Mortgage
Features Can Cause Mischief
By
Richard
W. Crockett
The
Federal Reserve has approved a plan to limit some mortgage lending practices
seen as risky lending. Chairman,
Ben Bernanke, of the Federal Reserve on December 19, 2007 remarked, ÒUnfair and deceptive acts and
practices hurt not just borrowers and their families, but entire communities,
and indeed, the economy as a whole,Ó according to the New York Times. This is
a reversal of the position stated by former Federal Reserve Chairman, Alan Greenspan
who contended the Federal Reserve Òwas ill suited to investigate deceptive
lending practices.Ó The New
York Federal Reserve Bank, according to the New York Times declared, bluntly, Òno bubble exists,Ó in 2004, and
Greenspan further argued the FedÕs accountants and bank examiners were not
equipped to monitor this industry.
Sub-prime
loans in recent years have become 25% of all new mortgages and are often
written by banks or other lenders and bundled and sold to Wall Street investors
as Òmortgage backed securities.Ó The increasing default rate as high as 20%
among sub-prime loans has created a crisis in this industry, which threatens
well-known financial institutions with severe financial loss or even collapse.
Merrill Lynch, Morgan Stanley, City Group, and Goldman Sachs come to mind as
companies who have announced losses in this sector.
In
the public discussion of the sub-prime mortgage crisis, one of the targets of
the discussion is the adjustable rate mortgage. Other features of mortgages have also been discussed,
including Òstated income loans,Ó which do not require borrowers to document
income, Òpiggyback loans,Ó loans not requiring a down payment, and Òoption
ARMSÓ allowing people to make less than the full payment, adding the shortfall in
any given payment to the end of the loan. Still other features included in the discussion
include low initial teaser rates, pre-payment penalties, and due-on-sale
clauses.
Adjustable
Rate mortgages in contrast with fixed rate mortgages are mortgages in which the
interest rate may change during the life of the loan. Adjustments in interest rates in these mortgages are often
tied to fluctuating interest rate indices and to the calendar more than to the borrowerÕs ability to
pay. From a borrowerÕs point of
view, these mortgages are to be avoided at all costs. From a lenderÕs point of
view these mortgages may provide a false sense of security, in the form of a barrier against financial loss and a
guarantee of profit during periods
when lenders face a rising cost of money.
This is the least stable loan arrangement for both borrower and lender.
Even under the best of circumstances, it is something of a shell game in this
writerÕs opinion.
The
borrower agrees to a loan, which he desperately wants to have, to finance his
home. He is sometimes unsophisticated concerning such financial matters, and on
the day he/she signs the documents for the bank, he is told what his payment
will be. The payment seems to fit his
budget, especially if it is based upon a Òteaser rate.Ó But after a period of time, imagine
that his payment increases because the mortgage is scheduled for a change in the interest rate. Adjustable rate mortgages (or
ARMs) permit the bank to change
the interest rate of a mortgage after a few months or after one or two years,
and the mortgage agreement specifies the amount of a change that is permitted
per adjustment and a total amount of change over the life of the loan. For example, the mortgage may permit a
maximum adjustment of no more than 2% in any one adjustment and a maximum of 5%
over the life of the loan. Let us
imagine that a borrower has an adjustable rate mortgage at 4% to finance
$100,000 for his home. His
beginning payment amortized over thirty years is $477.42 for the principal and
interest portion of the house payment.
(Some lenders required that taxes and insurance be escrowed or set aside
in a non-interest bearing savings account and therefore included in the
payment, which in this example would be in addition to the numbers I am
giving. This is OK, maybe even
desirable, but is not included in this example.) At the end of the first year
of successful payments, the borrower receives a notice of an interest rate
adjustment and the increase is a permitted 1% adjustment in the interest
rate. His house payment now goes
up to $536.52 per month for the principal and interest portion of the payment.
If the increase in interest rate were the maximum of 2% that is permitted in
the mortgage, the payment would increase to $599.55 per month. Over the life of
the loan, our example allows a total interest rate increase of 5%. Under such
an arrangement it is conceivable that at the end of three years, the interest
rate would reach 9% and the mortgage payment could reach $804.62. How does that compare to the initial
payment of $477.42? It seems to
have almost doubled to the casual observer and especially to the financially
pinched, want-to-be homeowner. If
escrow accounts for taxes and insurance are included, these amounts may
increase as well, compounding the homebuyer stress. Sub-prime mortgages may cost as much as 12%, which would
produce a principle and interest payment
in our example of $1028.61 per month.
Adjustable
rate mortgages sometimes are tied to an interest rate index, such as the LIBOR
(London Inter-bank Offered Rate) index or to the Treasury index, and the
interest rate could go up or the interest rate could even go down. Let us say
that a mortgage is governed by the LIBOR one-year rate. This week the rate was
at 4.34% per annum, one month ago it was at 4.44% per annum, and one year ago
it was at 5.26% per annum. It is clear that this rate went down over the last
year, but it can also go up. A bank that uses this index might also add some
amount of money called margin to these rates, which represents the banks mark
up or profit. For example a 5.256%
interest rate may have another three percent added to it so that the consumer
pays 8.256%. However, Cathy
Alexander of Firstbank Mortgage St. Louis office, told me on December 27, that in her experience, Òrate
adjustments are not a primary cause of default.Ó
Interest
rates in specific mortgages may be also tied to the calendar. For example there
is a one month, a three month, and a six month version of LIBOR rates. In this
instance, fluctuations in a borrowerÕs payments could occur even more
frequently. However some mortgages
may have a minimum below which the rate will not fall. For the borrower, the adjustable rate
mortgage still may appear to be something of a tempting crapshoot.
Stated
income loans are loans in which the borrower does not have the burden of
providing income documentation to get the borrowed money. This appears to be a loan, which allows
the borrower to maintain some measure of privacy in their personal financial
affairs. But even here there is a
downside. For the bank or lender,
the loan is riskier because the bank will be extending a large sum of money on
the hope that the borrowers income is what is claimed to be, and that they will
be able to repay the loan. For the
borrower the loan may be riskier because their actual, verified income is not
run through the rigorous scrutiny of the loan officer and underwriter, which
would reveal whether they really could afford the loan.
Piggyback
loans allow borrowers to buy a home without making a down payment. These occur
when at the time a mortgage is written, the financing takes the form of a first
mortgage and a second mortgage.
The first mortgage may be an 80% loan to value mortgage, and can be
borrowed at a better interest rate,
and the remaining 20% of the funds are raised in a second mortgage. First mortgages are frequently offered
at a better interest rate than second mortgages, but now the borrower has 100%
financing and a somewhat more ÒconventionalÓ interest rate on 80% of his
financing.
Option
ARMS are feature of a mortgage which permits the borrower to make a partial
payment and the amount that the payment is short is simply added to the end of
the loan. This of course results
in serious compounding of interest upon interest driving the cost of the loan
even higher.
Low
initial teaser rates under new Fed rules on mortgages could not serve as a
basis for determining a borrowerÕs ability to pay. These rates are associated
with adjustable rate mortgages.
Some
mortgages contain prepayment penalties. This means that a borrower who pays off
their mortgage early, usually within the first two years, will have to pay
additional fees. The new FED rules do not prevent this practice and their
remedy for this is limited to an exemption of a sixty day window
prior to the first interest
rate adjustment during which a payoff of the loan may occur without penalty.
The borrower would need to be aware of this window of opportunity. Consider the implications of
pre-payment penalties in an instance where a borrower determines that he cannot
afford to keep the property and he attempts to sell the property. Prepayment penalties when added
to the actual mortgage balance may cause the payoff amount to the bank to be
larger than the market value of the property, especially in a declining
market. The borrower is
effectively locked into keeping the property, a property that they may not be
able to afford. In some cases
where the borrower is unable to keep up the payments, this could lead to a
foreclosure rather than a sale.
Due-on-sale
clauses are a feature of
mortgages, which interfere with a borrowerÕs ability to get around pre-payment
penalties and a potential foreclosure.
They are a common practice in mortgages today, and a due-on-sale clause
simply means that if the owner of a property sells the property, he must pay
the lender in full. That seems
reasonable enough on its face, but mischief lurks even here. Sometimes when
loans are bundled and sold in a secondary market, homeowners are able to
surreptitiously do contract sales without being discovered, because local
lenders no longer service the loans.
What if a homeowner is struggling financially, due to a plant closing
and job loss or whatever. He is
having difficulty making ends meet on his unemployment check, but he is current
on his mortgage payment.
He knows that his unemployment is running out. He doesnÕt want to lose the equity in his home. So he puts the home on the market for a
possible sale. But because the
mortgage financing market is tight, and there is a glut in the housing market,
lenders will not finance his home for a buyer at a level, which permits the
seller to protect his equity or even complete the sale. In other words potential buyers cannot
get financing from a lender on the home at the sellerÕs price. If he accepts a lesser price, it may
not be enough to pay off his mortgage. But suppose he has a buyer who is willing to pay his
asking price, but in a stressed market canÕt get bank financing. An alternative method of financing is
the Contract for Deed. The buyer
and seller agree to the terms of the contract and the dwelling is sold at full
price Òon contract.Ó The new
ÒownerÓ has a contract for deed requiring the seller to deliver a deed when the
last payment is made to the seller, in the same manner that the bank will have
to release a mortgage when the seller makes his final payment to the bank. The contract specifies that the buyer
will pay an agreed upon amount to the seller, and the seller in turn makes the
payment to the bank. The seller is still in the middle: he is not off the hook
for the mortgage. He gets
payments from the new ÒownerÓ and in turn makes his own payment to the
bank. Technically the seller is
still the owner. However, this is
not so in the eyes of the original lender, the bank. The original lender or the bank regards this
transaction as a sale. When the
bank learns of it, under the Òdue on saleÓ clause, the bank calls the mortgage
due and the seller in the transaction has to cough up the money for the full
balance of the loan. If he canÕt refinance or doesnÕt have the cash, the seller
could be in a jam. It is easy to
see how due on sale clauses could prohibit transactions conducted by contract
for deed.
Due-on-sale
clauses came into being on a widespread basis during the housing crunch of the
early nineteen eighties. This
occurred when homeowners facing a pinch or seeing an opportunity would sell
their homes Òon contractÓ and receive a higher rate of interest in the contract
for their financing than they were paying the lender for the underlying fixed
rate, long-term mortgage. Lenders were in pain over these transactions because
they were locked in to long-term, low interest mortgages from which they could
not escape, and their cost of money was going out of sight. For example, imagine that I have
a fixed rate mortgage at 6% interest but I sell my property to a buyer Òon
contractÓ at a rate of 8% interest.
I am making money on the bankÕs loan. And if the bank is having to pay 8,10,or 12 percent for
their new money, this is a losing proposition for the bank. Lenders didnÕt like this, and out
of sheer greed and perceived necessity they used their economic clout to
restrict the use of contract sales. Today, it is very difficult to find a
mortgage that does not have a Òdue on saleÓ clause in it. With this widespread practice, they
have plugged a safety valve that had been available to stressed property owners
during times when mortgage lending is tight or real estate markets were in
decline.
Higher
interest rates are leveled at the most vulnerable, and are punitive measures
presumably for a customerÕs prior poor credit record. Loans to such borrowers are sometimes characterized as a
Òdrop in standards.Ó One problem
is that ÒstandardsÓ almost always have a punitive bias against the borrower and
may have a perverse effect against the lender. For instance, the 100% financing of a home is one such
drop in standards, which provides an opportunity for higher interest
rates. The fact of 100%
financing is less of a problem per se
that are the terms under which it is made. While the lenderÕs justification is
that because this borrowerÕs weak credit profile makes him a Òmore riskyÓ
investment for the bank, it may also make him look like a profitable
opportunity to the bank. Rational
economics would expect that a borrower with ÒweakÓ credit will have to pay a
higher rate of interest, but this more fragile borrower is one who needs a more
stable and affordable loan arrangement.
So offering this borrower a higher priced loan has the perverse effect
of a self-fulfilling prophecy—it decreases the chance that the loan is
affordable and increases the chance for a default.
ÒWhy
are the most risky loan products sold to the least sophisticated
borrowers? The question answers
itself,Ó according to the late Edward M. Gramlich, an appointee to the Federal
Reserve, and head of the FedÕs Committee on Community and Consumer Affairs,
1997-2005, ÒThe least sophisticated
borrowers are probably duped into taking these products.Ó
1/3/08