A duty to whom? Part 2, the economics
[Continued from yesterday’s Part 1.]
Yesterday we discovered that the OCC had issued a strong cautionary guidance warning lenders that they had new responsibilities when selling new financial products.
So let’s see why these new products are riskier.
We start with the old-style mortgage everyone’s parents took out:
+ Interest
+ Principal reduction
= Monthly mortgage payment
In the ordinary world of home mortgages, the borrower has a ‘level-payment self-amortizing loan,’ meaning that the mortgage payment stays the same month after month.
[For instance, a $180,000 loan, with interest at 6.7%, and level payments over 30 years, would have a monthly payment of $1,162, of which $1,005 would be the first month’s interest, and $157 the first month’s principal.]
In the early years, those principal payments are teeny-tiny, as interest consumes most of the loan. Each next month’s interest is always a little lower than the preceding, because of that nibble of principal, thus over time the rate of repayment increases, leading to the accelerating amortization curve:
That loan is incredibly safe — make the payment the first time and every subsequent payment gets easier — but it’s also a big hurdle. So the lending community a few years back began pushing interest-only loans:
+ Interest
+ Zero! (No principal reduction)
= Monthly mortgage payment
Such a loan is level payment, but not self-amortizing. The loan amount stays the same, so the customer is betting on nominal-dollar appreciation or a later increase in his payment ability. Either way, this is an easier loan to get into … and harder to repay.
There’s a lot of cautionary literature on the risks of interest-only loans — written, I will uncharitably infer, by people who already owned their own houses and forgot how hard it was to start out. But even I got raised eyebrows at the newest wrinkle:
… “option” mortgages, in which borrowers decide each month how much to repay.
Let’s put that into our payment equation
+ Interest (say 100% of monthly amount)
– Portion of interest customer defers
+ Zero! (principal reduction)
= Monthly mortgage payment
Wow-ee! Not only does this loan not repay any principal, it doesn’t even cover the monthly interest. So the loan balance is increasing, not decreasing. This is not a level-payment loan; it’s what the industry calls, with precise if obscurist terminology, a negative amortization loan.
For such loans, the good news is simple:
Because monthly payments are lower than with traditional fixed-rate mortgages, borrowers can buy more expensive houses. In the past five years, millions of Americans have bought or refinanced homes using these loans. The risk comes because eventually these loans “reset,” meaning the payment is adjusted upward — sometimes as much as doubling — to repay the full interest and principal owed.
But the bad news is that in such a loan, you had better hope that you’re getting richer, or the property’s going to appreciate rapidly … or you’re screwed.
“We are deeply concerned about the potential contagion effect from poorly underwritten or unsuitable mortgages and home equity loans,” Suzanne C. Hutchinson, executive vice president of the Mortgage Insurance Companies of America, wrote in a recent letter to regulators. . . . “The most recent market trends show alarming signs of undue risk-taking that puts both lenders and consumers at risk.”
If both lenders and consumers are at risk, who isn’t? Golly gee, potentially those mortgage originators and individual agents: the people right in the solar system’s center, buzzing around the borrower. And what advice do you think they’ll give?
Many borrowers are paying as little as possible. About 70% of the people who take out an option adjustable-rate mortgage, which lets the buyer avoid paying even the full interest on the loan, end up paying the lowest permissible amount each month, according to the Federal Deposit Insurance Corp., which regulates banks.
Well, duh.
I mean, that was obvious to me
The amount unpaid is added to the mortgage balance, so borrowers end up owing more than when they started. Having no equity in a home increases the risk of foreclosure, especially when housing values fall and houses are hard to sell.
Late last year, regulators began telling the industry that some of the new loan types put some buyers in jeopardy and lenders at risk of loan losses.
It seems pretty clear that adding a high-calorie food to the ecosystem would stimulate a massive growth of agents and mortgage originators eager to bring the product to the people.
But lenders continued making the loans at a fast clip.
Observe that each animal in the ecosystem is behaving as one would expect, maximizing its own interest. Originators and their agents who can place loans with investing lenders will continue to do so as fast as they can.
How doth the underwriting bee?
Assess its shining risk?
In 2000, just 1% of American homeowners who got new loans had these types of loans, but by May 2005, about a third of all borrowers did — about the same percentage as in May 2006, according to new data from First American LoanPerformance, which tracks the statistics.
I believe that one-third could have been adjustable rate or interest-only, but one-third adjustable payments? Doubt it.
I’m not convinced you’ll be around to repay when the wages of sin rise
Wells Fargo said that although it “applauds” the regulators’ efforts, the agencies should distinguish between mortgages that are really risky, such as those with mortgage balances owed that can rise rather than fall or with introductory teaser rates likely to increase, and interest-only loans, which the bank said were less risky.
What then is the risk?
But the mortgage insurers, which cover the losses when loans go bad, see big problems.
Again, each animal responds based on its own self-interest.
Their trade group, in a plea to regulators delivered in a comment letter last month, alluded to its fear of widespread foreclosures if some of these new borrowers default on their loans. An increase in such problem properties could weaken the real estate market and drive down home values even for those who bought conservatively and diligently paid their mortgages.
Yet if that’s the case — if the loans really are risky, why didn’t individual insurers just withdraw from the market?
Competitive pressure.
Some of you won’t be able to maintain your position …
Fear of losing market share.
I gotta get me some of them adjustable-payment loans!
How then to crack the problem of policing those that will not police themselves?
Can’t crack the problem without you change-a some eggs-pectations
[Concluded tomorrow in Part 3]
