Mortgage lenders get creative

First of three parts

NEW YORK — With the housing market cooling and loan demand shrinking, banks and other lenders are turning to nontraditional and sometimes riskier mortgages to bring in more business and make up their lost revenue.

“We’re at a pretty difficult time for the mortgage industry,” said Stephen Rotella, president and chief operating officer of Washington Mutual Inc., a Seattle-based thrift which also is one of the nation’s largest mortgage lenders.

Many lenders have turned to mortgage products designed to lower monthly loan payments and help borrowers qualify more readily for larger loan amounts, while others require little in the way of documentation during the approval process. These loans do make it easier for some people to get mortgages, but they can also raise the possibility that some borrowers may end up in default.

The slowdown in home sales and lending was first apparent during the summer and has become even more evident in recent weeks. Last week, the Mortgage Bankers Association’s gauge of demand for home loan refinancings fell to lows not seen since December 2004 and a survey of sentiment among home builders dropped to a level not seen since April 2003. That survey by the National Association of Home Builders found diminished expectations for home sales in coming months.

Next year, lenders expect to process $2.26 trillion worth of loans, down from this year’s $2.78 trillion, according to the MBA, a Washington, D.C.-based trade group. Much of the expected drop will come from a decline in demand for home loan refinancings that, in recent years, were a bulk of the industry’s business.

In 2003, when banks saw a record amount of mortgage lending, as much as 75 percent of the loans processed were refinancings. Now, however, refinancings account for about 40 percent of all mortgage bank business and this source of business is sure to further decline as rates rise.

To make up for the drop in borrowing, lenders have resorted to what the industry calls alternative payment products, loans designed to lower monthly payments to help borrowers qualify more readily, according to Keith Gumbinger of HSH Associates, which tracks the mortgage banking industry.

One of these new mortgages allows borrowers to pay only interest for a certain period, giving them smaller monthly payments and enabling them to take on larger loans. That in turn has helped push home prices higher. These loans became popular because steady gains in home prices allowed borrowers to hop from one home to another without feeling the pay shock that comes when regular principal payments are due.

Some of these interest-only loans were also structured as adjustable rate mortgages, which had the effect of further lowering the required down payment. These loans carry risks for borrowers who stay in their homes longer than expected and have not budgeted for a sharp rise in monthly payments.

Catering to borrowers with lower credit ratings is nothing new, but some market observers fear that these risky consumers may soon be able to borrow money with little in the way paperwork detailing their annual incomes or the value of their assets.

Known as low-doc, as in low document, and no-doc, as in no-document, loans, this is a market expected to continue to grow rapidly, according to Art Frank, head of mortgage research at Nomura Securities International Inc.

Often, these loans are marketed to consumers who have their own businesses and can verify their assets, so their income does not fit a traditional mode of assessing a borrower’s ability to make monthly loan payments. These loans, however, may be problematic if they are made to less creditworthy consumers who are not making much of a down payment.

The industry’s gravitation toward non-traditional mortgages — and toward less creditworthy customers — raises concerns about whether some borrowers will be able to keep up with their payments.

“When the industry is topping out, people stretch to get that last unit of output and the result is you find yourself in a situation where there will be definite problems in the next six to 12 months,” warned Richard Bove, banking analyst at Punk Ziegel & Co.

David Olson, co-founder of Wholesale Access, a Columbia, Maryland-based firm that tracks the mortgage industry, predicted that mortgage defaults will increase.

“As long as we had the mantra that prices only go up, you could have the most stupid mortgages and it was great,” he said. But going forward, “the public will see more foreclosures … people are maxed out with debt.”

The rise in rates, meanwhile, may encourage lenders to bring back what are known as 2:1 buydown mortgages, a loan designed to initially lower monthly payments.

When the Fed hikes interest rates, the most immediate impact is felt in short-term rates. In the current interest rate environment, short-term interest rates have climbed steadily while at the same time, long-term interest rates haven’t moved much.

As a result, there is what is known in banking as a flat yield curve. The minuscule difference between long-term and short-term borrowing costs makes it tough to sell adjustable rate home loans — typically, a loan product used when rates are high or rising. To get around this problem some lenders may reintroduce 2-1 buydown loans.