IO Extravaganza

We've had warnings about a real estate slowdown, most recently from outgoing Federal Reserve Board chairman Alan Greenspan. But what mortgage servicers really should focus on is one corollary to rising home prices in high-cost markets: the interest-only loan phenomena.

Recent data compiled by MSN affiliate, the Quarterly Data Report, show that interest-only loans accounted for 26% of loan production in the second quarter. That's a startling number, and it has ramifications for the servicing segment of the mortgage business.

Rating agencies have sounded a note of caution about this market, asserting that there is too little performance history in the IO market for anyone to fully understand how these loans will perform over time. What we do know is that delinquency and default rates on IO loans are likely to be much, much higher than on plain vanilla, 15-year and 30-year, fixed-rate, fully amortizing loans.

Despite the popularity of more conservative loans in years past, it is easy to see how demand for IO loans has grown. For many homebuyers today, keeping the monthly mortgage payment as low as possible is the only way they can afford to get into the house they want, especially in high-cost markets. But if house prices fall, and some think they will (the chief economist at National City Corp. thinks that 53 markets are "extremely overpriced"), the IO market could deflate fast, much as the high loan-to-value did a few years back.

Who is going to be managing these loans when that happens? Those of you in the mortgage servicing business, of course.

We hope that servicers are prepared for the possible burden the booming IO market will put on collection resources in the years ahead. If nonprime loans are "high-touch" products, this new phenomena could end up being equally resource intensive. We hope that lenders and risk managers have a good handle on what the growing IO market means for their business.

It will take time to see how newly popular loan products, including IO loans and option-payment ARMS, perform in the market. But clearly these loans present new administrative and risk management challenges to loan servicers. We hope the industry is pricing these loans appropriately from a credit risk perspective.

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