“A house built on sand” might be the best way to describe the foundation of today’s exuberant housing market, as sub-prime mortgage loans and looser underwriting standards foreshadow trouble for lenders down the road.

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.

“Certainly groundwork has been laid that could lead to problems,” said Keith Gumbinger of New Jersey-based financial publisher HSH Associates.

And Economy.com, an independent research provider, says the overall delinquency rate for mortgage loans “is pretty much a straight upward path in delinquency between now and the end of 2007,” according to Celia Chen, its director of housing economics.

The situation began, many say, when home loan lenders in a market with too much liquidity pushed to find more customers. And find them they did: the U.S. had its two biggest years of total residential mortgage production in 2003 and 2002, with a third-best $2.74 trillion total predicted for 2005 by the Mortgage Bankers Association.

The President and Congress also pushed for higher home-ownership rates, with their government-sponsored enterprises, Fannie Mae and Freddie Mac, leading the way. The mortgage giants buy up loans from original lenders, enabling them to loan more to consumers; Fannie Mae alone boasted an $890.8 billion investment portfolio in February.

Loosened underwriting standards also contributed to the situation.

The average annual growth rate of sub-prime originations from 1994 to 2003 was 25 percent, according to the March 2004 Mortgage Statistical Annual. In 2001, there was $173 billion worth of sub-prime mortgage originations out of $2.1 trillion in total U.S. mortgage loans; by 2003, the number grew to $332 billion.

Such loans, while enabling a greater number of Americans to attain the dream of home ownership, also are associated with higher levels of foreclosure, as Edward Gramlich, then-governor of the Federal Reserve Board, remarked in May 2004. Like Gramlich, Gumbinger noted that loosened underwriting standards are a double-edged sword.

“Underwriting standards are appreciably looser than they have been historically,” Gumbinger, who is vice president of HSH, said. “With looser standards, more borrowers have access to credit. Whether that turns out to be a good thing or not such a good thing will become apparent over time,” he said.

“It’s fair to say that certain of the mortgages being made today will become the foreclosures of tomorrow. Because these are borrowers who are stretching themselves to the limits of their ability to manage the debt,” Gumbinger said.

Another piece of the puzzle is innovative mortgage products such as interest-only loans, which some describe as risky financing.

Alan Greenspan, chairman of the Federal Reserve, warned Monday in a speech to the National Association for Business Economics that growing use of riskier new mortgages could lead to “significant losses” for lenders and borrowers if the market cools.

According to industry analysts, formerly niche debt products like adjustable-rate mortgages and interest-only loans accounted for an eyebrow-raising 63 percent of mortgage originations in the second half of last year.

Three years ago, interest-only mortgages comprised about 2 percent of the market, Don Bisenius, senior vice president, credit risk management, Freddie Mac, has told Inman News.

Today, this once-fringe financing vehicle – originally meant for high-net-worth clients desiring investment liquidity – is up to 15 percent (in some high-priced areas, like California, that number is reported to be 50 percent).

It is true that 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.

“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,” Frank Nothaft, Freddie Mac’s chief economist, said in a previous interview.

That’s 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.

The Federal Reserve is widely expected to continue to raise the cost of overnight money (the Fed raised the rate to 3.75 percent Sept. 27, the tenth of a series of consecutive hikes).

Gumbinger says it’s too early to tell what scenario will play out, and it will probably take at least a year.

“I don’t think any portfolios are in bad shape just yet, given that many loans are of very recent vintage,” Gumbinger said. “Given that despite Fed interest rate increases, long-term interest rates remain at very attractive levels, I have not heard of any pain yet.”

Gumbinger said that process may lie ahead as interest rates increase in the next year or two.

“As the rates on adjustable-rate mortgages begin to adjust, those loans that feature interest-only payments, even if interest rates don’t go up, those borrowers will be facing higher payments in the next year,” he said.

What’s not known, Gumbinger said, is whether borrowers will be able to manage those payments and for how long.

“The other area of concern is what happens to real estate prices, not necessarily now but at some juncture down the road. If borrowers can’t meet their monthly payments and find the need to sell, will they be able to sell or will they be selling in a climate that brings them profits or not?” he asked.

“It’s hard to know. If price increases level off or, God forbid, should decline, some borrowers may find themselves squeezed when it comes time to sell,” Gumbinger said.

Economy.com’s Chen echoed Gumbinger’s concerns.

“What will happen is that as mortgage rates rise, people with interest-only loans or adjustable-rate mortgages will see a rise in their payments,” Chen said. Those with interest-only loans eventually must pay off interest as well as principal and once that kicks in they will see higher monthly payments.”

The danger is, Chen said, that if the economy is not providing enough job or income growth, these folks will find it difficult to keep up with their payments and this will translate into trouble for the mortgage industry. Problems such as rising oil prices or disasters such as Hurricane Katrina could negatively affect the economy in the coming months and years, she said.

“Going forward there’s an air of uncertainty. If something changes in the economy, people might not be able to make payments and might go into delinquency or even foreclosure,” Chen said.

“Our outlook is that mortgage credit quality will likely deteriorate some because of rising interest rates. This will affect all those people with novelty loans negatively because their rates are adjustable,” the director of housing economics said. “The 30-day delinquency rate will rise.”

Economy.com expects the overall delinquency rate for all loans to go from about 4.2 percent this year to about 5.2 or 5.3 percent at the end of 2007. “It’s going to worsen, but factors we just talked about, risk factors would make this baseline even worse,” Chen noted.

Chen pointed out that even a 5.3 or 5.4 rate is not a historical high. “It’s not worse than it’s been. The rate went over 6 percent in 1984, so it’s not going to be horrible in a historical context. But there are risks that it could be worse, such as price softening and the issue with the mortgage markets with the fact that there could be some sort of economic event such as another hurricane or oil prices going higher.”


Send tips or a Letter to the Editor to janis@inman.com or call (510) 658-9252, ext. 140.

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