Is the mortgage market more risky than it used to be? Does this mean more foreclosures loom ahead?
It’s been obvious since they first became popular a few years ago that interest-only and option ARMs represent new and unknown levels of hazard. As the Office of the Comptroller of the Currency explained last year, “higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations — have introduced more risk to retail portfolios.”
Okay — so just how much additional risk has been added to the marketplace?
A study of mortgage lending patterns by Standard & Poors, the venerable and well-regarded ratings agency, shows that fixed-rate mortgages and traditional ARMs are being pushed aside by “nontraditional” loan products.
S&P says that option ARMs and interest-only loan products made up 77 percent of all loan originations in the second quarter of 2006 — up from 61 percent a year earlier.
The rising use of interest-only and option ARMs is not the whole story, however. At the same time that the volume of these new loan formats has increased, so has the use of “simultaneous seconds” and “stated income” loan applications.
Since few buyers can purchase with 20 percent down, especially first-time buyers, S&P reports that 63 percent of all loans during the reporting period used simultaneous seconds, up from about 50 percent a year earlier.
The purpose of simultaneous seconds — or, as they’re often called, “piggyback” loans — is two-fold: First, borrowers get a purchase money mortgage equal to 80 percent of the sale price and then a second mortgage for 15 to 20 percent of the balance. The result is the ability to buy a home with little or nothing down. Second, since the first loan is equal to at least 80 percent of the sale price there’s no requirement to purchase private mortgage insurance (PMI).
The problem with the piggyback strategy is that it greatly increases lender and borrower risk. The Standard & Poors analysis of second quarter mortgage portfolios shows that “loans with simultaneous second liens, on average, have a 43 percent higher probability of default compared with ‘standalone’ loans.”
You might believe with less down, lower initial monthly payments and potentially far-higher payments in the future that lenders would tighten application procedures for the new loan formats.
What S&P found is that almost four of five loans now rely on “stated income” mortgage applications. Forget about written confirmations, these applications require only verbal verifications for income and employment (66 percent) or no verifications (13 percent).
If 79 percent of all loan applications do not require written income confirmations, and if 77 percent of all loans are interest-only and option ARM products, it follows that as many as 60 percent of all new loan formats are being made on the basis of stated-income loan applications — applications where borrowers say how much they make and lenders usually don’t check.
Why this is good for lenders and how this reduces investor risk is difficult to understand?
“These numbers do not bode well for the future,” says James J. Saccacio, chief executive officer of RealtyTrac, the nation’s largest source of foreclosure data. “Unfortunately, the future is not too far away for a growing number of homeowners.”
“Many borrowers now have loans where monthly payments are guaranteed to rise but the same cannot be said for home values or incomes,” Saccacio added. “In too many cases individuals will not be able to hold, sell or refinance and the result will be an inevitable climb in foreclosure rates, especially if interest levels rise in the next few years.”
The S&P research is directed toward securities investors, but investors are not the only ones with risk when it comes to the newest mortgage formats. Owners are betting that incomes will rise or that homes can be refinanced or sold before the higher monthly costs associated with interest-only financing and option ARMs start to kick-in. That means there’s a period of three to seven years for most borrowers before rising payments become an issue.
Toxic “nontraditional” mortgages began to be popularized in 2001 and as might be expected we are now seeing a bump in foreclosure rates.
How bad is it? Figures from RealtyTrac show that loans in the process of foreclosure in August were up nearly 53 percent from a year earlier. Given the increased use of interest-only and option ARMs, and given the growing utilization of piggyback financing and stated-income loan applications, it seems clear that foreclosure rates will not be declining any time soon.
Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 90 newspapers.