by Calculated Risk on 12/01/2005 09:03:00 PM

John C. Dugan, Controller of the Currency, remarked today on exotic mortgages and the housing market. The first half of his talk, before the Consumer Federation of America, concerned changes to credit card regulations. Here are his remarks (pdf) on negative amortization mortgage products:

"And so, just as we come to the end of the neg am story in credit card lending, I fear we are at the beginning of one in the mass marketing of home mortgages. One of the new “non-traditional” mortgage products you may have heard about is the so-called payment-option ARM – a mortgage that allows borrowers to select from a menu of payment possibilities, ranging from a fully amortizing monthly payment to the neg am payment option that does not cover the outstanding interest. Such products have been available for quite a long time, but until recently had been provided primarily to a narrow group of very creditworthy borrowers who found differing payment options to be an attractive “cash management” tool over time. In this niche market – which is different from the credit card market because of the collateral securing the loan – borrowers have generally had the wherewithal and sophistication to handle temporary periods of negative amortization without jeopardizing their ultimate repayment of principal.

In the last two years, however, we have seen a spike in the volume of payment-option ARMs, which are no longer largely confined to well-heeled borrowers who can clearly afford them. Increasingly, they are being mass marketed as “affordability products” to borrowers who appear to be counting on the fixed period of exceptionally low minimum payments – typically lasting the first five years of the loan – as the primary way to afford the large mortgages necessary to buy homes in many housing markets across the country. And as the loans become more popular, the prospect of using them to penetrate the subprime lending market cannot be far behind.

The fundamental problem with payment option ARMs, other than the growing principal balance due to negative amortization, is payment shock. A traditional 30-year fixed-rate mortgage requires the borrower to amortize the principal balance through equal payments over the 30-year life of the loan. In contrast, a typical payment-option ARM is a 30-year mortgage that permits five years of negative amortization by allowing a borrower to make very low minimum monthly payments during that period. Beginning in the sixth year, the borrower must begin paying the full amount of interest accruing each month, and must also begin amortizing the increased principal over the remaining 25-year life of the loan. The combination of these factors can produce sharply increased payments in year six. For example, a typical payment-option mortgage of $360,000 at 6 percent can produce a monthly payment increase of nearly 50 percent in that year, assuming no change in interest rates. If rates rise to just 8 percent, the payment increase when amortization begins would nearly double.

To the extent that they are planning for such contingencies, many payment-option-ARM borrowers calculate that they will be able to sell their property or refinance the mortgage by year six. But if real estate prices decline – and there already is evidence of softening in some markets – these borrowers could face the bleak prospect of loan balances that exceed the value of the underlying properties. In that case, selling the property or refinancing the loan would not be a viable escape valve for avoiding huge payment shocks.

In these circumstances, do consumers really understand the potential consequences of the neg am feature inherent in a payment-option ARM? Is this an appropriate product to mass market to customers who may be looking at the less than fully amortizing minimum payment as the only way to afford a larger mortgage – at least for the five years before the onset of payment shock? And are lenders really prepared to deal with the consequences – including litigation risk – of providing such products in markets where real estate prices soften or decline, or where interest rates substantially increase?

I fear the answer to all these questions may be “no.” That is one reason why, if all goes according to plan, the Federal banking agencies will propose new guidance with respect to nontraditional mortgage products by the end of this month. While the guidance will cover many other issues besides negative amortization and payment option ARMs, these will certainly be central among the topics addressed. I am mindful of the history of neg am products in credit cards, and I recognize that the nationwide mass marketing of neg am mortgages is in its infancy. As a result, I firmly believe that the guidance should draw clear lines about appropriate standards for qualifying borrowers for payment option ARMs that explicitly take into account potential payment shock. Put another way, lenders should not encourage or accept applications from borrowers who clearly cannot afford the dramatically increased payments that are likely to result at the end of the five-year, low minimum payment period. Disclosures should also be clear, timely, and meaningful. And lenders should have very substantial controls in place to manage the potential risk of such loans."