Street in mortgage product driving seat

The Federal Reserve Board imposed its fifth and final interest rate hike of the year on Dec. 14, and while it won’t have any immediate effect on the booming mortgage market, the industry is keeping a nervous watch as it anticipates higher rates and an end to the glory days.

Wall Street, which develops mortgage products, is keeping an especially close watch. Intent on keeping the mortgage juggernaut rolling, it has been devising an increasing number of alternatives to fixed-rate loans to cushion the blow.

Products such as hybrid adjustable-rate mortgages, interest-only loans and pay-option mortgages assure a steady stream of buyers willing to pay lower rates up front, and provide continued returns for those backing the $3.5 trillion mortgage backed securities business.

While such products were initially designed for buyers with high but sporadic incomes, such as bankers who receive large year-end bonuses, these products are now being marketed to the masses.

Some analysts are concerned that looser credit from lenders will erode underwriting standards and that these products could lead to many homebuyers overextending themselves.

“It’s in everyone’s interest to keep things rolling,” says Michael McMahon, a bank analyst and managing director at Sandler O’Neill & Partners. “It’s in Wall Street’s interest to keep developing products you can sell.”

The national average for a 30-year fixed mortgage hovered around 5.7 percent at press time, according to Freddie Mac. But despite the low rates, rising prices could prompt even greater numbers of buyers, particularly in the expensive New York market, to opt for alternatives to fixed-rate loans, which will keep the good times rolling for brokers uptown and bankers downtown.

While refinancing activity has dropped nationwide, the percentage of adjustable rate mortgages, or ARMs, has hit a record high, according to the Mortgage Bankers Association. ARMs made up 19 percent of all mortgage loans in 2003 but are projected to make up 35 percent in 2004, the group said.

“It’s either a record or very close to a record,” says Doug Duncan, the MBA’s chief economist.

The one-year adjustable rate average finished near 4.15 percent in mid-December, a large enough difference from the 30-year fixed rate to be the deciding factor for buyers who might have otherwise stayed out of the market.

The rush to ARMs, which now lock in fixed rates for one, three, five and seven years before shifting to the 30-year rate at the time, in what are known as hybrid mortgages, have helped New Yorkers trying to keep pace with skyrocketing housing prices. While the national average home price climbed 13 percent in 2004, New York real estate jumped more than 20 percent.

“The interest-only loan has made real estate in New York City more affordable,” says Melissa Cohn, president of the Manhattan Mortgage Company.

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But some analysts say Wall Street is driving the new array of products, rather than consumer demand. Wall Street also dictates the array of products that mortgage professionals offer to consumers.

“Wall Street has become more and more interested in mortgage products,” says Nick Bratsafolis, chairman of Homebridge Mortgage Bankers. “The need is like anything else — necessity is the mother of invention. We don’t have the driving power to say, ‘What the market needs is 3-year hybrid ARMs.’ We sell these to the Bear Stearnses and Morgan Stanleys. And even though Wall Street originates these types of transactions, the Countrywides and Washington Mutuals follow suit.”

There is a broad range of ARM products being offered. Interest-only loans have seen a big increase in volume, jumping 30 percent in first half of the year, according to the Mortgage Bankers Association. Interest-only loans represented only 2 percent of all mortgage originations in the first three months of 2004, a figure that increased to 2.6 percent for the second quarter, the most recent period for which data are available.

It’s harder to track the number of so-called pay-option mortgages, which allow borrowers to vary their payments each month. Borrowers can make a minimum payment of 1 percent, which is less than the market rate; pay only the interest, or pay as much as they wish. For example, a $600,000 mortgage at 6 percent would have a fully amortizing payment of $3,048 a month, but the interest only tab would be $2,261 a month. The 1 percent option would be $1,929 a month, which would lead to negative amortization, or money being added back to the outstanding principal.

Consumer advocates warn that these products could lead to many homebuyers overextending themselves, but some pay-option and some types of interest-only loans, particularly ones that don’t carry prepayment penalties, are particularly suited to the New York market, where borrowers who get large bonus payments such as Wall Streeters and elite lawyers can set the pace at which they repay the loan principal, without committing themselves to high monthly expenses.

“What’s changed in the marketplace is the advent of more traditional lenders offering interest-only on a widespread basis,” says Cohn. “Typically, these loans were available through private banks and were only for high-end borrowers.”

There are also risks associated with the explosion of ARMs on the investment side, analysts say.

For example, McMahon cites the prospectus of a recent collateralized mortgage obligation, or CMO, offered by IMPAC Mortgage Holdings, a mortgage investment group with a market capitalization of $1.67 billion.

He says nearly 80 percent of that CMO’s underlying loans are interest-only, and that volume could mean less qualified borrowers are flocking to these products. This could be a sign of danger, though underwriters the people responsible for evaluating the creditworthiness of buyers routinely base their decisions on higher rates than a borrower would actually pay.

McMahon adds that IMPAC as a whole reports that only 10 percent to 20 percent of its underlying loans are interest-only, and that the company continues to perform well. Over the last 12 months, the company’s shares have risen from $17.15 to $23.67 as of Dec. 14.

While it’s clear that the rise of ARMs and interest-only loans is putting more people into their own homes, a continuing rise in rates could prove the national housing boom is, in fact, a bubble.

“It’s a little early to tell,” says McMahon. “It seems to me the jury’s still out on IOs. You have to go through a credit cycle or two to find out.”


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