Investors Fret Mortgage Balloons Will Burst

By JESSE EISINGER
July 27, 2005; Page C1

There has been plenty of talk about a housing bubble, but very little about a mortgage bubble.

Now investors are starting to see worrisome signs in some banks' latest quarterly earnings reports. In others, such signs are absent. Good news? Nope, because disclosure is so poor at so many banks.

As home prices have soared, banks have been enticing customers with sweet-sounding mortgages that lower monthly payments, including interest-only loans. The most dangerous development is mortgages that offer payment options.

Typically, these so-called option adjustable-rate mortgages, or option ARMs, let customers choose how much to pay each month. They can make the standard principal-and-interest payment or pay just the interest. And then there's the even dicier option to make just a low minimum payment, as with a credit-card bill.

Hey, when there are Escalades to buy and home prices are always rising, you really have to learn to stop worrying and love that minimum payment. The catch is that the unpaid portion of the interest gets tacked onto the principal -- a "negative amortization" that increases the size of the mortgage. Left with more debt, the customer is more vulnerable to rising rates.

These products are advertised in misleading ways. Banks pitch that customers can pay back the loan at a rate of, say, 1%. But that's just the rate used to calculate the minimum payment in the first year, not the actual underlying rate. The rising popularity of option ARMs concerns some prudent banking executives, including Golden West Financial's Herb Sandler, who runs the midsize bank with his wife and sells plenty of the mortgages. Some lenders "are clearly faking their borrowers out," he says.

Along with Golden West, publicly traded lenders with big exposure to these products include Countrywide and Washington Mutual and smaller California banks such as Downey, First Fed and Indymac. Golden West has been selling them for 25 years and has a solid track record with them, even in recessions and rising-rate environments. When fully explained to the right customers, such as a Porsche salesman who makes plenty each year but doesn't know how much he'll score from month to month, "it's a terrific borrower loan," says Mr. Sandler. "We have never had a delinquency, much less a foreclosure, due to the structure of the loan."

But some banks are lowering their credit standards, sometimes qualifying borrowers based on their ability to make the minimum nut, not whether they can afford the whole deal. "That is an outrage," Mr. Sandler says.

Option ARMs are wonderful not just for borrowers who can't afford their houses, but also for investors who look only superficially at a bank's earnings report. A bank books the entire amount that a customer owes as income each month, not the minimum payment that's actually paid. Voilà, noncash earnings.

It gets better: The unpaid interest gets tacked on to the bank's outstanding loan total, allowing the bank to display loan growth, which investors love. "You get earnings and growth. What more can you ask for?" says Keefe, Bruyette & Woods analyst Fred Cannon.

But there could be credit problems down the road. And at some point, it's plausible regulators might fret about the bank's capital.

Last week, Golden West's stock took a hit after it disclosed how much its exposure to option ARMs has increased. The company reported that $160.2 million of its loans was actually unpaid interest tacked on to borrowers' principal -- that negative amortization I mentioned. That's a huge leap from last quarter's $90.2 million and $27 million in last year's second quarter.

The company reassures investors that the total is a mere 0.14% of its loans. But as a percentage of net interest income, the $70 million change in the negative amortization figure was 10% in the second quarter, compared with 5% in the first quarter and practically nothing a year ago, says Mr. Cannon.

Mr. Sandler says Golden West's lending practices are disciplined, so it won't get into trouble. The only risk, he concedes, is that home prices decline broadly, in which case all mortgages suffer, regardless of structure.

But good companies are often undermined by the irrational practices of competitors. It's not quite fair of me to pick on Golden West. I do so only because it fully discloses its exposure.

Other major banks are more reticent. Washington Mutual disclosed some aspects of its exposure for the first time this quarter, but left questions unanswered, says Mark Agah, analyst for independent research firm Portales Partners. It originated $19.6 billion of option ARMs in the second quarter, or 37% of its home-loan volume. WaMu didn't report the total amount of deferred interest beefing up its loan totals. Instead, it said option ARM borrowers' principal had grown by $26 million, or 0.04% of outstanding balances. That doesn't count all the deferred interest from borrowers who paid down their principal for a time but then started making minimum payments. Washington Mutual actively sells most of its option ARMs into the secondary market, but that market might not always be available on attractive terms.

A WaMu spokeswoman says in an email that the company is considering how best to disclose option ARM data.

Countrywide discloses even less. It says its second-quarter ARM volume was $67 billion, or 56% of its home-loan volume. But the company didn't disclose the percentage of option ARMs in its financial statements and doesn't disclose the amount of negative amortization. In response to questions from investors during its earning conference call yesterday, the bank said that 20% of its loan production this year has been option ARMs, at least 50% from California. Countrywide said on the call that it, too, planned to increase disclosure.

What should investors do? Problems won't come today or tomorrow, but don't look now: Rates, they are arisin', and that's when some borrowers will run out of options. At least investors still have some options left. Like reducing their exposure to mortgage banks.

NEWS: Mortgage Lenders Loosen Standards

Mortgage Lenders Loosen Standards
Despite Growing Concerns, Banks Keep Relaxing Credit-Score, Income and Debt-Load Rules

By RUTH SIMON

Staff Reporter of THE WALL STREET JOURNAL

July 26, 2005; Page D1

Mortgage lenders are continuing to loosen their standards, despite growing fears that relaxed lending practices could increase risks for borrowers and lenders in overheated housing markets.

Novel loan products have helped fuel much of the run-up, which continues to defy expectations, as reflected in home-sales data released yesterday. Existing-home sales hit another record in June, up 2.7% from May's heated levels, according to the National Association of Realtors. Median home prices rose 14.7% from June 2004.

But lenders are making it still easier for borrowers to qualify for a loan. They are lowering the credit scores needed to qualify for certain loans, increasing the debt loads borrowers can carry and easing the way for borrowers to get loans while providing little documentation. In some cases, lenders are easing standards not only for homeowners, but also for the growing number of people buying residential real estate as an investment.

In one recent move, Chase Home Finance, a unit of J.P. Morgan Chase & Co., this spring began allowing some of its customers to take out home-equity loans and lines of credit without having their incomes verified. Under the new program, income verification isn't required for home-equity loans of up to $200,000, provided that the borrower's total mortgage debt doesn't exceed 90% of the property's value or $1.5 million. The change "is not for all customers -- it's only for customers with the very highest credit rating," a company spokeswoman says. Loans with little or no documentation have grown in popularity industry-wide.

Last month, Wells Fargo & Co. began allowing buyers of investment properties in some parts of the country to take out interest-only mortgages, which let borrowers pay interest and no principal in the loan's early years. Another recent change in some markets boosts the standard for how much total debt and housing expenses certain borrowers can carry to 45% of their income from 38%.

A Wells Fargo spokesman says the company doesn't discuss specific changes, but that it consistently monitors economic conditions in its major markets and will at times "modify our lending guidelines in a specific market." He added, "On a national basis, we have made no substantive changes to our lending policies and practices."

Banking regulators, meanwhile, are paying closer attention to mortgage lending practices. "Lending standards are continuing to ease," says Barbara Grunkemeyer, deputy comptroller for credit risk at the Office of the Comptroller of the Currency, which is putting the finishing touches on its annual survey of bank underwriting standards. Federal Reserve surveys of bank loan officers show that lenders have tended to loosen standards since early 2004, following a period of relative tightening.

In some cases, lenders have tweaked their offerings by reducing the minimum credit scores needed to qualify for certain loans. Countrywide Financial Corp., for instance, recently cut by 20 points the minimum credit score borrowers with bigger loan amounts need to qualify for one of its popular loan programs. A Countrywide spokeswoman says the change was designed to make the terms of this loan consistent with its other offers.

The continuing loosening of lending standards has helped push the homeownership rate to a record 69% of U.S. households. Mortgage delinquencies, meanwhile, have remained low, with just 1.08% of residential mortgages in foreclosure proceedings at the end of the first quarter, down from 1.17% five years earlier, according to the Mortgage Bankers Association. Low interest rates and rising home prices have helped keep delinquencies down by keeping monthly payments in check and making it easy for borrowers who run into trouble to refinance or sell their homes at a profit.

But the lowering of standards has also raised concerns that some borrowers may run into trouble making their payments, and that defaults could rise. In May, in response to concerns about looser underwriting standards, bank regulators issued their first-ever guidelines for credit-risk management for home-equity lending. Regulators are working on new guidelines for mortgage lenders.

In addition, bank examiners "are looking more at how banks originate first mortgages today than they were a year ago," says Ms. Grunkemeyer of the Office of the Comptroller of the Currency. "The reason they are doing it is because the mortgage products [lenders] are originating are higher risk."

Washington Mutual Inc. says it's loosening its guidelines on some products while tightening them on others. In June, it began offering home-equity lines of credit to borrowers who buy condominium units as an investment or as a second home. Another recent change lets borrowers who buy a second home or investment property finance as much as 90% of the home's value, up from 75%. Sales of investment properties have surged recently, adding fuel to the heated housing market.

The Seattle-based lender says it has also moved to toughen some standards. Earlier this year, Washington Mutual began setting stricter limits on the size and loan-to-value ratios for loans above $7 million. It is also reassessing its credit standards for investment properties and second homes, says Jim Vanasek, the company's chief enterprise risk-management officer.

"There's been a growing awareness over the past six to nine months that the risks are starting to increase with the very, very rapid price escalation we have seen," Mr. Vanasek says. "I would be surprised if mortgage lenders don't do some degree of reining in or tightening over the next several months."

So far, evidence of tightening has been hard to detect. "The trend toward relaxing standards is still relatively strong," says Gibran Nicholas, a mortgage broker in Ann Arbor, Mich. Mr. Nicholas expects this pattern to continue as long as foreclosure rates remain low and demand remains high from investors who buy bonds backed by pools of mortgages.

Some lenders say they are being forced to relax their standards to remain competitive. U.S. Bank Home Mortgage, a unit of U.S. Bancorp, says interest-only mortgages and loans with less-than-full documentation now account for about 10% of its business, up from just 4% a year ago.

"We're just offering the product that a lot of our competitors have offered," says U.S. Bank President Dan Arrigoni. "If anything, we have to think about loosening them if we want to compete." But, he says, U.S. Bank has resisted pressures to offer increasingly popular option adjustable-rate mortgages -- which carry starting rates as low as 1% and give borrowers multiple payment choices -- because the bank considers them too risky.

Lenders also say that advances in technology and data analysis enable them to do a better job of determining who is a good credit risk. "One of the things that is often missed is that we've become much better predictors of loan performance with automated underwriting systems and appraisal practices," says Jerry Baker, president and chief executive of First Horizon Home Loan Corp., a unit of First Horizon National Corp.

First Horizon recently reduced the credit scores and boosted the loan-to-value ratio allowed on limited and no-documentation loans that it sells to investors through Wall Street. The bank says such loans represent a tiny portion of First Horizon's volume.

The loosening of standards also shows up as products that were initially geared toward the most sophisticated borrowers -- such as option ARMs and interest-only loans -- have become more mainstream. A recent analysis by UBS AG shows that the average credit scores for borrowers with option ARMs has declined over the past three years. In addition, more than 22% of the borrowers who took out option ARMs this year financed more than 80% of the purchase price, up from 12% of borrowers in 2004 and less than 2% in 2002, according to the UBS analysis, which looked at loans sold to investors.

Similarly, interest-only mortgages, which were first aimed at wealthy borrowers, are increasingly being offered to people with poor credit. Interest-only mortgages accounted for 30% of the subprime loans originated in April, according to UBS, up from 14% in all of 2004. Average credit scores and other measures of credit quality have also been declining, according to UBS.

REPORT: Real Estate Indicators and Financial Stability

BIS Papers No. 21, April 2005

The papers in the volume are grouped into broad thematic areas as they were discussed in the conference: review of the impact of real estate on monetary and financial stability, usefulness of available statistics, country experiences in the compilation of real estate price indices, methodological issues on residential and commercial real estate prices, hedonic real estate price indices, aggregation issues, valuation of real estate in special situations, and areas of future work. The volume also contains a summary of the discussion that took place at the conference on possible future areas for work. Transcripts of the discussions during the individual sessions of the conference are available upon request.

[MORE]

Flipping Exchange

By Matt Reed, USA TODAY

Converted apartments aren't the only hot spot in the nation's booming condominium market. In rapidly growing South Florida, new condos are traded almost like a commodity.

Entrepreneurs have launched two online exchanges where visitors can buy, sell and "flip" condos in a global marketplace.

"Condos are more and more being bought sight-unseen, based on price per square foot and the view," says Richard Swerdlow, CEO of United States Condo Exchange, or USCONDEX.

In the Miami area alone, developers have proposed as many as 70,000 units in glossy towers to be built in the next two to four years. The Web sites aim to move them in bulk, collecting commissions along the way:

USCONDEX.com. This Web site charges developers $2,500 per building per month to showcase existing and preconstruction condos. Potential buyers can search listings from West Palm Beach to Miami and negotiate online. This year, the site will launch live auctions, similar to eBay.

CondoFlip.com. This site helps buyers of unbuilt Miami condos find secondary buyers so they can sell the condos at a higher price, or "flip" them.

In a flip, the first buyer pays a deposit and signs an agreement with a developer to close on a condo when it is finished, sometimes a year or two later. As construction proceeds, the condo's value rises, new buyers want in and the original buyer can sell the unit for a profit moments after closing. Sellers pay a 4% commission for help brokering a flip.

Condo Flip founder Mark Zilbert says flipping can't work like day trades or commodity deals, when instant transactions happen online. Florida law requires contracts and paperwork to be signed and officially recorded.

Reed reports daily for FLORIDA TODAY in Melbourne, Fla.

NEWS: Renters must choose: Buy or goodbye

By Charisse Jones, USA TODAY

SAN DIEGO — For James DeForest, the transformation of his rented apartment into a condominium for sale offers a chance at the American dream.

"I called my mom and dad ... and let them know I could be a homeowner out here in California," says DeForest, 48, an operations coordinator for a Bed Bath & Beyond store, who hopes to buy his bungalow unit and carry a mortgage for the first time. He expects to pay at least $300,000.

For Valerie Shield, an elementary school principal in a different pocket of San Diego, the planned conversion into condos of an apartment complex where 75 of her students live means something less rosy: Many of their families will have to find new places to live.

"These are people cleaning hotel rooms, busing tables," she says. "They can barely make the $900 to $1,000 rent. ... I'm worried about the children."

Condo conversions such as these in San Diego's stratospheric housing market are gaining momentum in metropolitan areas around the nation. In places such as Miami, Las Vegas, Charlotte and Washington, D.C., developers are buying and renovating apartment buildings, then selling the units as condominiums.

The condos, often priced far less than new condominiums or single-family homes, offer some longtime renters a fleeting chance at homeownership. Tenants who can't scrape together a down payment or obtain financing must move.

"Conversions create opportunities for entry-level purchases," says Gabe del Rio of Community HousingWorks in San Diego, which helps low- and moderate-income families. "Then we also see the other side. These are the very low-income individuals who have usually been in that complex for a very long time. ... They don't have many options."

The rental-to-condo rush is particularly hot in Las Vegas, the nation's fastest-growing metro area. Ten thousand to 13,000 apartments were converted to condominiums last year in Clark County, which includes Las Vegas.

The lower prices of converted condos are a big draw for would-be home buyers. Converted condos in Las Vegas cost $90,000 to $150,000. The median price of a new single-family home there is $305,500.

Converted condos are attractive to empty-nesters who want to downsize, but they are most popular with first-time home buyers, particularly firefighters, teachers and others who earn moderate incomes in expensive markets, says Walter Molony, spokesman for the Chicago-based National Association of Realtors.

Some cities where condo conversions are underway have the nation's lowest apartment vacancy rates, triggering concerns among local officials that renters are being left with few places to go.

In the Washington area, the vacancy rate for multifamily rental units was 3.6% as of July 1, according to the Realtors group. The rate was 2.9% in Miami and 2.7% in San Diego. The projected national average vacancy rate this year is 5.7%.

"We are definitely concerned about the displacement (of tenants) and the loss of rental housing, particularly affordable rental housing," says Melodie Baron, division chief for the Office of Housing in Alexandria, Va. Since November, applications have been filed to convert 2,365 rental units in that city.

Here's what some cities are doing to ease the crunch:

• Alexandria is offering interest-free loans of as much as $40,000 to tenants with moderate incomes who want to buy their unit when it goes condo.

• Clark County in Nevada is allowing homeowners on lots of 5,000 square feet or more to build another structure that they could rent to people who are not family members.

• The San Diego City Council has set aside $1.9 million for loans to displaced renters who earn the area's median income of $64,000 a year or less. Displaced tenants receive three months' rent, which they can use for a down payment on a home or another rental.

DeForest was worried when he learned five months ago that his bungalow community was going condo.

"It was a little scary because everything is just sky-high here ... and I don't make a whole lot of money," he says. But he also saw a chance to become a homeowner.

Fiel Barrow, 29, who attends San Diego State University, paid $217,000 in April for a converted one-bedroom condo. He says he was able to buy only because of the relatively low cost of the condo and loans he obtained through programs for first-time home buyers.

Mayor Mark Lewis of El Cajon, a San Diego suburb where apartments make up 52% of housing, welcomes conversions. Conversions enable residents to put down roots, and they also increase tax revenue for city services, he says.

Art Madrid, mayor of neighboring La Mesa, isn't so sure conversions help his town. La Mesa ties the number of conversions it will allow to the number of apartments built in the previous two years. No apartments have been constructed in the past decade.

"I think we have a legal and moral responsibility to make sure that the residents who've lived here for years and years aren't displaced just for the sake of money," Madrid says.

[MORE]