The most used word in the world of mortgage financing during the past few weeks has been "surprise," as in, "oh my, cover your eyes and turn away from those poor wretched loans." "The U.S. mortgage giant Freddie Mac said it would no longer buy those high-risk home mortgages that it deems to be the most vulnerable to foreclosure. The surprise move came amid a deteriorating market for sub-prime loans affected by slumping home prices and rising interest rates." Freddie Mac tightens home mortgage standards, The International Herald Tribune., Feb. 28, 2007. However, the fact is that home prices are not slumping in many local markets and interest rates are plainly at the low end of historic norms. Such factors are simply not the root cause of today's mortgage instability. Instead, problems in the sub-prime mortgage market -- and a growing sense of problems in other parts of the mortgage universe -- are the result of dicey loan concepts that turned out to be exactly what any lucid person would expect: risky beyond reason. Who could have known such things? Anyone with common sense, including readers of this column. Let us begin with interest-only loans. These are mortgages where borrowers do nothing to reduce the principal for the first several years of the loan. Once the interest-only "start period" ends, the loan must be repaid at the fully indexed and fully amortizing rate. Given that most interest-only loans are adjustable, and given that fewer years remain after the end of the start period, it follows that such financing will inevitably require higher monthly payments.

"There's no doubt," it said here in 2004, "that the newest trend in real estate financing is the interest-only loan, a trend which needs to be examined with care by anyone who prefers to avoid poverty." Moreover, said the column, "with an interest-only loan your initial monthly cash payments each month will be -- and be sure to read the rest of this paragraph -- lower than with a self-amortizing loan of the same size and with the same rate and terms. However, the interest-only borrower has more debt for a longer period and thus higher total costs. And if rates rise, monthly costs and overall interest costs could be substantially larger than with fixed-rate financing."

Home prices have risen substantially since 2001 and thank goodness. While those in real estate prospered, the stock market largely took a snooze during the same period. The catch, as noted in 2005, was that "the only way we're supporting high real estate prices is by fudging traditional rules. We allow people to buy at levels that would have been unaffordable under past lending standards." "Playing mortgage roulette is fine as long as everyone realizes there are massive opportunities to lose." Is anyone "surprised" that a number of lenders are now in trouble -- and that their backers are taking losses? Why? Some of the risk represented by "non-traditional loans" can be offset by rising home values. But two years ago it was pointed out that if home values do not rise -- and they plainly have not in many areas during the past year -- then "lenders may be using Arms to offset future rate risk, but what about future asset values? Is it worth originating loans today that may sink lenders tomorrow? A large number of foreclosures won't look good on anyone's books; reason enough to tighten ARM loan standards."

One of the most widespread of the new financing concepts seen during the past few years has been the use of "stated-income" loan applications. In the summer of 2004, it was explained, "stated-income loans represent too much risk for lenders -- and too much temptation for borrowers. Perhaps a little rigidity in the lending process is not so bad. After all, how hard is it to produce tax returns and pay stubs? "What's obviously best is to get the numbers right when making a loan application," it said here in November 2004. "It's equally obvious that 'stated income' mortgages open the vault to temptation. Such no-tell loans ask borrowers what they earn and the borrower then puts down a number. Unlike a typical mortgage application, the lender usually does not verify the figure with tax returns, pay stubs or calls to employers." Of course, if it happens that self-estimates of incomes are off a touch then lenders will have problems. "With a growing number of stated income loans on the books, financing with exaggerated numbers could quickly become a lender concern if home values dip, the economy slows and monthly payments don't show up. That's the point at which stated income loans will come home to roost."

It is hard to look at the tough times now facing the mortgage industry without mentioning the worst of the worst, the option ARM combined with little or nothing down plus a stated-income loan application. Here is a loan concept, which gleefully allows borrowers to make payment and after payment that will not even cover interest costs. Obviously, -- no "surprise" here -- the loan must be repaid at some point, which means that monthly costs must rise if the loan is held past the start period. As stated here in 2005: "In the next two to four years we'll see elective payments end for many option loans. Then we will find out who should not have bought and who should not have loaned. Do not be surprised if a lot of cheap real estate floods the market -- and do not be shocked if the value of your home is impacted as a result. As to lender share prices and dividends, how attractive will such companies appear when huge numbers of loans are unpaid; especially if in many cases, the size of the debt exceeds the value of the underlying properties?

"Alternatively, if we restrict option loans now by regulation or lender choice, the pool of buyers will shrink and home prices will be under far less pressure to go up. We will see less appreciation and even price declines in some local markets. Acting now we may face moderate and tolerable declines in market activity, an opportunity which should not be ignored in the face of the financial calamity which looms ahead." The growing number of loan failures has produced a rising volume of foreclosures. RealtyTrac.com reports that foreclosure actions rose from 885,468 in 2005 to 1,259,118 in 2006 -- a 42 percent increase. The huge number of foreclosure means that we have a growing supply of distressed properties, properties that are often available at discount. Even a small number of foreclosures can drag down local real estate prices. "To believe that an increasing number of foreclosures will not have a marketplace impact is neither logical nor believable. Just ask the people in the subdivisions and condominium projects where developers have recently cut prices on just a few units.

At this writing, we have evidence that home values have fallen in about half of all major metro areas. The problem, of course, is that we really do not know the extent of value declines and thus cannot project future loan failures and foreclosure levels. "While unit sales are easy to track, data regarding recorded prices is less certain. If you have a strong sellers market, you can bet that sale prices are what people paid because sellers have no need to offer discounts and buyers will not pay any more than required. However, if you have a market that is losing steam, the same assurance is not plausible. "The problem with slowing markets is that sale prices may not tell the whole story. Sale prices may be discounted, and the extent of those discounts cannot be reliably estimated."

The news today is concentrated on the sub-prime market, but guess what? This situation is not a problem that can be contained to poor and marginal borrowers. Numerous well-funded entrepreneurial people bought with toxic loans, and they too will be facing tough times as required payments rise and in too many cases property values fall. "We now have a large percentage of loans that involve negative amortization and potentially huge payment increases. It's impossible to believe that some portion of these loans -- and perhaps a large portion -- will not result in financial disaster." If "nontraditional" mortgages are so great, why is it that loan buyers and regulators are now demanding a return to long-time lending standards? More importantly, why did they accept such risky concepts in the first place? Surely, no one will be "surprised" if lawmakers start asking pointed questions as foreclosure rates rise and increasing numbers of lenders fail.

2007 Realty Times. All Rights Reserved.  By Peter G. Miller