by Kenneth R. Harney
An important mortgage market player has sounded an alarm about limited-doc and interest-only features in a growing percentage of home loans, especially those made to purchasers with subprime credit.
In an advisory issued last week, Wall Street's Dominion Bond Rating Service, which assigns risk ratings to mortgage-backed securities pools, expressed "concern" about lenders' potential "easing of credit standards" to boost origination volumes in the post-refi boom climate of 2005.
The rating agency cited interest-only and "stated documentation" loans in new subprime mortgage pools as especially worrisome. "Stated" doc mortgages generally do not require homebuyers to provide hard evidence of income and assets to support their applications. Interest-only loans allow home buyers reduced monthly payments -- there is no principal reduction for an agreed-upon initial period -- but then convert to full amortization for the balance of the term.
Dominion said "mortgages underwritten (with) minimal documentation sometimes account for as much as 50 percent of mortgage pools" in the subprime arena. Yet the no-doc/stated-income concept was originally designed to assist self-employed, business-owning homebuyers with solid credit histories who preferred not to divulge their full financial details. The idea was not designed for buyers with marginal incomes and credit.
No-doc "has since been expanded to include salaried borrowers who cannot or will not show proof of income," said Dominion in its advisory. Some analysts have called such mortgages "liar loans" because the income or assets claimed by the applicant may be illusory or fraudulent. That potential, in turn, raises the chance of future delinquencies and foreclosures.
Dominion is hardly alone in its opinions. Last spring, two major mortgage insurance companies blew the whistle on "NINAs" -- no income, no asset verification loans -- and curtailed issuance of new insurance to no-doc borrowers with low downpayments.
"It may be stating the obvious," said Curt Culver, president and CEO of Mortgage Guaranty Insurance Corp. (MGIC), the largest underwriter in the industry, "but you can't document what you don't have. In many instances (NINAs) are allowing borrowers to do just that. Why wouldn't a borrower choose to fully document their income to assure that they get the lowest possible rate?"
Another insurer, United Guaranty, stopped underwriting non-docs after investigators found that in 90 percent of NINAs that defaulted, mortgage or realty professionals working with the home buyers knew in advance they really didn't have the income or assets necessary to afford the house.
Dominion's concerns about interest-only subprime loans centered around the fact that the industry has "only a limited performance history" on this breed of mortgage. Other analysts have pointed out that interest-only mortgages have a heightened propensity to default because of possible "payment shocks" after the initial low-payment period expired.
For example, say a home buyer takes out a 30-year $333,700 hybrid ARM with an interest-only period of five years. The lender sets the initial fixed payment rate at 5.25 percent -- or $1,460 a month. But in the 61st month, the loan morphs into a one-year LIBOR-indexed adjustable with a standard 2.25 percent margin. With the onset of principal reduction, plus a compressed 25-year remaining amortization term, the monthly payment due from the homeowner would shoot up by 30 percent overnight -- to $1,895 -- if market rates remained flat. But if rates in the economy overall rose by just 1.5 points during the five-year period -- a scenario not unlike what could happen under current Federal Reserve monetary policies -- the payment due in the 61st month would jump by 50 percent to nearly $2,200 a month. That might well be too great a jolt for the homeowners to handle.
The bottom line for realty and loan professionals: Tempting though it may be to "make the deal go through" with the help of short-term payment reduction techniques such stated-income and interest-only, the long-term result for home buyers with subprime credit could prove disastrous -- loss of their home to foreclosure.
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