Trends in the Marketplace: Exotic Mortgages and Their Impact on Low to Moderate Income Communities Facilitated by David Berenbaum Instructor, NCRC Academy

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Trends in the Marketplace Exotic Mortgages and
Their Impact on Low to Moderate Income
Communities Facilitated by David
BerenbaumInstructor, NCRC Academy
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Introduction

• The market that borrowers see today is flooded
  with enticing mortgage products boasting record-
  low introductory rates, interest-only loans,
  option adjustable-rate mortgages (ARMs), no money
  down, and no income documentation required.
• Originally considered nontraditional mortgages
  because of their high risk and small pool of
  qualifying borrowers, these products are now
  cropping up nationwide and becoming mainstream.

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• In 2005, 63 of new mortgages were interest-only
  and adjustable-rate mortgages. Over an 18-month
  period in 2004 and 2005, approximately one-third
  of homebuyers did not put any money down for
  their loan. And in California, Nevada and New
  Jersey, negative amortization loans accounted for
  27.5, 20.1, and 14.2 of non-agency
  securitizations in the state.

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• As lenders increasingly and excessively target
  borrowers with these dangerous products, the
  potential risk of payment shock, negative
  amortization, loss of equity and ultimately loss
  of home will also continue to escalate for
  borrowers.
• We hope to orient member agencies to the steps we
  need to take in order to inform our clients about
  these products and to urge regulatory agencies to
  prevent lenders from making unnecessary and
  inappropriate loans.

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The Wink-Nod

• The proliferation of exotic mortgages has
  largely occurred because more than 70 of
  mortgage origination is through wholesale
  channels rather than retail. The industry is
  incentivized to qualify the borrower and will
  find the product to match affordability. This
  places the lending industry in a precarious
  position. On one hand they are encouraging home
  ownership, but on the other hand, it has been one
  of the factors in the run-up in housing prices.
  - John Miller, Miller Samuel

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Joint Center for Housing Studies

• Between 5-10 of American Households will see
  their Mortgage reset in 2006 - Harvard State of
  the Nations Housing Report
• 6 likely
• Percentage to increase annually due to prevalence
  of ARMs.
• One-third of households spend more than 30
  percent of their income on housing, and more than
  one in eight spends more than 50 percent. The
  number of such cost-burdened household jumped by
  5 million from 2000 to 2003, the Harvard Center
  calculates.

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• Overall 35 percent of mortgage loans in 2005
  carried adjustable rates, up from just 18 percent
  in 2004.
• In the mid-1980s, more than 50 percent of
  mortgages were adjustable, but back then
  short-term rates were significantly lower than
  rates on traditional 30-year mortgage loans.
• The difference now is that home buyers
  essentially are grabbing loss-leader rates that
  are almost certain to require sharply higher
  payments in a year or two.

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When exotic mortgages reset.

• Lets begin our discussion by introducing and
  reviewing the most recent and exotic mortgage
  products out there, along with the types of
  borrowers who should steer clear of them or, in
  the alternative, can reasonably consider them.
• Foreclosure Risk
• Safety net for securitizers - insurance

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• Twenty-nine percent of borrowers who took out
  mortgages last year have no equity in their homes
  or owe more than their house in worth - Study by
  Christopher L. Cagan, director of research and
  analytics for First American Real Estate
  Solutions, a unit of First American Corp.
• That compares with 10.6 of those who took out
  loans in 2004.

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• Credit Suisse study looked at borrowers with good
  credit who were at least 90 days late on their
  mortgages.
• Credit Suisse found that borrowers who took out
  adjustable-rate mortgages in 2005 were three
  times as likely to be delinquent on their
  payments after the first year as those who took
  out ARMs in 2003 and 2004. Payments on ARMs can
  adjust after as little as a month, or after
  several years, depending on the terms of the
  loan.
• The study didn't include borrowers with option
  ARMs.

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• Credit Suisse also found that borrowers who were
  delinquent were more likely to have lower credit
  scores and to have taken out piggyback mortgages,
  which combine a mortgage with a home-equity loan
  or line of credit.
• It also found that delinquency rates were
  shooting up in California, where double-digit
  gains in home prices have made affordability an
  issue.
• MBA reports increase in delinquency, roughly 4.7
  of residential mortgages were delinquent in the
  fourth quarter of 2005. Excluding the effects of
  Hurricane Katrina, delinquencies were 4.55. That
  is up from 4.44 in the third quarter and 4.38
  at the end of 2004.

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The Color of Money
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Exotic Mortgage Types

• 40-Year Mortgage
• Portable Mortgage
• Interest-Only Mortgage
• Negative Amortization Mortgage
• Flex-ARM Mortgage

• Piggy Back Mortgage
• 103s and 107s
• Home Equity Line of Credit
• Loan Modification Mortgage
• ?Short-Term Hybrids.

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Forty Year Mortgage

• These products are similar to 30-year fixed-rate
  mortgages, except that borrowers stretch the
  payments out for an extra 10 years. Lenders,
  however, often charge a slightly higher interest
  rate, up to half a percentage point.

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• Pros A 40-year mortgage offers lower monthly
  payments than a 30-year loan, while locking in
  today's attractive interest rate. On a 300,000
  mortgage at today's prevailing interest rates (6
  for a 30-year and 6.25 for a 40-year), a home
  buyer could save nearly 95 each month.
• Cons By extending the length of the mortgage,
  the borrower increases the amount of interest
  paid over the life of the loan. On that same
  300,000 mortgage, a home buyer would spend an
  additional 170,030.42 using a 40-year mortgage.
• Good For Experts recommend this product only
  for first-time home buyers who don't plan on
  staying in the house for more than a few years,
  and who can't afford the higher monthly payment
  associated with a 30-year mortgage. NCRC is
  critical of this product.

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Portable Mortgages

• In 2003, ETrade launched a program called
  Mortgage on the Move It allows home buyers to
  lock in today's low interest rates and take the
  loan with them should they move into a new house
  a few years down the line. A second mortgage can
  be used if the buyer needs to borrow more money
  for the next home.

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• Pros With current mortgage rates low and by
  most estimates likely to rise locking in
  today's rate for the next 30 years is attractive.
  
• Cons Interest rates for portable and second
  mortgages come at slightly higher interest rates
  than do standard loans. A portable mortgage is
  priced at 3/8 to 1/2 a percentage point higher,
  and a second mortgage is often 3/4 of a
  percentage point higher than a typical 30-year
  fixed-rate product, based upon NCRC product
  review.
• Good For People who know they will be moving in
  a reasonable amount of time and want to lock in
  at a low rate.

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Interest Only Loans

• With an interest-only loan, lenders allow
  borrowers to pay just the interest portion of
  their mortgage during the first, say, 10 years of
  their commitment. After that, the loan
  essentially becomes a new mortgage with new
  interest and principal payments stretched out
  over just 20 years.

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• Pros In addition to smaller monthly payments
  during the interest-only repayment period, all of
  the money a borrower puts toward the mortgage
  during this time period is tax deductible.
• Cons Should home prices stagnate, or depeciate,
  homeowners would build up no equity during the
  interest-only years. Also, monthly payments jump
  significantly once the principal-payment period
  begins. Most of these loans also carry variable
  interest rates, further increasing a borrower's
  risk for higher monthly obligations.

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• Good For Consumers who know (and remember, there
  are no guarantees in life) that their incomes
  will rise significantly over the next few years
  not low to moderate income consumers.
  Interest-only loans can also be a good option for
  professionals who receive bonus payments as part
  of their compensation. This product allows them
  to make minimum payments during most of the year
  when cash is tight and then put down several
  thousand dollars toward principal when they get
  their bonus checks. NCRC is critical of this
  product.

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Negative Amortization Loan

• This interest-only product allows buyers to pay
  less than the full amount of interest necessary
  to cover the costs of the mortgage. The
  difference between a full interest payment and
  the amount actually paid each month is added to
  the balance of the loan.

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• Pro An even smaller monthly payment than an
  interest-only mortgage, during the first few
  years of the loan.
• Con This is the riskiest mortgage lenders offer.
  Should housing prices stagnate or fall, buyers
  would find themselves "upside down" or in
  "negative equity," meaning they would owe money
  to the lender if they sold their homes. NCRC is
  critical of this product.
• Good For Sophisticated borrowers with large cash
  reserves who want the flexibility of lower
  payments during certain parts of the year but
  plan to pay off their loans in large chunks
  during other parts the year.

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Flex-ARM Mortgage

• This is a cross between a hybrid ARM, which
  offers a lower fixed rate during the first five
  or seven years and then adjusts annually, and a
  negative amortization loan.
• Each month the lender sends the borrower a
  payment coupon that calculates four possible
  payment options a negative amortization, an
  interest-only, a 30-year fixed and 20-year fixed.
  The homeowner then decides how much he wants to
  pay. (Some mortgages offer only an interest-only
  and a 30-year fixed option.)

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• Pro The bank does all the thinking. Each month
  it recalculates the balance and tells the
  borrower how much he or she would owe under
  different scenarios, giving the homeowner
  significant flexibility.
• Con Borrowers could end up owing more money on
  their mortgage than they can fetch for their
  homes.
• Good For People who like options and have large
  cash reserves for when the mortgage payments
  increase during the later portion of the loan.
  Like interest-only loans, Flex-ARMs may be good
  tools for those who derive much of their income
  from bonuses. NCRC is critical of this product
  because consumers will of get into the trap of
  negative amortization.

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Piggy Back Mortgage

• This product is actually two mortgages. The first
  covers 80 of the property's value. The second,
  which comes at a slightly higher rate, covers the
  remaining balance

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• Pro In most cases, homeowners save money by
  taking out a piggy-back loan (also known as a
  combo loan) since it allows them to avoid paying
  costly private mortgage insurance when buying a
  home with less than a 20 down payment. Plus, the
  money that would have gone toward PMI is now tax
  deductible, since it's going toward an interest
  payment.
• Con As we mentioned, borrowers pay a higher
  interest rate on the second mortgage. And rates
  can vary greatly depending on credit score. Also,
  since the borrower has little equity in the home,
  should it fall in value when it's time to sell,
  the borrower would need to pay the difference in
  cash. NCRC is critical of this loan product due
  to fair lending pricing concerns and the fact
  that many predatory loans involve Piggy-Back
  mortgage products.
• Good For Folks with high salaries but little
  savings.

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103s 107s

• Who needs a down payment? Nowadays, people can
  even borrow 3 to 7 more than the house is
  worth.
• Good For People with large cash reserves who
  prefer to invest in, say, the stock market rather
  than tying up their assets in real estate, and in
  some cases when tied to comprehensive housing
  counseling or special homeownership mortgage
  initiatives, first time homebuyers.

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Home Equity Line of Credit

• Known in the industry as HELOCs, these products
  let buyers finance home purchases or use the
  equity in their existing home using a credit line
  rather than a traditional mortgage. HELOCs are
  variable-rate loans tied to the prime rate. If a
  HELOC is used as a first-position loan, all of
  the interest is tax deductible. Here's how it
  works The buyer makes a down payment, and the
  credit line covers the rest. HELOCs typically
  cover up to 90 of the appraised value of the
  home. Lenders also offer up to 100, at
  significantly higher interest rates

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• Pro In this environment, HELOCs offer much more
  attractive interest rates. A 30-year fixed-rate
  mortgage now carries a 6 interest rate,
  Borrowers can also take out additional funds
  against the equity in their homes without hassle
  or additional cost.
• Con Most HELOCs are structured for just 10 or 20
  years, rather than the customary 30. And since
  the interest rate is variable, payments can be
  volatile, and can rise substantially higher
  alongside the prime rate.
• Good For People who plan on paying off their
  home quickly but want the flexibility of access
  to more cash at a moment's notice. This is not
  the typical NCRC members agency constituent.

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Loan Modification Mortgage

• With this loan, the borrower can subsequently
  change the terms just by making a phone call,
  with a capped closing cost each time of just
  1,000 for every million dollars borrowed.
  Moreover, the mortgage's duration isn't changed
  each time the rate is modified.
• Pro No paperwork is necessary, and closing costs
  are kept to a bare minimum.
• Con The added flexibility comes with a price tag
  of roughly 3/8th of a percentage point on every
  type of loan.
• Good For People who like to follow interest
  rates. But borrowers should make sure to factor
  in the 1,000 fee every time they consider
  modifying their loan. To quote an industry
  source, most of this products customers have
  financial planners who manage their mortgages for
  them. Again, not the typical NCRC member agency
  constituent.

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Short-Term Hybrids

• Like traditional hybrid adjustable-rate
  mortgages, these short-term ARMs offer fixed-rate
  periods and then the interest rate floats with
  the index they're tied to. But since the fixed
  portion is for a very limited time say, six
  months or one year lenders offer very
  competitive rates.

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• Pro Very low interest rates during the fixed
  portion of the loan. The initial monthly payments
  are relatively small.
• Con Six months or a year can pass by in the
  blink of an eye and rates can change
  dramatically during that span. Back in July 2003,
  for example, Charles Schwab offered a six-month
  ARM with an interest rate of 2.995. Today, that
  same product sits at 5.1. On a 250,000 loan,
  that would mean an increase of 400/month.
• Good For People who plan on moving in a very
  short period of time, again, not the typical NCRC
  Member constituent.

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The Legal Toolbox

• Appraisal Valuation issues, FIRREA and USPAP
• Federal Fair Housing Act Steering Complaints
• Truth In Lending Act (TILA)
• Equal Credit Opportunity Act (Reg B)
• Home Ownership Equity Protection Act (HOEPA)
• Home Mortgage Disclosure Act (Reg C)
• Community Reinvestment Act - Wachovia Merger
• Fair Debt Collection Practices Act
• Real Estate Settlement Procedures Act (RESPA).
• State Local Protections
• Fraud Racketeering Arguments
• FTC Act

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Interagency Guidance

• Federal Agencies issue guidance on
  non-traditional mortgages on September 29, 2006
• Guidance addresses interest-only and option ARM
  loans
• Guidance does not cover fully-amortizing ARM
  loans such as 2/28 and 3/27 loans

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Interagency Guidance

• Fully Indexed Rate assuming Full Amortization
  Non-traditional loans should not be underwritten
  using the initial teaser rate, but should be
  underwritten using fully indexed rate (rate at
  loan origination plus margin). Loans should be
  underwritten based on the term of the loans.
• Loans Permitting Negative Amortization Loans
  should be underwritten based on initial loan
  amount plus any balance increase that may accrue
  from negative amortization

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Interagency Guidance

• Collateral Dependent Loans Agencies will
  consider loans to be unsafe and unsound when the
  lender has not qualified borrower based on
  ability to repay but instead assumes that the
  borrower will be able to sell or refinance the
  loan based on the value of the property.

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Interagency Guidance

• Risk Layering Combining non-traditional
  features such interest-only, simultaneous second
  liens, or reduced income documentation. When
  risk factors are layered, mitigating factors are
  needed such as higher credit scores, or lower
  Loan to Value ratios, or lower Debt to Income
  ratios.
• Stated Income should only be used if mitigating
  factors reduce risk. Generally, lenders should
  use W-2s, paystubs, or tax returns in
  underwriting.
• Simultaneous Second Liens or Piggyback
  Borrowers with minimal equity should not have
  delayed or negative amortization.

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Interagency Guidance

• Introductory Rates Lenders should minimize
  spread between introductory rates and fully
  indexed rates so that borrowers do not experience
  payment shock.
• Brokers Monitor third parties including brokers
  to ensure that brokers are adopting the lenders
  standards. Terminate relationships with brokers
  as needed.

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Interagency Guidance

• Consumer protections Disclosures recommended
  before the disclosures required by the Truth in
  Lending and other laws. Disclosures should occur
  when consumes are shopping and not only when Good
  Faith Estimate is issued and consumer has paid
  fees.
• Advertising Lenders should describe risks as
  well as benefits of non-traditional loans
• To minimize chances of payment shock, disclosures
  could include the maximum monthly amount a
  consumer could pay.

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Interagency Guidance

• Consumer Disclosures Borrowers should be
  clearly informed of prepayment penalties and the
  possibilities of negative amortization for option
  ARM loans. Consumers should be alerted to the
  price premium associated with reduced
  documentation loans.
• Clear disclosures of Impacts of Choices
  Borrowers should be clearly informed of how their
  choice of monthly payment options affects the
  amount paid off each month or whether negative
  amortization results
• Avoid deceptive practices such as emphasizing
  benefits and obscuring significant risks to
  consumer.

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Subprime Guidance

• The non-traditional guidance did not cover
  subprime 2/28 and 3/27ARM loans. The regulators
  have just issued proposed guidance to cover 2/28
  and 3/27 loans. The proposed subprime guidance
  is very similar to the non-traditional guidance.
  It is good overall, but should also apply to
  prime ARM loans
• Freddie Mac adopted many elements of the proposed
  subprime guidance a few days before the agencies
  issued the proposed guidance.

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Building Coalition

• Building coalition to address the issue, change
  practices and create a safety net Group
  exercise on next steps and a discussion of the
  NCRC Consumer Rescue Fund.
• Nontraditional mortgages pose heightened risk to
  sub-prime borrowers. Already beginning the life
  of their loan with higher interest rates due to
  credit blemishes, sub-prime borrowers are often
  more sensitive to rate fluctuations than prime
  borrowers.

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CFA Study

• Exotic or Toxic? An Examination of the
  Non-Traditional Mortgage Market for Consumers and
  Lenders - Consumer Federation of America, May,
  2006

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• Significant Shares of Non-Traditional Mortgage
  Borrowers Earn Less Than 70,000 Annually. More
  than one third (36.9) of interest only borrowers
  earned below 70,000 annually and about one in
  six (15.6) earned under 48,000 annually. More
  than one third (35.0) of payment option
  borrowers earned under 70,000 annually and about
  one in eight (12.1) earned between under
  48,000. (70,000 was about the median for
  Atlanta, Philadelphia and Chicago metropolitan
  areas, according to HUD figures for 2005, and the
  national median is 44,300.)

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• African Americans and Latinos More Likely to
  Receive Payment Option Mortgages Latinos are
  nearly twice as likely as non-Latinos to receive
  payment option mortgages. One in fifty (2.1)
  non- Latino borrowers received payment option
  mortgages compared to the 4.0 of Latinos that
  received payment option mortgages. African
  Americans were 30.4 more likely than non-African
  Americans to receive payment option mortgages.
  2.2 of non-African Americans received payment
  option mortgages compared to 2.9 of African
  Americans.

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• African Americans were more likely than
  non-African Americans to receive interest-only
  loans. Nearly one in ten (9.0) of African
  Americans received interest-only mortgages, 11.7
  higher than the 8.1 of non-African Americans
  that received interest-only mortgages.

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• Many Non-Traditional Borrowers Have Only Average
  or Even Weaker Credit Scores. More than half
  (53.8) of payment option borrowers and nearly
  two-fifths (38.0) of interest only borrowers
  have credit scores below 700. More than one
  fifth (21.4) and about one in eight (12.1)
  interest only borrowers had credit scores below
  660.

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• The majority of these two types of
  non-traditional mortgages are used to purchase
  homes. Nearly four out of five (79.0)
  interest-only mortgages and nearly three fifths
  (57.5) of payment option loans were used to
  finance the purchase of a home. The high
  proportion of purchase mortgages in the
  non-traditional mortgage portfolio tends to
  support the contention that the increased use of
  these mortgage products is related to the rapidly
  escalating cost of housing.

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CFAs Bottom Line

• Many borrowers are increasingly relying upon
  non-traditional mortgages as a means to buy homes
  they could not otherwise afford. Non-traditional
  mortgage products typically offer initial lower
  monthly payments than traditional fixed-rate
  loans. But when these loan terms reset after a
  brief period, usually 2 to 5 years, consumers
  could be vulnerable to payment shocks, making
  their homes suddenly unaffordable and potentially
  ruining their finances.
• For example, a 200,000 home with adjustable rate
  (ARM) non-traditional mortgage, an interest only
  ARM payment would rise by 54 and a payment
  option ARM payment would rise by 123 if the
  interest rate rose from 5.00 to 6.50.

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• Question Answers
• For more information, please contact me at (202)
  464-2712 or dberenbaum_at_NCRC.org
• Thank you for participating today!