Do Consumers Understand Nuances of Option-Payment ARMs?

Federal regulators appear to be scared that option-payment ARMs are going to blow up in the next few years and borrowers could get burned, especially if the economy goes into recession.

As option adjustable-rate mortgages become mainstream loan products, the regulators are seeing underwriting standards slip along with low documentation of borrowers' income and piggyback loans to lower the downpayment and avoid mortgage insurance.

As Office of the Comptroller of the Currency, Federal Reserve Board and Federal Deposit Insurance Corp. officials draft guidance on interest-only and option ARMs, they are concerned about this layering of risks, as well as mortgage and appraisal fraud.

But they are also beginning to wonder and worry if consumers understand these loans and what the lenders are telling them.

Deputy comptroller Barbara Grunkemeyer told risk managers at a conference last week that type of IO and option ARMs originated in past few years has not been tested in a recession.

She cited a recent report by UBS Securities that shows 70%-80% of option ARM borrowers are taking the minimum payment option. These borrowers, due to negative amortization and higher interest rates, could see their monthly mortgage payments increase by 50% when these mortgages reset.

"They are going to remember that you did not explain to them that the payments were going to go up 50% after five years. And now they can't pay it," Ms. Grunkemeyer said.

Banks can and do sell option ARMs into the secondary market to move the credit risk off their books. "But it doesn't get rid of the reputational risk," she told the Risk Management Association conference.

Borrowers are going to remember that they got the loan for the "ABC" Bank, she said, even if a mortgage broker made the loan.

The deputy comptroller noted that interagency guidance on IO and option ARMs will be released before the end of the year and it will focus on the underwriting standards and how banks qualify borrowers for these products.

"We are very concerned about these products," she said, and the regulators want to make sure they are properly underwritten, that consumers understand them and the banks are adequately managing the risks.

An August UBS report shows that option ARMs accounted for 33% of non-agency mortgage securitizations during the first half of this year. An MSN survey shows that IO loans accounted for 26% of all loans funded in the second quarter.

John Silvia, chief economist of Wachovia Bank NA, expects the regulators' guidance will direct bankers to be "more cautious" about pricing and lending terms.

"The regulators see problems down the road because these instruments are untested," he said. He explained that a lot of people, especially younger people who qualified only on the easiest of standards, won't be able make their payments if there is a recession three years down the road and they lose their jobs. "I think this industry is going to have to be prepared for that," Mr. Silvia said.

Federal regulators also worried about the rapid growth of commercial real estate lending at small and midsize banks over the past three years.

Federal Reserve associate director David Wright said regulators are drafting guidance on CRE lending that focuses on concentrations - particularly institutions with construction and development loans in excess of 100% of tier-one capital and non-owner-occupied CRE loans in excess of 300% of tier-one capital.

"We are much more concerned with risk related to non-owner-occupied exposure than owner-occupied," Mr. Wright told a told the RMA conference last week.

The regulators expect these banks to stress test their CRE portfolios and stratify the loans by occupant and property type.

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