Minimum-Payment Loans Get Maximum Crackdown
Federal financial regulators appear to be on the verge of reining in one of the most popular mortgages in hot housing markets nationwide -- loans that allow 1 percent to 2 percent payment rates leading to "negative amortization."
In a speech last week to the Consumer Federation of America, Comptroller of the Currency John C. Dugan hinted strongly that banks and their mortgage subsidiaries can expect significantly toughened rules for 2006 governing "payment-option" home loans. Payment-option mortgages have accounted for about a third of all new home loans originated by some major lenders this year. They are especially popular in high-price, high-appreciation markets on the west and east coasts because their low payments permit buyers to purchase costly properties they would otherwise be unable to afford.
Payment-option mortgages typically carry 30-year terms, but allow up to five years of reduced rates as one of several optional payment plans. The other two options allow interest-only monthly payments or fully amortizing payments including principal reduction. About 70 percent of borrowers choose the minimum payment option, according to mortgage securities research.
When a buyer pays the minimum rate, the loan balance increases rather than decreases. A $400,000 original loan balance might balloon into a debt of $440,000, for example. The deferred principal and interest payments get tacked onto the homeowner's total debt on the mortgage, a process known as negative amortization.
Though many lenders restrict the total amount of negative amortization to 15 percent above the starting balance, federal regulators worry that tens of thousands of borrowers may be accumulating heavy debt loads on houses with the expectation that double-digit appreciation will bail them out.
But Dugan warned, "If real estate prices decline -- and there already is evidence of softening in some markets -- these borrowers could face the bleak prospect of loan balances that exceed the value of the underlying properties."
Payment-option plans have another major worrisome aspect, in Dugan's view: "payment shocks" of 50 percent to 100 percent looming just over the horizon. For example, a $360,000 payment-option loan with an underlying rate of 6 percent and a five-year payment-reset deadline would push a borrower's monthly payments up by 50 percent in year six, even assuming no increase in market rates, Dugan said. "If rates rise to just 8 percent, the payment increase when amortization (principal reduction) begins would [be] nearly double."
Financial regulators worry that thousands of borrowers might not be able to handle the abruptly higher mortgage payouts and would be forced to sell or default.
"Is this an appropriate product to mass-market to customers who may be looking at the less than fully amortizing minimum payment as the only way to afford a large mortgage?" Dugan said.
His clear implication was no -- a conclusion with huge potential significance for the real estate market. Dugan's office heads the Treasury Department's main regulatory oversight unit for national banks and their mortgage subsidiaries. If it directs banks and mortgage companies to stop making negative-amortization loans or sharply cut back on them -- as it did several years ago with negative-amortization plans for credit card accounts -- banks nationwide could shut off the spigots for such loans.
That, in turn, would cut off a key tool being used by buyers to qualify for high-cost homes. Prices on those houses would either have to decline to more affordable levels, or sales would plummet. Either way, it would be painful.
No drastic shut-off of that sort is expected from financial regulators. But a task force of regulatory agencies headed by Dugan's office has been studying mass-marketed creative financing products -- payment-options, interest-only, "stated income" and other minimal-documentation loans -- for the past several months.
The task force is expected to issue new guidance to banks and their mortgage subsidiaries by the end of this month on how to market, underwrite and service loans that carry elevated risks of borrower default.
Among the key focuses of the new rules, Dugan hinted, will be toughened standards on loan applicant suitability: If home buyers are not likely to be able to afford payments at higher than the minimal rate, lenders should not extend payment-option mortgages to them.
Lenders also will need to disclose all the high-risk scenarios -- declining property values, inability to handle payment increases and the dead-weight burdens of negative amortization -- that could harm borrowers. And they will need to have programs to deal with cut-rate loan deals that go belly-up.
The bottom line for 2006: Look for tougher standards on popular 1 percent and 2 percent minimum-payment plans, and fewer qualified buyers in high-cost markets where wild appreciation has been sustained in part by reality-bending rate-reduction programs.
Kenneth R. Harney's e-mail address isKenHarney@earthlink.net.