"
For a number of years the reverse mortgages insured by the FHA were a successful product in the sense that borrowers got their cash and the FHA had few claims.
However, the FHA reverse mortgage program does not work in isolation — it actually requires rising home values. The typical reverse mortgage is outstanding for about six years and with home prices generally 15.7 percent lower than in 2007 many reverse mortgages are now producing big claims against the FHA.
Why does this happen?
With a reverse mortgage the borrower does not make monthly payments for principal and interest so the loan is actually a negatively-amortizing mortgage. That means the loan debt goes up over time. The loan ends when the borrower sells, moves or dies. When the loan ends the property can be sold to pay off the debt or it can be refinanced by the heirs if they want to keep the property. Since a reverse loan is non-recourse financing there are no claims against the estate or the heirs, other than the house.
However, the amount owed by the borrowers is limited to the value of the property. If the size of the debt is great than the fair market value of the property FHA insurance kicks in to protect the lender.
HUD Deputy Assistant Secretary Charles Coulter has told US News & World Report that to stabilize the reverse mortgage program there are “four fundamental changes that are required: restricting the amount of the up-front draw; implementing a financial assessment process to ensure seniors are equipped to meet their long-term financial obligations; requiring some combination of a tax and insurance set-aside and/or borrower escrow account; and addressing complications resulting from non-borrowing spouses. (See: Time to Rethink Home as Retirement Nest Egg, Feb. 6, 2013)
In other words:
- Limit the amount of cash that can be taken out at closing.
- Institute financial qualified standards to assure that borrowers have the capacity to pay for property taxes and insurance, a borrower responsibility which has always been required.
- Require escrow accounts to actually collect property taxes and insurance.
- Figure out how to handle spouses who are not on the mortgage when the borrower dies. Typically this happens when the borrower is age 62 and older while the spouse is younger.
Are the Coulter proposals a trial balloon? Perhaps.
However, HUD under Secretary Shaun Donovan has been very straight-forward regarding it’s intentions. There is little reason to believe that the Coulter proposals are either implausible or impractical.
Notably missing from the Coulter list is a reduced level of risk for HUD. When lenders make loans which are insured by the VA or with private mortgage insurance (MI) companies they do not get 100 protection against loss. With the FHA they do. The most–obvious way to lower HUD’s risk is to tell lenders that from this point forward federal insurance only covers 95 percent of the risk.
What will then immediately happen is that there will be fewer home equity conversion mortgages — HECMs, the term used by HUD to describe reverse mortgages. The reverse mortgages that are made will have a higher quality. Combine the two results and HUD will have a lot less risk.
As always with reverse mortgage products, speak with several lenders and an HUD-approved housing counselor as well as an attorney who specializes in elder law and a fee-only financial planner. Why so much research? Because reverse mortgages are complex and they are part of the overall process of retirement, financial and estate planning.
America’s major banks now hold derivatives with a notational worth of $225 trillion – about a third of the world total. No kidding. Trillion.
And that’s up from a mere $120 trillion six years ago. Rather than being weened off derivatives, America’s big banks are more deeply entrenched then ever.
Hopefully Wall Street has it figured out just right and there won’t be any major losses, say a few billion here or there. After all, when has Wall Street ever been wrong about financial instruments?
“Derivatives are dangerous,” says Warren Buffett. “They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.”
While many in Washington would like to limit derivatives trading, make such trades open to public scrutiny or both, Wall Street is vehemently against regulation.
In fact, there’s a simple way to resolve derivative worries. Allow unlimited derivatives trading — but only by individuals and partnerships willing to personally take the risk of profits and losses.
What’s A Derivative?
In basic terms a derivative is a bet tied to the movement of anything that can be valued. We could have a derivative bet which says the price of a mortgage-backed security (MBS), Hungarian currency or lemonade indexes will go up by a certain date. If the value rises then one party to the derivative will make money and the other will lose. And vice versa.
Notice, however, that derivatives are not like stocks or bonds — or mortgages or home loans.
First, unlike mortgages there’s no limit to the size of a derivative bet or the size of the derivative marketplace because none of the bettors actually are required to own the underlying asset. For instance you might bet that the price of oil will rise or fall without owning a single drop. The bet concerns the movement of value and not the ownership of the oil.
Second, there’s huge leverage because not much cash is needed to enter into a derivative agreement.
Third, if you bet on a derivative you typically make an off-setting bet to limit risk. Hopefully you do it right.
According to the Bank for International Settlements (BIS), the notational value of derivatives at the end of 2011 was $648 trillion.
The gross credit exposure from these securities was believed to be $3.912 trillion according to the BIS — that’s up from $3.5 trillion at the end of 2009.
But what if the estimates are wrong? For instance, let’s say losses are just one tenth of one percent bigger than expected. Not a big deal, except in the context of international derivative levels that’s more than $640 billion.
Do taxpayers have exposure? You bet. According to the FDIC, at the end of June 2012 all depository institutions held derivatives with a notational value of $224,998 trillion. However, such bets are not spread across the entire banking system. Banks with at least $10 billion in assets hold virtually all derivatives, securities with a notational value of $224.803 trillion. While the FDIC insures deposits in some 7,200 banks and savings associations, only 59 FDIC-insured institutions have deposits of more than $10 billion. Your little community bank, savings association or credit union likely has no derivatives department.
Derivatives are simply bets. They finance no factories, no research, no colleges, no homes and no cars. Any jobs they produce are incidental and inconsequential relative to the potential risk they represent, the risk that credit exposure has been incorrectly figured by hundreds of billions of dollars if not more. Since big banks hold virtually all derivatives, and since taxpayers can face massive costs if big banks fail, it follows that something should be done to limit taxpayer risk.
“In banking,” said Buffett in 2003, “the recognition of a ‘linkage’ problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a ‘chain reaction’ threat exists within an industry, it pays to minimize links of any kind.”
How can we control derivative worries? If they’re so necessary and safe, let bankers and traders take the risk. Personally.
This can be done with regulations which restrict the ownership of derivatives and derivative interests to individuals and partnerships. Federally-regulated banks, savings associations and credit unions would be prohibited from originating, buying, selling, brokering, owning, trading, holding or financing derivative interests, directly and indirectly, for themselves or for another party.
Such rules, of course, would apply to regulated financial institutions as well as their subsidiaries and partnerships, both in the US and abroad. And the regulations would also apply to financial products which fit within the definition of a derivative, even if called something else.
Under this system, derivative profits would be owned entirely by individuals and partnerships. And derivative losses? They too would be owned entirely by individuals and partnerships. No longer would taxpayers be forced to pick up the pieces if something goes wrong.
For those who believe in less government regulation here’s your chance….
This posting has been updated and expanded from material published originally by the author on the Huffington Post.
President Obama inherited the worst financial crisis since Hoover and the Great Depression. It follows that getting the country back on track is no easy task and while his new housing plan includes much to support it also includes a provision to dump appraisals when they are most needed.
Dump is really the right word. Fannie Mae and Freddie Mac, says a White House fact sheet, “would be directed to use mark-to-market accounting or other alternatives to manual appraisals for any loans for which the loan-to-value cannot be determined with the GSE’s Automated Valuation Model. This will eliminate a significant barrier that will reduce cost and time for borrowers and lenders alike.”
This sounds great except that the goal of an appraisal is to protect not only borrowers and lenders, it’s also to protect mortgage investors such as pension funds and insurance companies — entities we want to attract or face far-higher interest rates.
The Need For Appraisals
It’s true that appraisals are a cost, but so are food, shoes and tires. The important point is not that appraisal are an expense, it’s that appraisals made by actual humans have value.
For some time there has been an effort to eliminate appraisers from the mortgage process with seers, soothsayers and automated processing. The pretext is that independent appraisals cost money and the computerized systems are pretty good.
Pretty good is an okay standard when you own thousands of loans, but residential borrowers typically have only one or two mortgages. To them, having a property accurately appraised is hugely important so they do not overpay whether they use conventional, FHA or VA financing. Indeed, most real estate sale agreements provide that the deal is off without penalty if the appraisal comes in below the sale price — speak with a buyer broker or attorney for specifics.
But not only home buyers are protected, with a good appraisal the lender does not lend more than it should (thus protecting shareholders) and a mortgage investor does not have excess risk (thus protecting pensions and insurance funds).
If you’re a buyer and make an offer on a property it will not get financed unless the appraiser says the home is worth at least the sale price. Without independent assurance from an appraiser — someone who is paid regardless of the valuation — no lender will provide the mortgage financing necessary to create the sale.
But it’s not just the buyer and the “lender” who are protected, if by “lender” we mean the folks who originate the loan.
Today after most loans are originated they are sold into the secondary market. Packagers gather up 5,000 or 10,000 loans and create a mortgage-backed security or MBS. Investors then purchase a portion of the MBS called a tranche.
One of the most basic protections for buyers, lenders and mortgage investors is an independent valuation of the property. The fact that a buyer and seller have agreed on a price does not mean they have accepted a price that will protect the investor if home values decline or the borrower defaults.
So, yes, let’s move ahead with new and better housing programs to reduce foreclosures and clean-up a system damaged by too many short-cuts. But while we’re at it, let’s not end a basic protection that makes the market safer for buyers, investors and mortgage insurers.
Oh no, Federal Reserve Chairman Ben Bernanke wants more taxpayer dollars to bailout the upper-class. He doesn’t actually say that, of course, but what else would be the result if the government — us — starts to buy mortgage-backed securities from poor, down-trodden investors who hold billions of dollars in mortgage-backed securities?
In basic terms a mortgage-backed security or MBS is created from thousands of mortgages bought and put together by a Wall Street packager. Investors don’t usually buy the entire security, instead they purchase interests — or “tranches” which reflect a certain level of risk and size. Buyers are supposed to examine their investments with care, make use of external ratings firms (which turned out to be largely wrong) and use MBS “enhancements,” a term largely meaning insurance. Unfortunately, the folks who sold insurance-that-was-not-called-insurance (because then it would be subject to state regulation) did not set aside sufficient money for losses (as the states would have required) — so when there were investor losses there were not enough dollars to cover the claims.
Happily the Federal Reserve stepped in and bought MBS investments worth $1.4 trillion with your money. Now the Fed is thinking of buying more mortgage-backed securities.
Speaking at a news conference yesterday, Bernanke said it would be a “viable option” for the Federal Reserve to buy mortgage-backed securities from investors.
Translating this comment into plain language and the impact on your wallet, here’s what it means: You’re going to lose and huge investors are going to win. Here’s why:
Investors with troubled mortgage-backed securities could sell their interests to Uncle Sam at face value. This means that once sold the investors would have 100 percent of their cash and the Federal Reserve would have pretty pieces of paper.
In effect, the federal government is assuring that MBS investors will have no risk. If the securities are good there’s no reason to sell. If the securities are bad, taxpayers will buy the paper and face any losses. For investors, it’s heads we win but if we come up with tails then it’s taxpayers who lose.
Why Bernanke is Wrong
But wait, wouldn’t mortgage rates remain low or actually fall if the federal government bought out the holdings of mortgage-backed investors?
“I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS),” said Federal Reserve Governor Daniel K. Tarullo in October, “something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.”
This is one argument made in favor of Mr. Bernanke but it doesn’t make a lot of sense. There’s no need to lower mortgage rates, they’re already at or near historic lows. Moreover, low rates are no favor to retirees or savers, another battered class of taxpayers.
Bernanke is wrong on the issue of buying mortgage-backed securities because it’s the security buyer’s job to invest smartly and it’s not the job of the US taxpayer to bail them out if they’re wrong. Somehow, for all the stated concerns about “moral hazard,” such worries never seem to apply to institutions and foreign governments with billions of dollars on the line. What Bernanke proposes is simply still-another bailout for Wall Street, more risk for taxpayers and more evidence that the banking system remains deeply troubled.
“Pro-Housing Policies will Stimulate Job Growth” says the National Association of Home Builders. Well, good, where do we start? What exactly are those “pro-housing” policies?
“The inventory of new homes for sale is at a record low and there are many areas of the country that are approaching a housing shortage. Tight credit conditions are preventing builders from meeting this emerging demand, putting workers back on the job and helping the economy move forward.” according to the NAHB.
Really? So, for example, we should have higher loan limits for FHA loans? That would do a lot for housing demand. Only .75 percent of all FHA loans were for more than $500,000 as of mid-September. Even fewer borrowers need or want loans above $625,500, the new single-family loan limit.
“Further exacerbating the situation is today’s pervasive anti-housing climate in Washington,” said NAHB Chairman Bob Nielsen.
Is that so? Name 10 “anti-housing” Republican congressional representatives and 10 “anti-housing” Democratic House members. If these folks are against housing do you mean they want people to live on the streets?
“Leaders in Washington must stop scaring consumers by talking about eliminating the mortgage interest deduction, ending a federal backstop for housing and calling for a minimum 20 percent downpayment on home loans,” said Nielsen. “This is counterproductive and harms consumer confidence, the housing market and the nation’s economy.”
Who, exactly, is talking about eliminating the mortgage interest deduction? Where is the scare? Where is the legislation which says — like Canada — that home mortgage interest will no longer be deductible for any reason by anyone?
Or, is the worry that rich folks will get less of a deduction? And if that’s the case, why is that bad for someone making $50,000 a year? Or someone without a job?
And about ending the “federal backstop” for housing? If that’s a problem speak to the special interests over at the Mortgage Bankers Association. They’re concerned — get this — “that the FHA programs will be over-utilized.” Where oh where would borrowers get their mortgages if FHA insurance was less available?
And no one is calling for a 20-percent minimum downpayment for ALL mortgage loans, no matter how often such a claim is repeated.
Under Wall Street reform — the Dodd–Frank Wall Street Reform and Consumer Protection Act — VA mortgages, FHA loans, and conventional loans sold to Fannie Mae and Freddie Mac are all within the definition of a qualified residential mortgage or QRM. Today you can generally get FHA financing with 3.5 percent down, nothing down with a VA loan and 5 percent down with conventional mortgages.
What the new rules say is that if lenders want to pump risky loans into the market such as option ARMs, interest-only mortgages or financing based on no-doc loan applications then they should have more skin in the game. That means a 5-percent reserve under the new rules for lenders who want to originate high-risk loans and 20 percent down for borrowers. The idea is to prevent lenders from again coming back to taxpayers asking for a bailout.
If home builders want to help the housing sector here’s a place to start: Make mortgage subsidiaries and other controlled lending entities illegal for home builders. Make sure no builder — directly or indirectly — receives compensation or a thing of value from any loan to any home buyer.
A new and revealing study by the Mortgage Bankers Association argues that the introduction of risky loan products during the past few years was caused in large measure by efforts to pump up lender stock prices.
Written by Clifford V. Rossi, a business professor at the University of Maryland, Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future “contends that expansion into riskier products by mortgage firms that subsequently suffered large credit losses was a strategy intended to grow the franchise and along with it the attractiveness of the firm to investors.”
The goal was to increase the “attractiveness of the firm to investors.” In other words, company stock. “If executives could not earn a higher return on invested capital,” explains Rossi, “they would be replaced through a takeover by executives who could. This message was consistently and convincingly hammered home by Wall Street analysts to every increasingly anxious CEO and CFO.”
The report says that new loan formats were developed in an environment where the true extent of lender risk was not understood.
Rossi says “no single factor was responsible for the significant expansion of credit and mortgage products during the period leading up to the mortgage crisis. However, there are indications that greater risk-taking could be attributed to the following factors:
- “An over-reliance on performance metrics not adjusted for risk which would lead management toward riskier products
- “Data and analytical limitations and blind spots that led risk managers to grossly underestimate credit losses
- “Cognitive biases among senior business managers that over time led them to take greater risks, and in the process reduced the effectiveness of risk management practices
- “Incentive problems leading to regulatory actions that wound up not being in the best interest of the taxpayer.”
Rossi says non-traditional mortgage products were introduced during a period when home appreciation was strong and interest rates were near historic lows.
“This favorable economic environment,” says Rossi, “contributed to a period in which mortgage default rates were very low by historical standards. As a result, the economic environment tended to bias loss estimates downward in a real
sense. This contributed to further mortgage expansion and vast understatement of potential losses due to risk layering and the expansion of nontraditional mortgage products such as option ARMs and piggyback HELOCs. The development of new products and the expansion of risk parameters on existing products came at perhaps the worst time. With virtually no historical experience with these new risk combinations and that which existed largely coming from a benign economic environment, risk models would have little hope to accurately reflect expected loss, let alone loss levels during an extreme event such as the financial crisis.”
Translation: Industry leaders should have listened to stock brokers who always remind us that past performance does not guarantee future results.
No Doc Loans
Another interesting point made by Rossi concerns the increased use of no-doc and low-doc mortgage applications.
“As underwriting standards on income documentation and LTV loosened, allowing for both limited or no income verification and low equity stakes in the property, traditional borrower sentiment toward home ownership changed. Renters were increasingly able to become homeowners with little downpayment and with creative cash flow structures that provided short-term payment capacity. As long as home prices continued to rise, a borrower in such a situation could refinance out of one loan and into another, or sell the property without loss. But once home prices peaked, particularly for those purchasing their home at or near the top of the cycle and possessing limited equity in the property, borrowers became stranded in the home with few alternatives. In such cases, borrowers ruthlessly exercised their default option as historically important ties to the home were outweighed by excessive payment burdens coupled with negative equity in the home. At the same time, widespread lapses in controls of counterparties as evidenced by a spike in mortgage fraud aggravated a growing credit problem.”
This is an area where I disagree with Rossi. While there was surely a lot of mortgage fraud, there was also a lot of predatory lending where — for example — borrowers who qualified for better financing were sold high-cost subprime mortgages. Unfortunately, the term “predatory” does not appear in the report. Also among the missing is the word “fiduciary,” as in the lack of an obligation under federal rules by lenders to get the best possible rates and terms for borrowers.
That said, the Rossi report is unusually well-done and should be read by anyone who wants a better understanding of the motivations which led to the mortgage meltdown. It’s a step forward, helpful and insightful.
The question that keeps coming up is this: If only a small portion of all mortgages are failing how come the general financial impact has been so enormous?
To resolve this mystery, let’s go back to the 1970s when the mortgage-backed security — the MBS — was developed. The MBS was a financial device designed to resolve a problem for investors. The problem? Imagine that you’re a loan investor and bought the mortgage on a single-family home. Your total income from the investment would be impacted if your one borrower was late, didn’t make a payment or was foreclosed.
With a MBS you own a security which is supported by a large number of mortgages, perhaps thousands. If someone misses a payment your income continues with little disruption.
In theory mortgage-backed securities make a great deal of financial sense.And in practice, until the past few years, mortgage-backed securities worked well.
Today mortgage-backed securities are troubled, especially those which include subprime loans. But why should this be? Even with subprime loans, the overwhelming majority of borrowers are making their payments.
About as good as an answer as you’ll find comes from Lew Ranieri, one of the developers of the MBS concept. As Ranieri told John Cassidy in The New Yorker, today MBS securities are fundamentally different from the paper that was invented several decades ago.
“They have created the perfect loans,” Ranieri says with irony of today’s mortgage-backed securities. “They didn’t know what the home was worth, they didn’t know what the borrower earned and the borrower wasn’t putting any money into the purchase. The system had gone completely nuts. A loan without a full appraisal, thorough underwriting, and full income verification was never what anyone envisioned when we started the market for mortgage-backed securities.” (See: “Subprime Suspect,” March 31, 2008)
You listen to Ranieri and it becomes obvious why mortgages have been so freely-available during the past few years. The answer has nothing to do with a push for more homeownership or some sort of philosophical imperative: If Wall Street is going to sell more high-profit mortgage-backed securities it needs a basic feedstock. What is that feedstock? More loans.
If it happens that a mortgage fails, who suffers? The loan officer has already been paid. The “lender” is often not a lender in the sense of a company with a vault stuffed with cash, but instead a retailer that instantly re-sells any loan it originates. If the borrower makes payments for a few months, the originating lender is then largely not responsible if the mortgage goes downhill.
With mortgage-backed securities the folks on Wall Street make money selling paper, real estate brokers make money selling homes, governments make tax money every time a home is sold or refinanced, title companies and attorneys make money with each closing. The list goes on but you get the idea.
What started out as a conservative way to protect investors morphed into something strange. You could buy a typical MBS or you could get a little more interest if you bought a somewhat riskier portion of a mortgage-backed security. But why worry — credit-raters gave MBS paper strong marks.
Unfortunately, the push for higher returns outpaced the push for financial sanity. Loans without full appraisals, stated-income mortgage applications, exploding ARMs, option ARMs and large numbers of interest-only loans will inevitably produce large numbers of distressed borrowers and outright foreclosures. Add in a gross lack of federal regulation — regulation that could easily have prevented the current mortgage meltdown — and the results we see today were pre-ordained.
Once a few mortgage-backed securities failed it meant that the assumptions used to value and rate all MBS paper needed to be reviewed. The value of MBS paper fell, so investors suddenly had less net worth and thus a lot less interest in once-attractive mortgage-backed securities.
For the folks on Wall Street, the problem was not lower MBS ratings but fewer MBS buyers. Essentially, brokerages and investment banks got caught with MBS and other sagging securities in their portfolios.
And this gets worse. There are not only mortgage-backed securities (MBS) and collateralized debt obligations (CDOs — securities backed with a variety of debts, including mortgages), there are also derivatives.
Derivatives are simply bets. While there is a limit to the number of MBS and CDOs you can have, there’s no limit to the number of derivatives. The value of these derivatives amounts to hundreds of trillions of dollars.
The good news? Most derivatives are hedged so that the investor has little financial exposure. The bad news? When you deal with hundreds of trillions of dollars a minor “whoops” can be worth billions and billions of dollars.
And that’s how a few foreclosures upset the strange world of mortgage-backed securities, CDOs and derivatives.
Published originally by The Real Estate Professional and posted with permission.
How low is 5.78 percent? In June, 2003 we saw 5.21 percent plus .5 points — the lowest mortgage rate in 45 years.
This would all be encouraging except that it’s difficult to reconcile both low rates and the way many homes are now financed. If you have low interest levels then you logically lock-in those bargain rates and buy with fixed-rate financing.
Or do you?
An odd thing has been happening. For the past few years fixed-rate loans have been shunned. It’s as though they have cooties or some mysterious curse. Huge numbers of borrowers are opting for adjustable-rate mortgages — loans with low start rates but the potential for higher costs in the future.
It’s not just that ARMs are a huge and hulking portion of the mortgage marketplace at a time when interest rates are depressed, they tend to be the bigger loans.
Why is this happening?
Someone with a given income can likely buy or refinance more with an ARM then with fixed-rate financing because qualification standards tend to be more liberal. With an ARM it’s the borrower who pays more if rates rise. In comparison, if rates are fixed the lender has more risk because it cannot get a better yield if interest levels increase, so opportunities to maximize returns are lost.
You can see the ARM trade: Lower up-front costs and easier qualification standards for borrowers willing to accept the risk of higher rates in the future.
It has made great sense in the past few years to finance with an ARM because rates have generally fallen and home values have largely increased. Thus there has been an opportunity to buy an appreciating asset at little cost and with little risk.
Given little or nothing down, many buyers have been acquiring the largest home possible. If you buy a $200,000 home and the value rises 9.7 percent you’re ahead by $19,400. Stretch and buy a $300,000 home and your net worth would grow by $29,100. In this example, more is better.
This is all great and wonderful but there are two looming worries: First, home prices do not rise everywhere and certainly not when values are corrected for inflation.
Second, even if values do rise, home costs can also grow rapidly for those who have financed with ARMs. A $300,000 loan at 4.26 percent requires monthly payments for principal and interest of $1,475. If the rate a year later is 5 percent then the monthly cost rises to $1,608. At 6 percent, the monthly payment would be $1,796. (In practice the future costs would be somewhat lower because the principal balance is being reduced each month.)
You see where this is going. Six percent is a bottom-dwelling interest level by the standards of the past five decades. It’s not unreasonable to think that rates could “soar” to 6 percent — or higher. And it’s also not unreasonable to think that some of folks who are “in” at $1,475 will be “out” at $1,796.
Lenders may be using ARMs to offset future rate risk, but what about future asset values? Is it worth originating loans today which may sink lenders tomorrow? A large number of foreclosures won’t look good on anyone’s books, reason enough to tighten ARM loan standards.
Published originally by Realty Times on June 7, 2005 and posted with permission.
The latest mortgages to catch the attention of both the media and federal regulators are “option” loans, a form of financing which is likely to end badly for lots of borrowers.
More than a decade ago a few California lenders came up with a clever idea for borrowers with good credit and a solid payment history: If you like, they said to selected borrowers, you can skip one payment in the coming year.
The beauty of this idea is that it works for both borrowers and lenders. For borrowers, such payment flexibility has value because sometimes finances are tight. For lenders, a single skipped payment means the interest due that month, say $1,000, is not paid — thus the loan balance increased by $1,000. Do this with thousands of loans and you’ve created the financial equivalent of many new mortgages with virtually no risk, no paperwork and no closings.
In 2002 Fannie Mae experimented with the Payment Power concept, a loan tried in cooperation with several lenders that allowed borrowers to skip up to two payments a year and up to 10 payments during the life of the loan. Like the payment skipping program a decade earlier, the Fannie Mae program represented a balance between borrowers and lenders, but was more risky because a larger number of payments could be missed.
Now we have a new category of mortgages which offer borrowers a choice of payment options during the first several years of the loan term. The programs differ somewhat but in general terms imagine that an option loan is a 30-year adjustable-rate mortgage for $250,000 with a start rate of 4.25 percent. In the first year the borrower might:
- Make monthly payments of $1,229.85 as if the loan will be paid off (amortized) in 30 years at 4.25 percent.
- Make monthly payments of $1,880.70 as if the loan will be paid off (amortized) in 15 years at the 4.25 percent start rate.
- Make prepayments so the loan will be paid off faster than 15 or 30 years, say $1,500 or $2,000 a month.
- Make interest-only payments of $885.42 a month.
- Make payments based on a below-market interest rate, say 1.5 percent. With this option the borrower pays just $312.50 a month — with $572.92 in unpaid interest added to the debt. ($885.42 less $312.50).
Of the choices above the first three are well within the framework of conventional financing. It’s the last two that are squirrelly.
Interest-only loan payments mean the debt is not being reduced. If the option period continues for five years and the interest rate adjusts to 6 percent for the remaining 25 years of the loan, the monthly payment for principal and interest at the start of year six will be $1,61075 — a huge increase from the interest-only payments of $885.42.
Is this a problem? Not if the property value increases and the home is sold or the borrower’s income has increased. Unfortunately, rising home values and growing incomes are not assured.
As to the 1.5 percent option, if the borrower never makes anything but low payments for five years the loan value will increase by $572.92 per month — that’s an extra $34,375 in principal not counting additional interest on the new and higher debt.
After five years at the low payoff level and as a result of “negative amortization,” the borrower will owe at least $284,375, money which will have to be repaid in 25 years. At 6 percent the monthly payment will be $1,832.23 — a huge increase from $312.50 per month. With interest, the actual payment and debt will be even higher.
Again, if the borrower rolls the dice and the home is sold at a higher value within five years or personal income increases substantially, then everything is fine, But what if home prices do not increase? What if the interest rate goes above 6 percent? What if the borrower is laid off?
There’s no question that some borrowers, perhaps many borrowers, will latch on to the low-cost payment with option loans for the entire choice period. And there is no question that some portion of these borrowers, perhaps many, will get burned.
Option loans now allow buyers to bid on properties that otherwise would be unaffordable. Given market trends in the past few years it’s easy to understand that people want to have a piece of the huge wealth machine represented by real estate. It’s also understandable that lenders want to originate loans, that lender shareholders want more profits and that more buyers mean more competition for homes, thus pushing up values.
I liked the one-payment loan skipping option because it was good for borrowers and represented almost no additional risk for lenders. The “Power Payment” approach was more chancy, but well within the realm of reason.
But option loans are different.
In the next two to four years we’ll see elective payments end for many option loans. Then we’ll find out who should not have bought and who should not have loaned. Don’t be surprised if a lot of cheap real estate floods the market — and don’t be shocked if the value of your home is impacted as a result. As to lender share prices and dividends, how attractive will such companies appear when huge numbers of loans are unpaid, especially if in many cases the size of the debt exceeds the value of the underlying properties?
Alternatively, if we restrict option loans now by regulation or lender choice, the pool of buyers will shrink and home prices will be under far less pressure to go up. We will see less appreciation and even price declines in some local markets. Acting now we may face moderate and tolerable declines in market activity, an opportunity which should not be ignored in the face of the financial calamity which looms ahead.
Published originally by Realty Times on June 28, 2005 and posted with permission.
My grandfather was always proud of the way he financed his home. Family lore says he bought a row house on a dirt road — in Brooklyn! It was an immigrant’s dream, financed with an interest-only “term” mortgage that lasted three to five years. At the end of the term you either paid off the loan or, more likely, signed up for another few years.
Term — or “straight” financing — pretty much came to an end in the 1930s because as homes and farms lost value during the Great Depression, loans could neither be paid off nor renewed. One result was the movement pioneered by the FHA toward long-term, self-amortizing mortgages which offered more security to borrowers during hard times.
Today self-amortizing loans, mortgages in which the entire principal is paid off during the loan term, are a given — but term loans are making a comeback. We don’t call them “term” mortgages, but in a practical sense that’s probably the best way to view today’s new crop of interest-only loans.
Around the country we have seen enormous increases in home values in the past decade. If you own real estate for five years or more the odds are overwhelming that you have an appreciating asset, one which simply reflects the growing imbalance between supply and demand seen in many communities.
Alternatively, 40 percent of all existing homes are bought by first-time buyers, people who tend not to be at their peak earning years or to have accumulated much in the way of savings. By definition, of course, they have no real estate equity to invest in a residence.
Interest-only loans address this issue by lowering monthly cash costs for borrowers. With an interest-only loan at $993 a month and 6.25 percent interest, it’s now possible to borrow $190,656. With 10 percent down, homes in the $212,000 range are suddenly approachable — homes which may be better located, bigger or with more amenities than less expensive offerings.
Since the interest is likely to be entirely deductible and the initial monthly cash cost is lower than with amortized debt, it’s easy to see how buyers can be attracted to such financing. No less important, many borrowers justify such loans on the grounds that only monthly payments count, not total debt. An interest-only loan is somewhat like “rent” in this view, only with the possibility for appreciation and better tax write-offs.
The catch is that interest-only loans are not without risk.
Such financing, for example, is often based on a fixed-rate, interest-only payment for five years after which the loan becomes a one-year ARM for the balance of the term. If the loan is then amortized, it must be amortized over 25 years, not 30 years. If future rates hit 7 percent, here’s what happens: Monthly payments for principal and interest after five years go from $993 to $1,497. At 8 percent, the new monthly P&I will be $1,635.
Will higher monthly costs be a problem down the road? Probably not for most borrowers — just think of what most borrowers earned five years ago. But what if incomes don’t rise or don’t rise much?
An alternative option is selling after five years or so — if home values rise sufficiently.
Can past home price movements guarantee future trends? No — there’s always risk in the marketplace.
I’ve recently heard that borrowers will “save” money each month with interest-only loans, an imprecise expression which may raise concerns with regulators.
Interest-only loans reduce monthly payment costs when compared with fixed-rate financing, however to say these lower costs are a “savings” is debatable. Why? An interest-only loan and a fixed-rate mortgage are different loan products. The term “savings” implies a benefit which isn’t there: The cost of the loan is not lower, instead borrowers are paying less per month because they have elected not to reduce the principal balance for some or all of the loan term.
There’s demand for interest-only loans, there are logical and reasonable arguments to be made for and against such financing, but in the end they’re merely loans past generations have seen before — and sought to avoid.
Published originally by Realty Times on August 10, 2004 and posted with permission.