by Calculated Risk on 5/04/2006 01:40:00 PM

Reuters reports: Rising rents may push CPI higher, Fed's Bies says

The U.S. consumer price index may move higher as the U.S. housing market slows and the rental market strengthens, Federal Reserve Board Governor Susan Bies said on Thursday.

Noting that the CPI's gauge of housing costs is based on rents, Bies told a banking conference in answer to a question: "We've come through a period of weaker rents. Now, housing has really sort of peaked ... that may rejuvenate rents and so you may see may see that, in turn, higher (CPI) inflation going forward."

This is a topic we've discussed before; as housing slows, rents increase and the largest component of CPI is "Owners Equivalent Rent". So, as housing slows, reported CPI could increase.

More from Susan Schmidt Bies on Nontraditional Mortgage Products:

Over the past few years, the agencies have observed an increase in the number of residential mortgage loans that allow borrowers to defer repayment of principal and, sometimes, interest. These loans, often referred to as nontraditional mortgage loans, include "interest-only" (IO) mortgage loans, on which the borrower pays no loan principal for the first few years of the loan, and "payment-option" adjustable-rate mortgages (option ARMs), for which the borrower has flexible payment options--and which could also result in negative amortization.

IOs and option ARMs are estimated to have accounted for almost one-third of all U.S. mortgage originations in 2005, compared with less than 10 percent in 2003. Despite their recent growth, however, these products, it is estimated, still account for less than 20 percent of aggregate domestic mortgages outstanding of $8 trillion. While the credit quality of residential mortgages generally remains strong, the Federal Reserve and other banking supervisors are concerned that current risk-management techniques may not fully address the level of risk inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing market.

Mortgages with some of the characteristics of nontraditional mortgage products have been available for many years; however, they have historically been offered to higher-income borrowers. More recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. These borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. Further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition in the mortgage banking industry intensifies.

Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans with weaker mitigating controls on credit exposures--for example, by accepting less documentation in evaluating an applicant's creditworthiness and not evaluating the borrower's ability to meet increasing monthly payments when amortization begins or when interest rates rise. These "risk layering" practices have become more and more prevalent in mortgage originations. Thus, while some banks may have used elements of the product structure successfully in the past, the easing of traditional underwriting controls and sales of products to subprime borrowers may have unforeseen effects on losses realized in these products.

In view of these industry trends, the Federal Reserve and the other banking agencies decided to issue the draft guidance on nontraditional mortgage products. The proposed guidance emphasizes that an institution's risk-management processes should allow it to adequately identify, measure, monitor, and control the risk associated with these products. It reminds lenders of the importance of assessing a borrower's ability to repay the loan including when amortization begins and interest rates rise. These products warrant strong risk-management standards as well as appropriate capital and loan-loss reserves. Further, bankers should consider the impact of prepayment penalties for ARMs. Lenders should provide borrowers with enough information to clearly understand, before choosing a product or payment option, the terms of and risks associated with these loans, particularly the extent to which monthly payments may rise and that negative amortization may increase the amount owed above the amount originally borrowed. Lenders should recognize that certain nontraditional mortgage loans are untested in a stressed environment; for instance, nontraditional mortgage loans to investors that rely on collateral values could be particularly affected by a housing price decline. Investors have represented an unusually large share of home purchases in the last two years. Past loan performance indicated that investors are more likely to default on a loan when housing prices decline, than owner occupants.