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Booming IO Market Sparks Concern

Two years ago, very few residential lenders were funding interest-only mortgages, but today these somewhat controversial loans account for 21% of the entire production market in the U.S., according to exclusive survey figures compiled by this newspaper.

In the first quarter, the nation's lenders funded $141 billion in IO loans out of a total production pie of $663 billion.

Lenders are aggressively marketing IOs, which allow for low initial loan payments sans principal. Hence, the name interest-only mortgages.

According to Mortgage Servicing News, and its affiliate the Alternative Products QDR, the nation's top 25 funders of IO mortgages originated $79.8 billion in these loans in the first quarter - a stunning 312% increase from the same quarter last year.

Many lenders weren't even making IOs a year ago.

Countrywide Home Loans, Calabasas, Calif., ranked first among all IO lenders in the quarter with $13.7 billion, followed by Wells Fargo Home Mortgage, San Francisco ($9 billion), and the Lehman Brothers-owned Aurora Loan Services of Colorado ($8.7 billion).

Countrywide's volume, however, is an estimate based on recent comments made by its CEO Angelo Mozilo that IO mortgages now account for 25% of its total volume. (For Countrywide, MSN assumed a 15% IO rate in the first quarter.)

IO loans are beginning to generate coverage in the general media, because of concerns that the lower payment could be fueling a speculative bubble in housing prices.

Back in January, Freddie Mac chief economist Frank Nothaft warned that IO loans carry potential credit problems because "no equity is being built up."

Wall Street conduits - which operate out of the public's eye in the secondary market - are aggressive buyers of IO loans, adding liquidity by purchasing huge volumes from prime and nonprime lenders.

Meanwhile, an Atlanta wholesaler is starting to see a shift in the secondary market from loans with IO features to loans with 40-year amortization schedules.

"There are some concerns about credit quality and rising interest rates," said Brian Smith, executive vice president at South Star Funding LLC.

On some loans, the interest-only feature goes away after two years. The loan becomes fully amortizing and the interest rate adjusts to a fully indexed rate. Investors and Wall Street conduits appear to be more concerned about this payment shock lately.

"I think they are more comfortable with 40-year amortization and they are using it as a substitute for the interest-only loans," Mr. Smith said.

In May, South Star funded $530 million in loans with IOs representing 30% of its loan volume. Three weeks ago, the privately held company introduced a 40-year amortizing loan with a 30-year term.

"Wall Street is buying 40/30 loans, " Mr. Smith said. "And I think you will see a lot more of this product."

Fannie Mae and Freddie Mac also purchase IO loans, but Freddie has been the more aggressive of the two.

Freddie introduced its IO product, called "Initial Interest," in July 2004. It is structured so the interest-only payments are fixed for the first three, five and seven years before becoming a one-year ARM that is fully amortizing.

In February, Freddie refined its product line to reduce the payment shock.

The new Initial Interest loans allow interest-only payments for the first 10 years before the borrower has to pay principal and interest.

"That version has been much more popular in the alt-A market since it does separate the payment shocks," Freddie vice president James Cotton said.

Fannie introduced its interest-only product called "InterestFirst" in 2001, but "it is still a real small part of our business," said company spokesman Alfred King.

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