Post by unlawflcombatnt on Dec 19, 2006 19:53:52 GMT -6
Below is an excerpt from a speech made by the Comptroller of the Currency, John C. Dugan, describing the impending disaster that may occur from recent loose lending practices being employed by banks when making home mortgage loans. The excerpt puts particular emphasis on the "options" type mortgages, and to a lesser extent, "interest only" loans.
"Remarks by
John C. Dugan
Comptroller of the Currency
Before the
Pittsburgh Community Reinvestment Group
Pittsburgh, PA
November 16, 2006
Today, some mortgages allow residents in your communities with steady incomes, but limited savings, to become homebuyers without making any down payment at all. In addition, the subprime mortgage market has grown from less than five percent of mortgage originations in 1994 to about 20 percent in 2005. This expanded market offers financing, albeit at a higher cost, to those with blemished credit or sparse credit histories who would not have qualified for loans in the past.
More recently, payment deferral products – so-called “interest only” and “paymentoption” mortgages – have emerged. These products were originally designed to help borrowers who had irregular income streams or were likely to experience significant future increases in income. But over time, they have come to be marketed, sometimes inappropriately, as a way to lower monthly payments to make mortgages more affordable –at least in the short term.
Not surprisingly, in an era of rising house prices and bigger mortgages, the market for products that lower monthly payments has taken off like a rocket. In 2000, interest only and payment option mortgages amounted to only two percent of the market. However, by the first half of 2006, the Mortgage Bankers Association estimates these types of nontraditional mortgage products represented over 40 percent of all loan originations. While these products have had the salutary effect of making financing available to many who otherwise would not have qualified for a home mortgage, there is a catch: the lower monthly payments are limited to the early years of the mortgage, and are offset by monthly payments that are higher in the later years – sometimes much higher. And that, in turn, is why they are called“payment deferral” products.
As its name suggests, interest-only mortgages lower monthly payments in the early years of a mortgage by requiring the borrower to pay only interest on the loan, without any repayment of principal. When the borrower begins repaying the principal – typically after five years – monthly payments increase significantly because the same amount of principal must be repaid in the shorter remaining period of the loan.
A payment option mortgage goes one step further. Here the borrower is given the option of reducing his or her monthly payment not only by deferring repayment of principal, but also by deferring repayment of part of the interest that is due. The unpaid interest is then added to the original principal amount of the loan – a process called “negative amortization”– so that with each minimum monthly payment the borrower’s debt actually increases. When the borrower begins repaying the principal, monthly payments increase even more than they would have with an interest only loan because an even larger amount of principal must be repaid in the shorter remaining period of the mortgage. How big is that increase? Big enough to earn the name “payment shock” under some very typical circumstances. For example, when a payment option mortgage of $150,000 at 6 percent resets after an initial five-year period, monthly payments can jump from $669 to $1,040, an increase of over 50 percent. If rates rise just two percentage points, to eight percent, the payment would increase to $1,314 – nearly doubling the amount of the initial monthly payments. Now, such payment deferral products can be fine for borrowers who have the financial wherewithal to handle higher payments in the out-years and really understand the risk. But that class of mortgagor is unlikely to include many subprime borrowers, who are least able to handle or understand the risk of payment shock. Yet these subprime borrowers are the very individuals to whom these payment deferral products are increasingly being marketed. During the first quarter of this year, for instance, nearly one quarter of new subprime mortgages were interest only loans.
The risks of payment shock are exacerbated if, as unfortunately can be the case, the lender offers these nontraditional mortgage products to subprime borrowers through so-called “stated income” programs. In such circumstances, the borrower pays the lender not to verify the borrower’s stated income on the loan application, making it possible for the borrower to artificially inflate the size of his or her income in order to qualify for a bigger mortgage. It is disconcerting, to say the least, that stated income loans comprise more than 50 percent of the subprime market, especially when, according to a study by the Mortgage Asset Research Institute, nearly 60 percent of the applications for stated income loans exaggerated income by at least 50 percent. In a housing market with rapid home price appreciation, borrowers may be able to avoid payment shock – at least temporarily – by refinancing their mortgages and extracting equity gained from the increase in value of their homes. But when interest rates rise and home prices remain stable or fall, this route may be closed to them. Indeed, some recent statistics from First American Real Estate Solutions indicate that more than one payment option ARM in five originated in the past two years is now “upside down” – which means that the loan exceeds the current value of the house. And if home prices drop by 10 percent, about 40 percent of such loans would be upside down according to this report. If true, such statistics portend potentially higher foreclosure rates on nontraditional mortgages, with an increasing number of people facing the prospect of unmanageable mortgage payments. Such a result could cause severe financial setbacks to the families.....
In sum, we believe our guidance provides an important foundation for the appropriate underwriting and marketing of nontraditional mortgages. Yet, as important as it is, the guidance should be viewed only as the start of a longer and larger process. After all, it applies only to federally regulated institutions – insured depositories and their affiliates. It does not extend to mortgage lenders not affiliated with banks, which are regulated exclusively by the states – even though such lenders constitute a large portion of nontraditional mortgage originators. Indeed, the old paradigm where consumers sought home financing directly from their neighborhood bank or thrift has plainly changed. Under the new paradigm, an increasingly large part of the mortgage market consists of brokers that originate mortgages and deliver them to banks, thrifts, and other financial firms, which in turn package and market them to investors here and abroad. These innovations have made the mortgage market more accessible and efficient. They deserve some credit for the record home ownership rate we have today. But they also introduce new issues and risks into the mortgage lending process. Often those who initially process such loans are far away when borrowers discover that escalating payments exceed their resources. A mortgage originator’s deal-making may center on closing the deal, focusing only on whether a buyer can afford the initial payments, not on whether the prospective borrower is really capable of shouldering the later payments necessary to fully repay the loan."
"Remarks by
John C. Dugan
Comptroller of the Currency
Before the
Pittsburgh Community Reinvestment Group
Pittsburgh, PA
November 16, 2006
Today, some mortgages allow residents in your communities with steady incomes, but limited savings, to become homebuyers without making any down payment at all. In addition, the subprime mortgage market has grown from less than five percent of mortgage originations in 1994 to about 20 percent in 2005. This expanded market offers financing, albeit at a higher cost, to those with blemished credit or sparse credit histories who would not have qualified for loans in the past.
More recently, payment deferral products – so-called “interest only” and “paymentoption” mortgages – have emerged. These products were originally designed to help borrowers who had irregular income streams or were likely to experience significant future increases in income. But over time, they have come to be marketed, sometimes inappropriately, as a way to lower monthly payments to make mortgages more affordable –at least in the short term.
Not surprisingly, in an era of rising house prices and bigger mortgages, the market for products that lower monthly payments has taken off like a rocket. In 2000, interest only and payment option mortgages amounted to only two percent of the market. However, by the first half of 2006, the Mortgage Bankers Association estimates these types of nontraditional mortgage products represented over 40 percent of all loan originations. While these products have had the salutary effect of making financing available to many who otherwise would not have qualified for a home mortgage, there is a catch: the lower monthly payments are limited to the early years of the mortgage, and are offset by monthly payments that are higher in the later years – sometimes much higher. And that, in turn, is why they are called“payment deferral” products.
As its name suggests, interest-only mortgages lower monthly payments in the early years of a mortgage by requiring the borrower to pay only interest on the loan, without any repayment of principal. When the borrower begins repaying the principal – typically after five years – monthly payments increase significantly because the same amount of principal must be repaid in the shorter remaining period of the loan.
A payment option mortgage goes one step further. Here the borrower is given the option of reducing his or her monthly payment not only by deferring repayment of principal, but also by deferring repayment of part of the interest that is due. The unpaid interest is then added to the original principal amount of the loan – a process called “negative amortization”– so that with each minimum monthly payment the borrower’s debt actually increases. When the borrower begins repaying the principal, monthly payments increase even more than they would have with an interest only loan because an even larger amount of principal must be repaid in the shorter remaining period of the mortgage. How big is that increase? Big enough to earn the name “payment shock” under some very typical circumstances. For example, when a payment option mortgage of $150,000 at 6 percent resets after an initial five-year period, monthly payments can jump from $669 to $1,040, an increase of over 50 percent. If rates rise just two percentage points, to eight percent, the payment would increase to $1,314 – nearly doubling the amount of the initial monthly payments. Now, such payment deferral products can be fine for borrowers who have the financial wherewithal to handle higher payments in the out-years and really understand the risk. But that class of mortgagor is unlikely to include many subprime borrowers, who are least able to handle or understand the risk of payment shock. Yet these subprime borrowers are the very individuals to whom these payment deferral products are increasingly being marketed. During the first quarter of this year, for instance, nearly one quarter of new subprime mortgages were interest only loans.
The risks of payment shock are exacerbated if, as unfortunately can be the case, the lender offers these nontraditional mortgage products to subprime borrowers through so-called “stated income” programs. In such circumstances, the borrower pays the lender not to verify the borrower’s stated income on the loan application, making it possible for the borrower to artificially inflate the size of his or her income in order to qualify for a bigger mortgage. It is disconcerting, to say the least, that stated income loans comprise more than 50 percent of the subprime market, especially when, according to a study by the Mortgage Asset Research Institute, nearly 60 percent of the applications for stated income loans exaggerated income by at least 50 percent. In a housing market with rapid home price appreciation, borrowers may be able to avoid payment shock – at least temporarily – by refinancing their mortgages and extracting equity gained from the increase in value of their homes. But when interest rates rise and home prices remain stable or fall, this route may be closed to them. Indeed, some recent statistics from First American Real Estate Solutions indicate that more than one payment option ARM in five originated in the past two years is now “upside down” – which means that the loan exceeds the current value of the house. And if home prices drop by 10 percent, about 40 percent of such loans would be upside down according to this report. If true, such statistics portend potentially higher foreclosure rates on nontraditional mortgages, with an increasing number of people facing the prospect of unmanageable mortgage payments. Such a result could cause severe financial setbacks to the families.....
In sum, we believe our guidance provides an important foundation for the appropriate underwriting and marketing of nontraditional mortgages. Yet, as important as it is, the guidance should be viewed only as the start of a longer and larger process. After all, it applies only to federally regulated institutions – insured depositories and their affiliates. It does not extend to mortgage lenders not affiliated with banks, which are regulated exclusively by the states – even though such lenders constitute a large portion of nontraditional mortgage originators. Indeed, the old paradigm where consumers sought home financing directly from their neighborhood bank or thrift has plainly changed. Under the new paradigm, an increasingly large part of the mortgage market consists of brokers that originate mortgages and deliver them to banks, thrifts, and other financial firms, which in turn package and market them to investors here and abroad. These innovations have made the mortgage market more accessible and efficient. They deserve some credit for the record home ownership rate we have today. But they also introduce new issues and risks into the mortgage lending process. Often those who initially process such loans are far away when borrowers discover that escalating payments exceed their resources. A mortgage originator’s deal-making may center on closing the deal, focusing only on whether a buyer can afford the initial payments, not on whether the prospective borrower is really capable of shouldering the later payments necessary to fully repay the loan."