APRIL 12, 2004

Home Buyers: ARMed And Dangerous?
Adjustable-rate mortgages are pulling in new buyers — but the risks are high
After being outbid twice last year on homes in the charming Old Town section of Alexandria, Va., Adam Brake decided to go for broke. The 40-year-old U.S. Army attorney offered $11,000 more than the asking price for the next property he liked. He got the house, but could put down just 5% and needed both an adjustable-rate mortgage and a fixed-rate one to finance the $340,000 purchase. For now, Brake can handle his monthly payments, but he could end up paying a lot more if rates rise, something that leaves him a little uneasy. “Every time the Fed meets to discuss raising rates, I cringe,” he says.

Just when it seemed that everyone who could afford a house had bought one, banks are devising ever more exotic ways for Americans to purchase their first homes or trade up to fancier ones. A record number of Americans already own a home, but the new loans — which usually require lower monthly payments at first — have kept the housing boom going full blast just as rates seemed to bottom out over the past year.

The trend is exploding as banks roll out everything from first mortgages for more than a home’s value to interest-only loans that don’t require any of the principal to be paid. “There’s a loan out there for everybody right now,” says Dianne L. Wilkman, president and chief executive of Springboard Inc., a credit-counseling service.

The attraction of the new breed of loans isn’t hard to understand. At the current rate of 5.5% on a conventional 30-year fixed-rate mortgage, a homeowner will pay $567 a month for each $100,000 borrowed; an interest-only 4% adjustable-rate mortgage (ARM) costs just $333 a month, figures IndyMac Bancorp Inc. (NDE ) in Pasadena, Calif. The cheap ARMs are pulling in scads of buyers. Such loans now make up 28% of new mortgages, double the level of last year’s first quarter.

No less an expert than Federal Reserve Chairman Alan Greenspan has sung the praises of ARMs. In February, he told credit union executives that such loans could have saved many homeowners tens of thousands of dollars over the past decade. He noted that ARMs are much more common in other countries, and he encouraged the mortgage industry to create more options. “The traditional fixed-rate mortgage may be an expensive method of financing a home,” Greenspan said.

However, if rates rise by just 2 percentage points, the $333 monthly cost on that $100,000 loan could nearly double when the interest-only period ends, leaving some homeowners unable to make their payments. Worse, those with interest-only loans or those who made very low downpayments could be stuck with homes worth less than what they owe on them if prices stop rising or even soften. Says Mark Agah, an industry analyst at Portales Partners, a New York investment-research firm: “At some point, rates will go higher, and when they do, we face serious risks of people losing their homes and banks taking losses.”

But banks seem unconcerned. In fact, many lenders are hanging on to more mortgages. In the last 12 months, the amount of mortgages and mortgage-backed securities held by large banks rose 10%, to $998 billion, according to Bear Stearns Cos. (BSC ). At Washington Mutual Inc. (WM ), an industry leader, mortgages and mortgages and home-equity loans rose 29% last year, to $140 billion.

The newfangled loans sometimes seem to stretch the limits of creative financing. Home buyers may now borrow as much as 110% of their home’s value, something that previously could be done only with a second mortgage. Some plans allow borrowers to skip payments, with the missed payments rolled into the principal. Also growing in popularity are “piggyback” loans such as Brake has — second mortgages taken out along with the first that allow buyers to avoid paying private mortgage insurance even though they’re putting little or no money down.

Lenders also have reduced the documentation some borrowers need to qualify. With “Low Doc” loans, a borrower may choose not to supply income-tax returns in exchange for a slightly higher rate. That allows a self-employed person with an erratic income to borrow. And by cutting the loan-processing time in half, buyers have a better chance of winning a bidding war in a hot housing market.

FANCY LENDING. Some of the new loans are tailor-made for borrowers with bad credit histories. The volume of new subprime loans has doubled in the past four years, to $332 billion, according to mortgage-industry trade publication Inside B&C Lending. They now make up nearly 10% of all mortgages outstanding, vs. just 3% in 1996. Subprime borrowers are twice as likely as those with high credit scores to take out ARMs.

All the new ways to go into hock are helping push the country’s mortgage debt higher than ever. Overall mortgage borrowings have climbed 50% since 1999, to $6.8 trillion, far faster than income grew. And even though many homeowners are converting credit-card and other personal loans into tax-deductible mortgages, the level of nonmortgage consumer debt has also risen. According to the Fed, Americans now spend 13.1% of their disposable income on debt payments, up from 12.5% four years ago. In the 1980s, when interest rates were much higher, payments ate up only 11% of income.

This easy money is almost certainly contributing to house-price inflation by enabling people to pay more, though this is hard to quantify. “Everybody keeps saying ‘interest rates, interest rates,’ but it’s really the mortgage products that are driving the market,” says Jay Robertson, a mortgage broker at First Capital Mortgage in Los Angeles. Many markets — such as New York, Washington, South Florida, Las Vegas, and Minneapolis — have seen double-digit increases lately. In California, where home prices have jumped 14% a year since 1999, just one in four households can afford a median-priced home, which now costs $405,000, according to the California Association of Realtors. And buyers in such high-priced states are far more likely to apply for ARMs.

With interest rates still low, problems with fancy lending have yet to surface. Delinquency rates for residential mortgages peaked at 5.5% in the third quarter of 2001 and have since fallen to 4.5%, according to Mortgage Bankers Assn. Bankers say they have invested heavily in recent years in technology that helps them avoid bad credits and price their loans to reflect risks. Although it becomes more expensive for banks to borrow money when rates rise, ARM borrowers start paying more interest, so banks don’t face such a big squeeze on their margins as with fixed loans.

All the same, the huge runup in the housing market makes the next few years unpredictable for banks. A record number of singles now owns homes, according to SMR Research Corp., and they typically default more often than couples. ARM borrowers also default more than homeowners with fixed rates. And default rates on sub-prime loans are much higher than they are for borrowers with good credit.

Experts have been predicting the end of the housing boom for some time. If that day of reckoning ever comes, the old-fashioned fixed-rate mortgage might not seem so fuddy-duddy anymore.

By Christopher Palmeri in Los Angeles, with Rich Miller in Washington