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Third of all loans in 2004 adjustable rate { June 26 2005 } Original Source Link: (May no longer be active)
http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2005/06/26/BUGL5DEQJU1.DTLLast year, interest-only loans, which are typically adjustable rate and don't require any principal payments for a number of years, accounted for nearly a third of all new mortgages that were packaged and sold to investors, according to Loan Performance, a mortgage data company.
http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2005/06/26/BUGL5DEQJU1.DTL
Investors now shouldering the risks for home mortgages
- Kathleen Pender
Sunday, June 26, 2005
If the housing market weakened or collapsed and homeowners started to default on their mortgages in big numbers, who would be left holding the bag?
Thanks to the growing secondary market for home mortgages, much of the default risk has been transferred from banks, thrifts and other lenders to investors who buy loans or, more often, interests in mortgage-backed securities.
These investors include pension and mutual funds, insurance companies and hedge funds, both domestic and foreign.
Fannie Mae and Freddie Mac, the government-sponsored entities that guarantee certain home loans, keep some of the mortgages they insure and buy interests in other mortgage pools, including uninsured ones. Many banks and thrifts also buy mortgage-backed securities, in part to diversify their loan portfolios. Some lenders even buy back their own mortgages after they have been guaranteed by Fannie or Freddie.
The mortgage investors taking the most risk are believed to be hedge funds and other unregulated entities. Because they are not required to disclose their holdings, there's no way to know whether this risk is spread out or concentrated in a few funds that could spark wider financial problems if they failed.
"I'm not sure anyone knows where, if anywhere, these risks are accumulating," says Keith Gumbinger, a vice president with HSH Associates, a mortgage information company.
To be sure, most home mortgages are considered high quality and unlikely to default unless we get a recession equivalent to the Great Depression. But there's no question that lenders over the past year and a half have become more willing and able to make riskier loans.
On June 9, Federal Reserve Board Chairman Alan Greenspan told Congress, "The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern."
Last year, interest-only loans, which are typically adjustable rate and don't require any principal payments for a number of years, accounted for nearly a third of all new mortgages that were packaged and sold to investors, according to Loan Performance, a mortgage data company.
An estimated 5 percent of those packaged loans were option ARMs, which let homeowners choose a variety of monthly payments, including one that is interest-only and one that does not even cover all the interest. The unpaid interested is added to the loan balance.
Traditionally, interest-only loans and option ARMs were niche products sold to higher-income borrowers who wanted to increase their tax deduction (by making their entire payment interest-only) or redirect the money they would have devoted to principal into other investments.
But recently, these loans have been pitched as an affordable product to people who are stretching to buy any house, or a bigger house.
Standard & Poor's, which assigns credit ratings to mortgage securities, took a new look at option ARMs when it noticed a drop in the average credit score of people who were taking them out.
The scores are still "very, very high," says S&P analyst Michael Stock, but "as it moves into the mass market, we were concerned that borrowers don't totally understand what they are getting into."
Last week, S&P announced that it will require greater credit enhancement in mortgage pools to account for the greater risk of option ARMs.
To understand where the risk in mortgages lies, it's important to know how the market works.
There are two types of mortgages: conforming (or conventional) loans are those that can be insured by Fannie Mae or Freddie Mac. To qualify for insurance, a loan on a single-family residence can't exceed $359,650, and it can't be for more than 80 percent of the home's value. The borrower also must have good credit.
Loans that can't be insured are called nonconforming and are generally considered higher risk than conforming loans.
When a bank or other lender makes a loan, it can either keep it or sell it to an investment bank or other intermediary operating in the secondary market. These intermediaries package loans, often from multiple lenders, into pools and sell interests in the pools to investors.
Conforming and nonconforming loans are packaged separately.
Securities backed by pools of conforming mortgages are considered almost risk-free because if the borrowers default, Fannie or Freddie will pay off the loans (assuming Fannie and Freddie remain solvent).
Nonconforming loans go into pools known as private-label securities.
In the first quarter of 2005, loans in private-label mortgage securities accounted for 14.4 percent of all outstanding residential mortgage loans, up from just 9.7 percent in 2003, according to Federal Reserve data.
Although private-label securities are riskier than pools of conforming loans, some are riskier than others.
For example, loans that are over the $359,650 limit made with large down payments to borrowers with high credit scores might go into a jumbo-prime pool, while loans made with low down payments to borrowers with sketchy credit histories might go into subprime pools.
The nation's rating agencies -- Standard & Poor's, Moody's and Fitch --
rate these pools based on their likelihood of default.
Even within each pool, there are different levels of risk.
Typically, each pool is sliced up into different classes, called "tranches." As borrowers make principal and interest payments on their mortgage, the money is paid first to people holding the AAA-rated slices, then to the AA-rated slices, then to A-rated slices and so on. The percentage of the pool allocated to each rating category depends on the quality of the underlying mortgages.
Lower-rated slices carry higher yields, to make up for the added risk.
If defaults in the pool are the same or lower than expected, investors with the lowest-rated or unrated slices can end up with very large payoffs -- 20 percent a year or more on average in some cases. But if defaults come in higher than expected, they could end up with nothing.
"The margin of error is large. You have a fraction of a percent of the pool and all the default risk," says Arthur Frank, director of mortgage research with Nomura Securities International.
Most mortgage securities are rated AAA and are highly unlikely to default. Most banks, pension and mutual funds stick with investment-grade mortgages securities, meaning those rated BBB or higher.
Mortgage securities that are either below investment grade or not rated are purchased mainly by hedge funds and other specialty investors, says Frank.
Theoretically, these are sophisticated investors who understand the risks they are taking and can absorb the potential losses.
If one or more were to go under, most experts say, they would not pose the same risk to the financial system that the failure of Long Term Capital Management did, mainly because they are not as large or as leveraged.
Also, Long Term Capital Management came to dominate a few small markets, whereas the hedge funds buying risky mortgage securities account for a small piece of an enormous market, says banking analyst Richard Bove of Punk Ziegel & Co.
Even so, the failure of a few hedge funds could have a ripple effect on the housing market.
"A modest economic slowdown could well be enough to make housing prices go down a few percent, and that would be sufficient to increase defaults," says Frank. Those defaults "get leveraged up to the (mortgage-backed security) market, some hedge funds go down, the whole market perceives there is more risk, then lending gets tighter."
People who had taken out interest-only loans or option ARMs, hoping to refinance before their mortgage payments go up, could be unable to do so, and that could put further downward pressure on housing prices.
"I don't think it could spiral into a true housing depression," Frank says, but it could cause problems.
Today, the housing market is enjoying the best of all worlds: low interest rates, a growing economy and investors willing to buy ever-riskier loans. "You probably only need to lose one of those things to cause some pain, " Frank says. "If you lose all three, you will have real pain."
Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at kpender@sfchronicle.com.
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