One of the hottest financing products in the home
purchase market -- so-called "option ARMs" -- could be
reined in as the result of new actions on Wall Street
and forthcoming guidelines for lenders from federal
financial oversight agencies.
As of August 1, all new mortgage pools containing
option ARMs rated by Standard & Poor's will carry the
capital markets equivalent of a scarlet letter --
extra penalties in the form of tougher "credit
enhancements."
Option ARMs have zoomed from a tiny niche product --
no more than 3 percent of new home loans in 2004 -- to
25 percent of all mortgage bond pools rated by
Standard & Poor's in 2005.
Option ARMs are popular with home buyers -- especially
in high-cost areas of California and along the Eastern
seaboard -- because they enable consumers to cut their
interest rates to as low as 1 percent for limited
periods of time. Option ARMs give buyers a choice of
several payment plans, ranging from minimum monthly
payments (like a credit card), interest-only or
fully-amortizing.
Borrowers who choose the minimum payment option are
actually deferring interest payments to a later date.
Their principal loan balance increases by the amount
of deferred payments, a process known as negative
amortization. Some option ARMs allow borrowers to rack
up as much as 25 percent higher principal debt than
their original loan amount.
For example, if they originally borrowed $400,000,
they might be able to defer full payments until their
principal loan balance hit $500,000. Option ARMs also
contain periodic payment readjustments that can hit
borrowers with severe monthly payment increases of 60
to 90 percent. Borrowers either have to come up with
the required extra payment or find a new loan.
Wall Street, which provides the capital to fund option
ARMs when they are pooled and securitized into
mortgage bonds, is worried that too many home buyers
using these loans have risky credit histories and are
opting for the minimum payment plan without
understanding the potential payment shocks ahead.
Standard and Poor's is the dominant rating agency in
the multi-trillion-dollar "nonconforming" mortgage
market that includes option ARMs. Its loan criteria
set the rules for mortgage lenders who want to fund
their loans through the global capital markets. When
Standard & Poor's penalizes a particular type of loan
-- considering it to be of higher than acceptable
default risk for investors -- lenders tend to cut back
on the number of such mortgages they make.
Standard & Poor's toughened its criteria on option
ARMs made to borrowers with FICO credit scores at or
below 695 -- a rising percentage of the overall option
ARM market going to securitization. S&P's crackdown
will not affect lenders who originate option ARMs for
their own portfolios, some of whom restrict loans to
borrowers with FICOs above 700.
"We wanted to jump in before this got any worse," said
Standard & Poor's mortgage bond director Michael
Stack.
Fitch Ratings, another major Wall Street agency, has
also warned lenders about the high default potentials
of option ARMs, arguing that the numbers of borrowers
exposed to payment shocks in the coming two years is
unacceptably high. Bond investors avoid mortgages with
elevated probabilities of default because their
pass-through payments of interest and principal are
likely to be less.
Federal financial regulators are also taking hard
looks at the risks posed by option ARMs, and are
expected to caution lenders about them in forthcoming
"guidance" expected by early Fall. Barbara
Grunkemeyer, deputy Comptroller of the Currency and
head of a multi-agency task force preparing the
guidance, said he government has special concerns that
option ARMs are being marketed in a "safe and sound
manner" and that consumers understand the risks.
The net effect of the guidance, when issued, is likely
to be to discourage lenders from extending them to
credit-impaired buyers who can only afford the minimum
payment, not the fully-amortizing payment.
The worst case scenario, according to Wall Street
analysts, would be that large numbers of borrowers in
high-cost but softening housing markets find
themselves "upside down" thanks to negative
amortization -- owing more to the lender than the
resale market value of their property.
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