Mortgage Features Can Cause Mischief


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,  “Unfair and deceptive acts and practices hurt not just borrowers and their families, but entire communities, and indeed, the economy as a whole,” 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 “was ill suited to investigate deceptive lending practices.”   The New York Federal Reserve Bank, according to the New York Times declared, bluntly, “no bubble exists,” in 2004, and Greenspan further argued the Fed’s 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 “mortgage backed securities.” 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 “stated income loans,” which do not require borrowers to document income, “piggyback loans,” loans not requiring a down payment, and “option ARMS” 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 borrower’s ability to pay.  From a borrower’s point of view, these mortgages are to be avoided at all costs. From a lender’s 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 writer’s 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 “teaser rate.”  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, “rate adjustments are not a primary cause of default.”


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 borrower’s 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 “conventional” 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 borrower’s 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 borrower’s 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 doesn’t 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 seller’s 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 can’t 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 “on contract.”  The new “owner” 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 “owner” 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 “due on sale” 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 can’t refinance or doesn’t 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 “on contract” 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 “on contract” at a rate of 8% interest.  I am making money on the bank’s 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 didn’t 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 “due on sale” 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 customer’s prior poor credit record.  Loans to such borrowers are sometimes characterized as a “drop in standards.”  One problem is that “standards” 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 lender’s justification is that because this borrower’s weak credit profile makes him a “more risky” 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 “weak” 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.


“Why are the most risky loan products sold to the least sophisticated borrowers?  The question answers itself,” according to the late Edward M. Gramlich, an appointee to the Federal Reserve, and head of the Fed’s Committee on Community and Consumer Affairs, 1997-2005,  “The least sophisticated borrowers are probably duped into taking these products.”