Fed chairman concerned about risky mortgages

WASHINGTON -- Federal Reserve chairman Alan Greenspan is turning up the volume on his warnings about the potential perils of certain risky mortgages if the high-flying housing market loses significant altitude.

There are signs some companies are getting the message. A few have begun scaling back some types of those mortgages or making them less appealing by raising costs.

Greenspan mostly is worried about homeowners who took out an interest-only mortgage or option adjustable-rate mortgages to buy property they otherwise could not afford. Borrowers and lenders holding such loans could get clobbered if housing prices drop or interest rates rise.

"In the event of widespread cooling in house prices, these borrowers, and the institutions that service them, could be exposed to significant losses," Greenspan said recently.

Doug Duncan, chief economist at the Mortgage Bankers Association, said it's "not only Greenspan, but it is also the market" that is driving some changes.

"If you are going to make a loan, you either have to be able to hold it in your own portfolio or you have to have someone to sell it to," Duncan said. As some investors demand a higher return for the risk they are taking, some companies may boost loan costs. "If you change the pricing, there's going to be fewer borrowers for which the loan will be viable," Duncan said.

Interest-only mortgages require that the homeowner initially pay only the interest on the loan for a set period. Option ARMs gives the homeowner flexibility to decide how much to pay each month. One of the options is a minimum payment that covers only a portion of the monthly interest.

These mortgages are appealing to people who need cash for other expenses. But it also exposes them to far greater risk -- if housing prices drop, their loan could be worth more than their property. If interest rates rise, their loan will become expensive to pay off.

The Mortgage Bankers Association estimates that interest-only loans accounted for 17 percent of the $1.225 trillion in home loans originated in the second half of 2004, the most recent period for which this information is available.

Previously, the association did not break out these types of loans.

It does not have figures for option ARMs.

Banking regulators are monitoring the flurry of risky mortgages and plan to issue regulatory guidance to banks.

"The easier availability of first mortgages has helped many marginal borrowers obtain loans and it has helped banks sustain loan volume and profits," said John Dugan, comptroller of the currency.

"But looser underwriting standards and the more widespread penetration of riskier mortgage products have raised questions about how these loans will fare in the event of a rise in interest rates or a softening in house prices," Dugan said.

Though there are signs of cooling, home sales still are on pace for a fifth straight record yearly increase, powered by low interest rates. Meantime, prices have skyrocketed.

The average home price soared by 13.43 percent during the 12 months ending June, the biggest gain in more than a quarter-century, according to the Office of Federal Housing Enterprise Oversight.

Nevada had the biggest increase, 28.13 percent, followed by Arizona, 27.82; Hawaii, 25.92; California, 25.16; and Florida, 24.45.

Greenspan has warned homeowners, lenders and investors that they should not count on similar increases. "History has not dealt kindly" with that kind of optimism, he said in August.

When the housing boom simmers down, prices will not rise nearly as much and could fall in some markets, he said.

New Century Financial Corp. is reducing the number of interest-only mortgages it issues to 25 percent during the second half of this year from 33 percent in the first half. It does not offer option ARMs.

A lessened appetite for these loans among investors in the secondary mortgage market was a driving factor behind the decision. In the secondary market, loans are purchased from banks and other lenders, pooled together, then sold to investors around the world.

H&R Block's Option One Mortgage raised the rates to brokers on all its mortgage products, including interest-only loans, by four-tenths of a percentage point. The boost was needed in part because profit margins had gotten extremely tight, spokesman David Gunasegaram said.

The company does not have plans to reduce interest-only mortgages. They accounted for 13.2 percent of mortgages granted to consumers through its retail business in the May-through-July quarter and 24.5 percent sold to brokers through its wholesale business. The mortgage lender does not offer option ARMs.

At Wells Fargo, interest-only mortgages so far this year make up about 25 percent of the mortgages it originates. It does not provide option ARMs. There are no plans to trim interest-only loans.

"We'll monitor the volume. We'll monitor the credit quality and as long as everything looks good we'll continue to offer it," said Greg Gwizdz, executive vice president and retail national sales manager for Wells Fargo Home Mortgage.

For prospective home buyers, there are a multitude of financing choices. That means it is more important then ever to do homework, ask questions and figure out what you can truly afford and be comfortable paying.

Lenders say they lay out to customers the risks and benefits of interest-only as well as other types of mortgages.

"In the end, we are here to provide a service," Gwizdz said. "If the customer really wants it, we are going to give it to them. Keep in mind we do have our credit guidelines. So the person will still have to qualify, will still have to have the down payment and the proper credit scores, the proper income and everything else."

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