Growth of Interest-Only Market Raises Red Flags

The secondary market is beginning to question the unbridled growth of interest-only mortgages, 40-year loans, pay-option adjustables and other products designed to capitalize on the rapid run-up in housing prices.

Interest-only loans "have a place, but where we get nervous is their suitability to the borrower," Thomas Lund of Fannie Mae said at the Mortgage Bankers Association's National Secondary Market Conference here last week.

Such loans may be appropriate for some borrowers, but they could prove disastrous for those who are relying solely on skyrocketing values" to build equity, Mr. Lund told the conference.

Borrowers are "not saving much" in the form of lower monthly payments "in relation to the potential for an upward adjustment" in their interest rate and monthly payments a few years into the mortgage, he warned. And the trade-off could prove disastrous if they can't afford to take the hit.

According to the MBA, 11% of all loan originations in the second half of 2004 were IOs. And that's in addition to the 42% share, which were traditional and hybrid adjustable-rate mortgages.

"It's big, it's too much," chief economist Douglas Duncan told Mortgage Servicing News. "In some markets, the share is much higher than that."

Donald Disenius of Freddie Mac said he also is beginning to worry about IOs, particularly when consumers use their mortgages to accumulate wealth through appreciation rather than amortization.

Ginnie Mae's Michael Frenz said Uncle Sam has "a lot of concerns" with the suitability of 40-year loans for low-income residents "in places which will never see the type of appreciation these products were designed for."

And William Batz, executive vice president of the Federal Home Loan Bank of Pittsburgh, said making interest-only and 40-year loans to some people could smack of predatory lending.

"IOs may be suitable for the right market," he said, "but they could be characterized as predatory for the wrong borrower."

In their wide-ranging conversation, which was led by Nicolas Retsinas, the director of the Joint Center for Housing Studies at Harvard, the four secondary market executives said that although they don't believe the rapid growth in house prices will last much longer, they weren't overly concerned about a so-called bubble.

"If you want to see a real bubble, look at the dot-com bust. One company that was trading at $244 in 1999 closed recently at $1.40; that's a bubble," Mr. Batz said.

"I don't see the 'bubble' bursting on a national level, but I am concerned about some individual markets," said Mr. Lund, who is a senior vice president at Fannie Mae and the interim head of single-family mortgage business for the big secondary market agency.

He is most worried about East and West Coast markets where investors account for 15%-20% of the home sales and a large percentage of loans are interest-only adjustables. The double-digit growth in home prices in these places is "not sustainable," he warned.

Mr. Disenius, who is senior vice president for credit policy and portfolio management at Freddie Mae, agreed. "Most markets are in reasonable balance," he said.

He also expects price appreciation to begin slowing soon. "We've squeezed about all we can" out of innovative mortgage products, he observed.

Mr. Frenz warned, however, that prices could tumble in some markets. Which ones? Those where buyers are saying things like "this time it's different" and where houses are trading at higher prices on the same day. Those, he said, are "sure signs" of a housing apocalypse.

The panelists also suggested that the mortgage business is finally ready to turn its full time and attention to undeserved markets.

"We've been talking about the changing markets since the mid-'90s, but we've been too busy dealing with refinancing booms to do much about it," Mr. Lund told the meeting. "Now it's finally happening."

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