Editor’s note: Signs of a slowing real estate market raise questions about who in the industry will be most vulnerable to a housing recession. Fewer real estate transactions means there is less money to spread around, and that will impact everyone. But some will be hit harder than others – especially if they are not prepared. In this special series, we examine who’s most at risk.

Editor’s note: Signs of a slowing real estate market raise questions about who in the industry will be most vulnerable to a housing recession. Fewer real estate transactions means there is less money to spread around, and that will impact everyone. But some will be hit harder than others – especially if they are not prepared. In this special series, we examine who’s most at risk. (See Part 1: Condo craze days may be numbered and Part 2: Newbie real estate agents bet on survival.)

Federal Reserve Chairman Alan Greenspan calls them “exotic loans.” The mortgage industry calls them “innovative mortgage products.” And the National Association of Realtors refers to them as “specialty mortgages.”

Whatever you call them, the rise of non-traditional home loans such as interest-only loans and negative amortization mortgages have helped lots of families buy homes, fueling the booming real estate industry.

But the red-hot housing market is increasingly viewed as a pending problem, putting housing bubble debates and the possibility of home-price declines back on the burner. Rising interest rates could lead to higher defaults, and lenders of newer, riskier loan products could get hit hard if borrowers default on loans that end up being worth more than the homes.

“There’s been a lot of research that shows if you look at two loans that otherwise are completely identical, but one is fully amortizing and the other is an interest-only loan… what you will find over time is that the interest-only loan has a greater likelihood to default,” said Frank Nothaft, chief economist for secondary mortgage giant Freddie Mac.

That’s precisely why some people, including Greenspan, have pointed to the increase in these types of loans as cause for concern – especially as interest rates are predicted to rise, which can spike the average monthly payments for many of these new mortgage products.

“Some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market,” the Fed chief has said. “Moreover, these contracts may leave some mortgagors vulnerable to adverse events.”

From a lender or investor perspective, nontraditional loans are risky, Nothaft said. However, most lenders will try to mitigate that risk by factoring it into the underwriting and pricing the loans to reflect that.

But others warn that while risky loans make sense for particular borrowers, many more people are using them today than intended. Many of the new mortgage products haven’t yet been through a slow housing cycle, which raises questions about what may lie ahead for lenders and investors.

“These products have been pushed out of the niches they were created to serve and pushed into broader-based borrowers,” Mark Milner, senior vice president and chief risk officer of PMI Group, said. “That’s the real risk issue.”

The share of interest-only mortgages climbed from just a few percent a few years ago to one-fourth of all home loans in 2004, according to data from Loan Performance and Harvard University’s latest State of the Nation’s Housing report. And interest-only loans are especially popular in pricey California markets where homes are less affordable and where some are predicting a slowing in price appreciation and sales.

“It’s sort of a vicious cycle – housing prices go up so many people are forced to use ‘exotic’ loan products,” Milner said. And that in turn supports the higher housing costs.

As long as economic fundamentals in local housing markets stay strong, there probably won’t be a dramatic drop in home values like areas of Southern California have seen in the past, he said. But home prices are rising much faster than incomes and at some point home prices will need to slow down and allow incomes to catch up.

“There is regional risk and compounding that with these new products may exacerbate that risk,” he said.

PMI Group compared monthly payments for an interest-only loan, piggyback loan and a 30-year fixed-rate loan on a $225,000 mortgage after one year, four years and six years. The monthly payment on the interest-only loan started at $1,054 for the first year, remained at that amount at the fourth year, then jumped 81 percent to $1,909 in the sixth year.

The monthly payment on the piggyback loan started at $1,168 the first year, increased to $1,445 the fourth year and jumped a total 42 percent to $1,656 by the sixth year. Meanwhile, the monthly payment on the 30-year fixed rate loan started at $1,375 the first year, then decreased to $1,278 for the fourth and sixth years. The decrease was due to mortgage insurance being cancelled between years three and four when the loan-to-value ration reached 75 percent.

PMI Group provides mortgage insurance through its subsidiaries.

Real estate markets are cyclical, Milner said. Home prices will slow and interest rates will rise, which will increase the monthly payments on a lot of the newer loan products. “People really need to think about the risks they’re taking on in order to get the initial payment,” he said.

Along with interest-only loans, low- and no-documentation loans and option-adjustable mortgages have all seen rapid growth in recent years, according to the Harvard report. Low-documentation loans enable borrowers to supply less information to speed up the loan process. With no-documentation loans, lenders waive income and asset disclosure requirements.

Many of the unconventional or “exotic” loan products haven’t been through a slow real estate cycle before so no one knows for sure what the impact will be on lenders and borrowers, Milner said.

The National Association of Realtors has partnered with the Center for Responsible Lending to distribute a new brochure that informs home buyers about the risks and advantages of specialty mortgage products.

“We’re warning home buyers to approach these new mortgages carefully,” said Mike Calhoun, general counsel for the Center for Responsible Lending. “They should be cautious about accepting a mortgage they can’t afford. These mortgages can be devastating for families who are stretching their budget to buy a home.”

The brochures are available online at Realtor.org and ResponsibleLending.org.

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Send tips or a Letter to the Editor to jessica@inman.com or call (510) 658-9252, ext. 133.

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