by Calculated Risk on 11/09/2005 09:47:00 PM

Here is the text of John Dugan's recent remarks at the OCC Credit Risk Conference. It is an easy read and well worth the few minutes. Dugan makes several key points:

1) This is the top of the credit cycle and standards are slipping.
2) Risk is overly concentrated in commercial real estate and residential mortgages.
3) Certain loans are especially risky.
4) The goal for the new interagency guidance is the end of 2005.

This is the "top of the credit cycle":

"... it’s at the top of the credit cycle where stresses and weaknesses typically appear, so what we are seeing today should not surprise anyone. With liquidity pouring into the market, we would expect to see increased competition for loan customers – and we are. With competition intensifying, we would expect to see underwriting standards easing – and we are. And we would expect to find emerging concentrations in some loan categories, such as commercial and residential real estate. We are most definitely seeing that."

And there is concern about mortgage risk:

"Today’s non-traditional mortgage products – interest-only, payment option ARMs, no doc and low-doc, and piggyback mortgages, to name the most prominent examples – are a different species of product, with novel and potentially risky features.
...
This dominance is increasingly reflected in the numbers. By some estimates, interest-only products constituted approximately 50 percent of all mortgage originations last year. In the first half of 2005, IOs started to decline in favor of payment-option ARMs, which, according to one source, comprised half of new mortgage originations. And roughly every other mortgage these days is also a “piggyback” or reduced documentation mortgage, which points to another development that concerns us: the trend toward "layering" of multiple risks. There is no doubt that when several risky features are combined in a single loan, the total risk is greater than the sum of the parts.

We can readily understand why these new products have become fixtures in the marketplace in such a short time. One reason is that they have helped sustain loan volume that would otherwise almost certainly be falling, because rising interest rates have brought an end to the refinance boom. More important, lenders have scrambled to find ways to make expensive houses more affordable – although there’s now a concern that the very availability of this new type of financing has done its share to help drive up house prices, which in turn stimulates demand for even more non-traditional financing."

And more on Option ARMs:

"And then there are payment-option ARMs, which take us to another level of risk. ... borrowers can easily treat payment-option ARMs in the same manner as a traditional mortgage, simply by selecting the fully amortizing option rather than the minimum payment option each month.

In practice, however, few borrowers treat them that way. Recent studies show that a significant number of borrowers are frequently choosing to pay the minimum amount possible, a payment amount that typically falls short of the interest accruing on the loan. Even more disturbing, this choice does not seem limited to high quality, affluent borrowers who may be using the product as a payment flexibility tool. The research indicates that borrowers at both ends of the FICO spectrum make this choice, with riskier borrowers resorting to it most frequently. Because such minimum payments fall considerably short of the total interest accruing each month, the unpaid interest is added to the loan principal, and negative amortization occurs. Thus, it should come as no surprise that, of the least creditworthy holders of payment-option ARMs, nearly 50 percent have current balances above their original loan amount."

And on the new interagency mortgage guidance project:

"This guidance will focus on underwriting standards, appropriate disclosure, and portfolio management concerns. Our current goal is to ready the guidance for release by year’s end, although serious interagency discussions about the initial draft have only just begun."

Well worth reading.