Designer mortgages increase risk

Bruce Bartlett
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Posted: Aug 30, 2005 12:00 AM

Over the weekend, Federal Reserve Chairman Alan Greenspan warned that those actively speculating in the booming housing market should be very careful.  What goes up fast can come down just as fast.

 A key factor underpinning the surge in housing prices is a belief by lenders that risks have fallen.  As a consequence, they became more willing to lend to people on terms that they would have been unwilling to accept in the past.  This made mortgages available to people who would have not previously have qualified and bigger mortgages for those with good credit.

 A new report from SMR Research found that in the first half of this year, 38.1 percent of homebuyers financed more than 95 percent of their purchase.  In other words, they bought with less than five percent down.  The percentage of those doing so has increased from 34.1 percent last year and 30.6 percent in 2000.

 The same report found that 66.3 percent of homes purchased in 2005 involved borrowing more than 80 percent of the home’s value, up from 60.9 percent in 2000.  Historically, loans with less than 20 percent equity have been considered risky.

 An important reason for the increasing loan-to-value ratio is the proliferation of what are called “piggyback” loans.  Basically, a borrower takes out two mortgages simultaneously—a first mortgage and a second, piggyback mortgage on top.  The first mortgage will be what is called “conforming,” which means that it can easily be resold on the secondary market.  The balance might be in the form of a home equity loan or credit line that is used to make the initial purchase, rather than taken out afterwards.

The effect of breaking the total mortgage into two parts like this is that it allows people to borrow more money with lower incomes than would be possible if they had a single “jumbo” loan, as would have been the case in the past.  According to a recent report from PMI, a mortgage insurance company, in many hot housing markets 60 percent of home sales are financed with piggyback loans.  The size of piggyback loans is also increasing rapidly, from $37,757 in 2001 to $51,617 in 2004.

Such loans are riskier than traditional loans because there is less equity backing the loan, making lenders more vulnerable to loss in the event of an economic downturn or falloff in home prices.

Further adding to the risk of default is the proliferation of interest-only loans. 
Historically, mortgage payments included a payment of principal that reduced the outstanding loan amount.  In 2004, a third of new home sales were financed with mortgages having no payment of principal, according to LoanPerformance.  As with piggyback loans, interest-only loans allow people to borrow more and buy more expensive housing, but with less of a margin to protect lenders from default.

Although they benefit enormously from such financial products, the National Association of Realtors recently warned about their proliferation.  It has published a pamphlet pointing out that some types of mortgages may have low “teaser” rates that escalate rapidly and may automatically add to one’s mortgage.  Other mortgages have payments that rise automatically as interest rates rise, which could price people out of their own homes if they aren’t careful.

The Realtors’ warning is admirable, but it’s hard to believe that very many real estate agents are going to go out of their way to warn potential buyers against using exotic mortgages if it’s going to cost them a sale.  So it’s really up to homebuyers themselves to use prudence and be careful about overextending themselves in a housing market that is not likely to continue rising.

As Mr. Greenspan warned on Saturday, “the housing boom will inevitably simmer down” and “prices could even decrease.”  Even if there is no increase in defaults, the leveling-off of housing prices is going to have a major impact on the economy, he said.  That is because refinancings have allowed homeowners to tap growing equity to finance consumption, which explains the nation’s zero percent savings rate.

Mr. Greenspan noted that there is a close correlation between the nation’s current account deficit, which measures the importation of foreign saving, and the extraction of home equity.  Consequently, if home prices flatten or fall, people will be forced to save more and consume less, which will reduce the current account deficit but also slow economic growth.

Although he is no alarmist, Mr. Greenspan warned on Friday that if lenders should perceive an increase in risk, rates could rise and qualifications for borrowing could tighten quickly.  “Newly abundant liquidity can readily disappear,” he noted.  Access to mortgages will become much more limited, people are going to have less money to pay for housing, and this must bring prices down.  A mild downturn could thereby become a collapse, with consequences throughout the economy.