Why Mortgages Blew Up
08/16/07 - 11:00 AM EDT
Many homebuyers in recent years took out exotic mortgages that ultimately backfired. This raises the question of why such booby-trapped financing was available at all.
The answer, in part, stems from overaggressive marketing of what were once niche products intended only for the most financially sophisticated and creditworthy customers. During the housing boom in recent years, banks began offering such elaborate loans to huge numbers of average homebuyers, allowing them to get in over their heads and contributing to the current mortgage crisis, as many borrowers ended up defaulting.
Last week, TheStreet.com
reported that several of nation's largest lenders, such as Countrywide Financial (CFC)
, were still offering the types of loans at the center of the current meltdown in the subprime mortgage market. That's despite the fact that the company has taken a beating on the stock price, down about 40% over the past month, and some of the loans offered seem doomed to fail from the outset.
The most exotic product, the option ARM (adjustable-rate mortgage), or negative amortization loan, allows the borrower the choice of paying a minimum amount that might not even cover the interest on the loan.
If that alternative is taken, the shortfall is added to the loan balance, and so the borrower gets further and further into debt over time. Such loans are inherently risky for the debtor and the lender as well. Another risky type of loan is the interest-only mortgage. The balance on an interest-only loan doesn't increase over time, but it doesn't decrease either. The borrower is essentially just treading water.
Such loan offers historically have been "a flexible financial tool for sophisticated financial households," says Doug Duncan, chief economist at the Mortgage Bankers Association in Washington D.C. And in that sense, these loans fulfill a real need and are particularly useful for borrowers who are paid unevenly in lump sums and don't receive a steady paycheck.
Senior investment bankers and lawyers would be examples of those with such an income stream. They often work for nominal base salaries throughout the year, with the overwhelming bulk of their total pay delivered in a single annual bonus check. With such swings in the size of each paycheck, the ability to make mortgage payments at different levels throughout the year is a distinct advantage.
In addition, condo-flippers might also find such option ARM loans useful -- although they likely weren't the type of buyer that lenders had in mind when designing such products.
"If a developer was coming in and buying up a whole bunch of properties and planning on selling them very quickly for a profit, then it might make sense," says James Holtzman, a personal finance specialist at Legend Financial Advisors in Pittsburgh.
These loans could also work for those starting out in a new job in a city with a high cost of living, such as San Francisco or New York, and where the borrowers would expect their income to quickly rise as they advance in their careers, Holtzman adds.
Other financial planners say an option ARM can be appropriate when borrowers expect a large inheritance, or where a spouse will likely to return to work and boost household income. Similarly, graduate students of medicine or law, who very likely will see their income rise rapidly soon after graduation, could make suitable candidates for these loans.
For similar reasons, interest-only loans, where the borrower has a choice to not pay down the amount borrowed, provide a certain level of flexibility.
But as most any financial adviser will attest, option ARMs don't make sense for the vast number of people who receive steady and predictable paychecks. For the most part, interest-only loans are considered similarly inappropriate for most borrowers, but were seen as less risky.
Nonetheless, such loans were handed out in great numbers over the past five years or so in great numbers. So what went wrong?
"The problem is that [the negative amortization loan] was oversold," says Allen Fishbein, director of housing and credit policy at the Washington-based Consumer Federation of America.
In fact, the percentage of option-arm loans issued has ballooned to the current level of about 7% in the first quarter of 2007, up from less than 0.25% of loans originated in the first quarter of 2002, according to estimates by TheStreet.com made using data from the Mortgage Bankers Association in Washington, D.C., and First American Loan Performance, a San Francisco-based mortgage research firm.
When negative amortization loans are grouped together with interest-only loans, the growth is slower, but still the number is still up sharply over the same period.
The reason? "It became an affordability tool rather than a financing tool," Fishbein says, allowing borrowers to buy more house than they could actually afford when their adjustable rate was reset to a higher level after a certain number of years.
Also exacerbating the problem: Some real estate developers looking to sell houses and apartments teamed up with mortgage brokers who would then use aggressive sales techniques to help get customers into apartments and houses.
By highlighting the lowest of the monthly loan payment alternatives, a home once viewed as too expensive now seem affordable. A $522,000 loan that would likely have a $3,299 monthly payment using a standard 30-year amortization, for instance, would seem much more appealing when presented as a $1,962 "minimum" payment of an option ARM.
More importantly, some borrowers previously priced out of the real estate market could qualify for a loan at the lower payment, but not at the higher one.
That's a factor at least some observers want to change. In a recent analysis of the housing crisis
), Michael Larsen, an analyst with Weiss Research, lays out a nine-point plan to reform the industry, including a recommendation that lenders only qualify borrowers for loans at the larger "fully amortizing payment," thus reducing the risk of default.
Although the report lays much of the blame with lenders and regulators, it also takes aim at borrowers who blindly bought in to the rally, leveraging themselves "to the hilt," picking the "most aggressive" types of financing, he says.
"In the perfect world, [such loans make] a house affordable to someone who may not otherwise qualify," says Morris Armstrong, a personal-finance specialist at Armstrong Financial Strategies in Danbury, Conn. "In our world, it increases the risk of defaults and reduces equity ownership."