Mortgage risk in today's market: while homeownership is at an all-time high, home equity is at an all-time low. That's just one element of the risks building in today's mortgage market, where borrowers are highly leveraged and the volume of loans facing rate resets in a rising-rate environment is sobering.
Once upon a time (and not that long ago, either) you saved a down payment, took out a 30-year mortgage and bought a house; when you finished paying it off, you held a mortgage-burning party. Today, according to the National Association of Realtors[R], Chicago, 25 percent of buyers finance 100 percent of their home's purchase price, and fully 42 percent of first-time buyers put no money down. Buyers choose from a dizzying array of new loan products, including 40-year, interest-only (IO), low-document or no-document and piggyback loans, as well as option adjustable-rate mortgages (option ARMs). And while mortgage-burning parties still get prime space in the newsletters of local senior citizens' clubs, most Americans under the age of 40 have never heard of them.
The changes are by no means all bad. For generations, homeownership has been a key component in building family wealth and assets over time, and it is thus encouraging that a record number of Americans now own their own homes: 69.2 percent, up from 64 percent in 1973.
Though white Americans are still significantly more likely to own homes than are African Americans, Asian Americans or Hispanic Americans (74.7 percent compared with 48.9 percent, 53.9 percent and 47.4 percent, respectively), it is also encouraging that homeowner ship rates are increasing more quickly among minorities and immigrants than among whites--a trend which, if it continues, will eventually close the gap.
But there are some worrisome developments: IOs, ARMs and second mortgages with floating rates expose more borrowers to interest-rate risk they may not fully understand, much less be able to service. Riskier loans are concentrated in geographical areas that are at highest risk of home-price declines (see Figure 1). Because many of the new mortgage products put less emphasis on building equity than did traditional, fully amortizing mortgages, Americans have lower levels of equity in their homes than ever before (see Figure 2). Speculation has increased as record appreciation has brought new players on to the field--many of them at once highly leveraged and inexperienced when it comes to managing investment property.
Each of these risks, by themselves, might be manageable. Together, however, they represent a layering of risks that is both quantitatively and qualitatively different from what we have seen before and unlikely to behave well in a more challenging economic environment characterized by slower appreciation and higher interest rates.
The mortgage smorgasbord
The development of new mortgage products--or more accurately, the widening availability of what were once thought of as niche products--has been driven by several factors: borrowers' desire for the lowest possible initial payment (and, in the case of refinancing, their wish to tap into equity); lenders' desire to refinance loans, even at the expense of replacing less-risky loans with more-risky loans; and above all, the need to make mortgages affordable in high-cost areas.
Nationwide, home prices have appreciated approximately 50 percent in the last five years, and some areas have seen more than twice that (in San Diego, for example, prices have gone up 118 percent). Borrowers trying to stretch their dollars to catch up have many options.
Interest-only loans: Developed to facilitate cash-flow management for higher-income and asset borrowers, IO loans have moved down the income and credit spectrum even into the subprime market. Their production has increased significantly since 2002, moving from less than 10 percent of mortgages to 26 percent nationwide in the second quarter of 2005, according to National Mortgage News.
Because the initial payment tends to be low compared with traditional mortgages, IOs have become particularly popular in areas where borrowers are financially stretched due to affordability challenges. In California, according to San Francisco-based LoanPerformance, they accounted for almost 50 percent of new mortgages in 2004 and more than 60 percent of new mortgages in the first few months of 2005. The risk inherent in an IO loan depends to a great extent on the term: An IO where the rate is fixed for 10 years, for example, provides significantly more borrower protection than a one- or two-year IO.
Option ARMs: Like IO loans, payment-option ARMs were originally developed as a financial-management tool for a niche market--people whose incomes fluctuate over the course of a year. These loans allow buyers to choose what kind of payment to make: interest and principal, interest-only or even less. Currently, according to industry sources, approximately two-thirds of option-ARM borrowers are using the negative amortization option.
Recent record appreciation may be fostering the expectation that home equity will rise without amortization, and thus encouraging borrowers to choose the negative amortization option (borrowers in high-cost areas are most likely to make this choice). While it's true that the risk of negative amortization can be offset somewhat if home-price growth remains strong, there are significant risks, because as affordability products these loans are most popular in high-cost states, many of which also have the highest probability of home-price depreciation.
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The consequences of choosing the negative amortization option are clear. Five years after taking out a $100,000 mortgage, a borrower who makes only the minimum payment would owe $110,526, and one who made the interest-only payment would still owe the full loan amount of $100,000. A borrower making the 30-year amortizing payment, in contrast, would have lowered his or her balance to $93,580.
Piggybacks: Piggyback loans--in which a second loan is piggybacked on a first mortgage to compensate for a down payment of less than 20 percent--are used primarily to support the purchase of housing in high-cost areas, where purchasing a house requires a larger loan. Because house prices have been increasing all over the United States, piggybacks have become not only more popular, but also larger.
According to SMR Research Corporation, Hackettstown, New Jersey, approximately 48 percent of home-purchase mortgage loan dollars involved piggyback loans during the first half of 2005, compared with 20 percent in 2001. Similarly, piggybacks with combined loan-to-value (LTV) ratios of 95 percent or more accounted for 60 percent of all piggybacks, compared with just 48 percent in 2004. In contrast to borrowers with more standard adjustable-rate mortgages, piggyback borrowers with home-equity line of credit (HELOC) second liens have greater exposure to rapidly increasing interest rates and monthly payment burdens because there are often no caps on how far and fast the interest rate on the HELOC can increase.
A layering of risk
None of the aforementioned products is inherently bad. In the struggle for affordability, however, they are being used much more frequently than originally envisioned and farther down the credit curve. As a result, some borrowers unknowingly may be assuming payment shock that they--and possibly the mortgage finance system as a whole--are ill-equipped to manage, with a consequent increase in aggregate risk in the market.
The problem for individual borrowers comes when risks are layered on top of each other--for example, a 100 percent LTV piggyback with an IO first mortgage and a HELOC second mortgage. And while many borrowers assume they will refinance their way out of whatever bind their particular loan puts them in, increasing interest rates, both long-term and short-term, may lessen the availability of affordable refinance opportunities.
Because the risks to borrowers are ultimately felt by the parties that hold their loans, layering creates a similar problem for investors and for the market as a whole. By contributing to decreased equity and increasing speculative investment, layering has undermined the stability of the mortgage market, and concentrated risk in certain geographic areas.
While homeownership is at an all-time high in the United States, home equity, which fell from 68.3 percent in 1973 to 55 percent in 2004, is at an all-time low (see Figure 2). Americans took $333 billion worth of equity out of their homes between 2001 and 2003 alone, according to the Federal Reserve--levels three times higher than at any time since Freddie Mac started tracking the data in 1993.
While some of the dollars were reinvested in home improvements, the majority of households that refinanced between 2001 and 2003 used the cash they received to cover living expenses and pay down credit-card debt, according to New York-based Demos, a policy think-tank. In a worst-case scenario, homeowners who reduced their equity during the recent boom could end up owing more than their house is worth if home prices fall. And if equity levels continue their current-trend, the next generation's retirement experience may differ significantly from that of its parents.
For decades Americans have relied on the equity in their homes to take them through their retirement years, as an asset that's valuable (and, more important, paid for) or as a source of income, such as with a reverse mortgage. The specter of a generation trying to manage on fixed incomes while still making significant mortgage payments is sobering indeed.
Real estate speculation has played a key role in decreasing equity: Encouraged by inexpensive mortgages that require little or no money down, Americans are not only pulling more money out of their homes, they are putting less in. And by any measure, speculation is at an all-time high. Membership in the National Real Estate Investors Association, Covington, Kentucky, a trade group for local real estate investors' clubs, has quadrupled since 2002. Eighty-six books on real estate investing were published last year, nearly three times as many as in 1998. According to the National Association of Realtors, 23 percent of homes purchased in 2004 were for investment--an increase of 14.4 percent over 2003.
In addition to creating a "musical chairs" situation for borrowers--what will happen when the music stops?--speculation has exacerbated affordability issues in many communities. In July, California's median home price had climbed to $540,900, affordable to only 16 percent of the state's households, according to the California Association of Realtors (C.A.R.), Los Angeles.
Florida is not much better: The average family in Florida earns nearly $44,000, which fell 26 percent short of the amount needed to finance a median-priced home last year, according to a study by the Federal Deposit Insurance Corporation (FDIC).
And to close the circle, skyrocketing housing costs have driven demand for loans that increase borrowers' buying power by allowing them to stretch farther. In his recent paper, "The Hidden Risks of Piggyback Lending," economist Charles Calhoun, an independent consultant and researcher based in Washington, D.C., noted significant concentrations of riskier loans in metropolitan areas at greatest risk of price declines. Figure 1 overlays data on the concentration of piggyback loans with data from PMI Mortgage Insurance Co.'s PMI U.S. Market Risk Index, which identifies areas most at risk of home-price depreciation, and shows a strong correlation.
Among the metropolitan statistical areas (MSAs) with a greater than 30 percent chance of depreciating in the next 24 months, 12 regions also had more than 30 percent of their mortgage lending for home purchases in piggybacks during the first half of 2004. Of these, eight are located in California.
While piggyback and other innovative loan products have facilitated high rates of house-price appreciation, they have also increased exposure to the risks of declining housing values. This represents a significant layering of risks to borrowers, lenders and investors within specific market regions having the highest risks of market decline over the next one to two years.
A shock to the system
Adjustable-rate mortgages have a long history, and many borrowers choose them with eyes wide open--trading the lower payment for a certain amount of interest-rate risk. According to Harvard University's Joint Center for Housing Studies, Cambridge, Massachusetts, the ARM share of conventional mortgage originations rose to 35 percent in 2004, significantly higher than the 18 percent share claimed by ARMs in 2003.
What this statistic does not reveal is that the newer loan types, such as IOs, piggybacks and option ARMs, leave borrowers much more vulnerable to rising interest rates than do traditional hybrid ARMs, which typically cap interest-rate increases. The HELOC second on many piggybacks, for example, behaves more like a credit card than a mortgage loan, adjusting monthly to top out at as much as 18 percent. Figure 3 compares a piggyback loan with an IO loan and a 30-year fixed-rate mortgage (FRM), both with mortgage insurance (MI), showing what would happen to each under a scenario of a two percentage point increase in the prime rate--not unlikely by any historical indicator. As shown, the payment on the IO jumps 81 percent while the piggyback payment jumps 42 percent. The payment on the 30-year FRM, in contrast, drops once MI is cancelled and then remains the same for the life of the loan.
The statistic of most immediate concern is the number of loans that face resets in coming years. Using New York-based Lehman Brothers Inc.'s recent estimate, with ARMs representing 25 percent of the roughly $8 trillion in outstanding one- to four-family mortgage debt, and most of those loans having been originated over the last two years, roughly $540 billion in subprime rate resets will occur over the next two years (excluding the impact of refinancings).
They will be followed by a wave of resets among prime loans. According to Fannie Mae, jumbo and alternative-A loans are just a step behind subprime loans, with some 50 percent of all outstanding jumbo loans and 40 percent of all outstanding alt-A loans having reset rates hitting between 2004 and 2009.
New loan products, stretched borrowers, less equity, geographical concentrations: Each of these developments in isolation might not be sufficient to cause concern. In early July, for example, Bear, Stearns & Co. noted that together, IO and option-ARM loans comprised about 9.5 percent of the total $4.6 trillion securitized mortgage market--a significant number, in the words of Dale Westhoff, Bear, Stearns's head of mortgage-backed securities (MBS) research, but not, at that point in time, "enough to pose a real systemic risk."
These developments, however, have not occurred in isolation. What we are seeing today is a confluence of factors that has resulted in an unprecedented layering of significant risks to mortgage borrowers, lenders and investors.
There's a difference between a gamble and a calculated risk. I've been in the mortgage business for more than 30 years, and I'm afraid that the mortgage lending world is leaning toward the former rather than the latter. In today's market, risk is increasingly dispersed among a variety of participants who may not have a full understanding of the nature and extent of the risk they are assuming. Everyone in the mortgage lending business depends on a stable, thriving mortgage market, and all of us will suffer if the system falters. While this is an avoidable outcome, it will be very unfortunate if the understanding of risk on which we all depend is not achieved until times of financial stress, when it is too late to deal with unintended consequences.
Steve Smith is president and chief executive officer of PMI Mortgage Insurance Co., Walnut Creek, California, and president of the Mortgage Insurance Companies of America (MICA), Washington, D.C. He can be reached at firstname.lastname@example.org.
Figure 3 Comparison of Interest-Only (IO), Piggyback and 30-Year Fixed- Rate Mortgage (FRM) (Purchase Price: $250,000; Down Payment: 10%; Loan Amount: $225,000) Interest- Piggyback (2) 30-Year Only (1) 3/1 FRM (3) Monthly Payment -- Year 1 $1,054 $1,168 $1,375 Monthly Payment -- Year 4 $1,054 $1,445 $1,278 Monthly Payment -- Year 6 $1,909 $1,656 $1,278 Change Since Year 1 +81% +42% -7% Balance Paid at End of Year 5 $0 $15,034 $16,964 Notes: 1 based on 5.1% initial rate on 5/1 IO with 0.52% mortgage insurance (MI), and 8.5% mortgage rate after reset 2 based on 4.75%, 6.75% and 8.25% on 3/1 adjustable-rate mortgage (ARM); 6%, 8% and 9.5% on home-equity line of credit (HELOC) 3 based on 30-year FRM of 5.5% and MI of 0.52% cancelled between years 3 and 4 when current LTV reaches 75%, assuming home-price appreciation of 4% per year SOURCE: PMI MORTGAGE INSURANCE CO.
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|Title Annotation:||COVER REPORT: INDUSTRY TRENDS|
|Date:||Oct 1, 2005|
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