Trends in the Marketplace: Exotic Mortgages and Their Impact on Low to Moderate Income Communities Facilitated by David

1. Trends in the Marketplace: Exotic Mortgages and Their Impact on Low to Moderate Income Communities Facilitated by David BerenbaumInstructor, NCRC Academy

2. Introduction • The market that borrowers see today is flooded with enticing mortgage products boasting record- low introductory rates, interest-only loans, option adjustable-rate mortgages (ARMs), no money down, and no income documentation required. • Originally considered “nontraditional” mortgages because of their high risk and small pool of qualifying borrowers, these products are now cropping up nationwide and becoming mainstream.

3. In 2005, 63% of new mortgages were interest-only and adjustable-rate mortgages. Over an 18-month period in 2004 and 2005, approximately one-third of homebuyers did not put any money down for their loan. And in California, Nevada and New Jersey, negative amortization loans accounted for 27.5%, 20.1%, and 14.2% of non-agency securitizations in the state.

4. As lenders increasingly and excessively target borrowers with these dangerous products, the potential risk of payment shock, negative amortization, loss of equity and ultimately loss of home will also continue to escalate for borrowers. • We hope to orient member agencies to the steps we need to take in order to inform our clients about these products and to urge regulatory agencies to prevent lenders from making unnecessary and inappropriate loans.

5. The Wink-Nod • “The proliferation of exotic mortgages has largely occurred because more than 70% of mortgage origination is through wholesale channels rather than retail. The industry is incentivized to qualify the borrower and will find the product to match affordability. This places the lending industry in a precarious position. On one hand they are encouraging home ownership, but on the other hand, it has been one of the factors in the run-up in housing prices.”- John Miller, Miller Samuel

6. Joint Center for Housing Studies • Between 5-10% of American Households will see their Mortgage reset in 2006 - Harvard State of the Nations Housing Report • 6% likely • Percentage to increase annually due to prevalence of ARM’s. • One-third of households spend more than 30 percent of their income on housing, and more than one in eight spends more than 50 percent. The number of such cost-burdened household jumped by 5 million from 2000 to 2003, the Harvard Center calculates.

7. Overall 35 percent of mortgage loans in 2005 carried adjustable rates, up from just 18 percent in 2004. • In the mid-1980s, more than 50 percent of mortgages were adjustable, but back then short-term rates were significantly lower than rates on traditional 30-year mortgage loans. • The difference now is that home buyers essentially are grabbing loss-leader rates that are almost certain to require sharply higher payments in a year or two.

8. When exotic mortgages reset…. • Lets begin our discussion by introducing and reviewing the most recent and exotic mortgage products out there, along with the types of borrowers who should steer clear of them or, in the alternative, can reasonably consider them. • Foreclosure Risk • Safety net for securitizers - “insurance”

9. Twenty-nine percent of borrowers who took out mortgages last year have no equity in their homes or owe more than their house in worth - Study by Christopher L. Cagan, director of research and analytics for First American Real Estate Solutions, a unit of First American Corp. • That compares with 10.6% of those who took out loans in 2004.

10. Credit Suisse study looked at borrowers with good credit who were at least 90 days late on their mortgages. • Credit Suisse found that borrowers who took out adjustable-rate mortgages in 2005 were three times as likely to be delinquent on their payments after the first year as those who took out ARMs in 2003 and 2004. Payments on ARMs can adjust after as little as a month, or after several years, depending on the terms of the loan. • The study didn't include borrowers with option ARMs.

11. Credit Suisse also found that borrowers who were delinquent were more likely to have lower credit scores and to have taken out piggyback mortgages, which combine a mortgage with a home-equity loan or line of credit. • It also found that delinquency rates were shooting up in California, where double-digit gains in home prices have made affordability an issue. • MBA reports increase in delinquency, roughly 4.7% of residential mortgages were delinquent in the fourth quarter of 2005. Excluding the effects of Hurricane Katrina, delinquencies were 4.55%. That is up from 4.44% in the third quarter and 4.38% at the end of 2004.

12. The Color of Money

13. 40-Year Mortgage Portable Mortgage Interest-Only Mortgage Negative Amortization Mortgage Flex-ARM Mortgage Piggy Back Mortgage 103s and 107s Home Equity Line of Credit Loan Modification Mortgage 
Short-Term Hybrids. Exotic Mortgage Types

14. Forty Year Mortgage • These products are similar to 30-year fixed-rate mortgages, except that borrowers stretch the payments out for an extra 10 years. Lenders, however, often charge a slightly higher interest rate, up to half a percentage point.

15. Pros: A 40-year mortgage offers lower monthly payments than a 30-year loan, while locking in today's attractive interest rate. On a $300,000 mortgage at today's prevailing interest rates (6% for a 30-year and 6.25% for a 40-year), a home buyer could save nearly $95 each month. • Cons: By extending the length of the mortgage, the borrower increases the amount of interest paid over the life of the loan. On that same $300,000 mortgage, a home buyer would spend an additional $170,030.42 using a 40-year mortgage. • Good For: Experts recommend this product only for first-time home buyers who don't plan on staying in the house for more than a few years, and who can't afford the higher monthly payment associated with a 30-year mortgage. NCRC is critical of this product.

16. Portable Mortgages • In 2003, E*Trade launched a program called “Mortgage on the Move” It allows home buyers to lock in today's low interest rates and take the loan with them should they move into a new house a few years down the line. A second mortgage can be used if the buyer needs to borrow more money for the next home.

17. Pros: With current mortgage rates low — and by most estimates likely to rise — locking in today's rate for the next 30 years is attractive. • Cons: Interest rates for portable and second mortgages come at slightly higher interest rates than do standard loans. A portable mortgage is priced at 3/8 to 1/2 a percentage point higher, and a second mortgage is often 3/4 of a percentage point higher than a typical 30-year fixed-rate product, based upon NCRC product review. • Good For: People who know they will be moving in a reasonable amount of time and want to lock in at a low rate.

18. Interest Only Loans • With an interest-only loan, lenders allow borrowers to pay just the interest portion of their mortgage during the first, say, 10 years of their commitment. After that, the loan essentially becomes a new mortgage with new interest and principal payments stretched out over just 20 years.

19. Pros: In addition to smaller monthly payments during the interest-only repayment period, all of the money a borrower puts toward the mortgage during this time period is tax deductible. • Cons: Should home prices stagnate, or depeciate, homeowners would build up no equity during the interest-only years. Also, monthly payments jump significantly once the principal-payment period begins. Most of these loans also carry variable interest rates, further increasing a borrower's risk for higher monthly obligations.

20. Good For: Consumers who know (and remember, there are no guarantees in life) that their incomes will rise significantly over the next few years – not low to moderate income consumers. Interest-only loans can also be a good option for professionals who receive bonus payments as part of their compensation. This product allows them to make minimum payments during most of the year when cash is tight and then put down several thousand dollars toward principal when they get their bonus checks. NCRC is critical of this product.

21. Negative Amortization Loan • This interest-only product allows buyers to pay less than the full amount of interest necessary to cover the costs of the mortgage. The difference between a full interest payment and the amount actually paid each month is added to the balance of the loan.

22. Pro: An even smaller monthly payment than an interest-only mortgage, during the first few years of the loan. • Con: This is the riskiest mortgage lenders offer. Should housing prices stagnate or fall, buyers would find themselves "upside down" or in "negative equity," meaning they would owe money to the lender if they sold their homes. NCRC is critical of this product. • Good For: Sophisticated borrowers with large cash reserves who want the flexibility of lower payments during certain parts of the year but plan to pay off their loans in large chunks during other parts the year.

23. Flex-ARM Mortgage • This is a cross between a hybrid ARM, which offers a lower fixed rate during the first five or seven years and then adjusts annually, and a negative amortization loan. • Each month the lender sends the borrower a payment coupon that calculates four possible payment options: a negative amortization, an interest-only, a 30-year fixed and 20-year fixed. The homeowner then decides how much he wants to pay. (Some mortgages offer only an interest-only and a 30-year fixed option.)

24. Pro: The bank does all the thinking. Each month it recalculates the balance and tells the borrower how much he or she would owe under different scenarios, giving the homeowner significant flexibility. • Con: Borrowers could end up owing more money on their mortgage than they can fetch for their homes. • Good For: People who like options and have large cash reserves for when the mortgage payments increase during the later portion of the loan. Like interest-only loans, Flex-ARMs may be good tools for those who derive much of their income from bonuses. NCRC is critical of this product because consumers will of get into the trap of negative amortization.

25. Piggy Back Mortgage • This product is actually two mortgages. The first covers 80% of the property's value. The second, which comes at a slightly higher rate, covers the remaining balance

26. Pro: In most cases, homeowners save money by taking out a piggy-back loan (also known as a combo loan) since it allows them to avoid paying costly private mortgage insurance when buying a home with less than a 20% down payment. Plus, the money that would have gone toward PMI is now tax deductible, since it's going toward an interest payment. • Con: As we mentioned, borrowers pay a higher interest rate on the second mortgage. And rates can vary greatly depending on credit score. Also, since the borrower has little equity in the home, should it fall in value when it's time to sell, the borrower would need to pay the difference in cash. NCRC is critical of this loan product due to fair lending pricing concerns and the fact that many predatory loans involve Piggy-Back mortgage products. • Good For: Folks with high salaries but little savings.

27. 103’s & 107’s • Who needs a down payment? Nowadays, people can even borrow 3% to 7% more than the house is worth. • Good For: People with large cash reserves who prefer to invest in, say, the stock market rather than tying up their assets in real estate, and in some cases when tied to comprehensive housing counseling or special homeownership mortgage initiatives, first time homebuyers.

28. Home Equity Line of Credit • Known in the industry as HELOCs, these products let buyers finance home purchases or use the equity in their existing home using a credit line rather than a traditional mortgage. HELOCs are variable-rate loans tied to the prime rate. If a HELOC is used as a first-position loan, all of the interest is tax deductible. Here's how it works: The buyer makes a down payment, and the credit line covers the rest. HELOCs typically cover up to 90% of the appraised value of the home. Lenders also offer up to 100%, at significantly higher interest rates

29. Pro: In this environment, HELOCs offer much more attractive interest rates. A 30-year fixed-rate mortgage now carries a 6+% interest rate, Borrowers can also take out additional funds against the equity in their homes without hassle or additional cost. • Con: Most HELOCs are structured for just 10 or 20 years, rather than the customary 30. And since the interest rate is variable, payments can be volatile, and can rise substantially higher alongside the prime rate. • Good For: People who plan on paying off their home quickly but want the flexibility of access to more cash at a moment's notice. This is not the typical NCRC members agency constituent.

30. Loan Modification Mortgage • With this loan, the borrower can subsequently change the terms just by making a phone call, with a capped closing cost each time of just $1,000 for every million dollars borrowed. Moreover, the mortgage's duration isn't changed each time the rate is modified. • Pro: No paperwork is necessary, and closing costs are kept to a bare minimum. • Con: The added flexibility comes with a price tag of roughly 3/8th of a percentage point on every type of loan. • Good For: People who like to follow interest rates. But borrowers should make sure to factor in the $1,000 fee every time they consider modifying their loan. To quote an industry source, most of this products customers have financial planners who manage their mortgages for them. Again, not the typical NCRC member agency constituent.

31. Short-Term Hybrids: • Like traditional hybrid adjustable-rate mortgages, these short-term ARMs offer fixed-rate periods and then the interest rate floats with the index they're tied to. But since the fixed portion is for a very limited time — say, six months or one year — lenders offer very competitive rates.

32. Pro: Very low interest rates during the fixed portion of the loan. The initial monthly payments are relatively small. • Con: Six months or a year can pass by in the blink of an eye — and rates can change dramatically during that span. Back in July 2003, for example, Charles Schwab offered a six-month ARM with an interest rate of 2.995%. Today, that same product sits at 5.1%. On a $250,000 loan, that would mean an increase of $400/month. • Good For: People who plan on moving in a very short period of time, again, not the typical NCRC Member constituent.

33. The Legal Toolbox • Appraisal & Valuation issues, FIRREA and USPAP • Federal Fair Housing Act – Steering Complaints • Truth In Lending Act (TILA) • Equal Credit Opportunity Act (Reg B) • Home Ownership & Equity Protection Act (HOEPA) • Home Mortgage Disclosure Act (Reg C) • Community Reinvestment Act - Wachovia Merger • Fair Debt Collection Practices Act • Real Estate Settlement Procedures Act (RESPA). • State & Local Protections • Fraud & Racketeering Arguments • FTC Act

34. Interagency Guidance • Federal Agencies issue guidance on non-traditional mortgages on September 29, 2006 • Guidance addresses interest-only and option ARM loans • Guidance does not cover fully-amortizing ARM loans such as 2/28 and 3/27 loans

35. Interagency Guidance • Fully Indexed Rate assuming Full Amortization – Non-traditional loans should not be underwritten using the initial teaser rate, but should be underwritten using fully indexed rate (rate at loan origination plus margin). Loans should be underwritten based on the term of the loans. • Loans Permitting Negative Amortization – Loans should be underwritten based on initial loan amount plus any balance increase that may accrue from negative amortization

36. Interagency Guidance • Collateral Dependent Loans –Agencies will consider loans to be unsafe and unsound when the lender has not qualified borrower based on ability to repay but instead assumes that the borrower will be able to sell or refinance the loan based on the value of the property.

37. Interagency Guidance • Risk Layering –Combining non-traditional features such interest-only, simultaneous second liens, or reduced income documentation. When risk factors are layered, mitigating factors are needed such as higher credit scores, or lower Loan to Value ratios, or lower Debt to Income ratios. • Stated Income– should only be used if mitigating factors reduce risk. Generally, lenders should use W-2s, paystubs, or tax returns in underwriting. • Simultaneous Second Liens or Piggyback– Borrowers with minimal equity should not have delayed or negative amortization.

38. Interagency Guidance • Introductory Rates– Lenders should minimize spread between introductory rates and fully indexed rates so that borrowers do not experience payment shock. • Brokers– Monitor third parties including brokers to ensure that brokers are adopting the lender’s standards. Terminate relationships with brokers as needed.

39. Interagency Guidance • Consumer protections – Disclosures recommended before the disclosures required by the Truth in Lending and other laws. Disclosures should occur when consumes are shopping and not only when Good Faith Estimate is issued and consumer has paid fees. • Advertising – Lenders should describe risks as well as benefits of non-traditional loans • To minimize chances of payment shock, disclosures could include the maximum monthly amount a consumer could pay.

40. Interagency Guidance • Consumer Disclosures – Borrowers should be clearly informed of prepayment penalties and the possibilities of negative amortization for option ARM loans. Consumers should be alerted to the price premium associated with reduced documentation loans. • Clear disclosures of Impacts of Choices – Borrowers should be clearly informed of how their choice of monthly payment options affects the amount paid off each month or whether negative amortization results • Avoid deceptive practices such as emphasizing benefits and “obscuring significant risks” to consumer.

41. Subprime Guidance • The non-traditional guidance did not cover subprime 2/28 and 3/27ARM loans. The regulators have just issued proposed guidance to cover 2/28 and 3/27 loans. The proposed subprime guidance is very similar to the non-traditional guidance. It is good overall, but should also apply to prime ARM loans • Freddie Mac adopted many elements of the proposed subprime guidance a few days before the agencies issued the proposed guidance.

42. Building Coalition • Building “coalition” to address the issue, change practices and create a safety net – Group exercise on next steps and a discussion of the NCRC Consumer Rescue Fund. • Nontraditional mortgages pose heightened risk to sub-prime borrowers. Already beginning the life of their loan with higher interest rates due to credit blemishes, sub-prime borrowers are often more sensitive to rate fluctuations than prime borrowers.

43. CFA Study • Exotic or Toxic? An Examination of the Non-Traditional Mortgage Market for Consumers and Lenders - Consumer Federation of America, May, 2006

44. Significant Shares of Non-Traditional Mortgage Borrowers Earn Less Than $70,000 Annually. More than one third (36.9%) of interest only borrowers earned below $70,000 annually and about one in six (15.6%) earned under $48,000 annually. More than one third (35.0%) of payment option borrowers earned under $70,000 annually and about one in eight (12.1%) earned between under $48,000. ($70,000 was about the median for Atlanta, Philadelphia and Chicago metropolitan areas, according to HUD figures for 2005, and the national median is $44,300.)

45. African Americans and Latinos More Likely to Receive Payment Option Mortgages: Latinos are nearly twice as likely as non-Latinos to receive payment option mortgages. One in fifty (2.1%) non- Latino borrowers received payment option mortgages compared to the 4.0% of Latinos that received payment option mortgages. African Americans were 30.4% more likely than non-African Americans to receive payment option mortgages. 2.2% of non-African Americans received payment option mortgages compared to 2.9% of African Americans.

46. African Americans were more likely than non-African Americans to receive interest-only loans. Nearly one in ten (9.0%) of African Americans received interest-only mortgages, 11.7% higher than the 8.1% of non-African Americans that received interest-only mortgages.

47. Many Non-Traditional Borrowers Have Only Average or Even Weaker Credit Scores. More than half (53.8%) of payment option borrowers and nearly two-fifths (38.0%) of interest only borrowers have credit scores below 700. More than one fifth (21.4%) and about one in eight (12.1%) interest only borrowers had credit scores below 660.

48. The majority of these two types of non-traditional mortgages are used to purchase homes. Nearly four out of five (79.0%) interest-only mortgages and nearly three fifths (57.5%) of payment option loans were used to finance the purchase of a home. The high proportion of purchase mortgages in the non-traditional mortgage portfolio tends to support the contention that the increased use of these mortgage products is related to the rapidly escalating cost of housing.

49. CFA’s Bottom Line • Many borrowers are increasingly relying upon non-traditional mortgages as a means to buy homes they could not otherwise afford. Non-traditional mortgage products typically offer initial lower monthly payments than traditional fixed-rate loans. But when these loan terms reset after a brief period, usually 2 to 5 years, consumers could be vulnerable to payment shocks, making their homes suddenly unaffordable and potentially ruining their finances. • For example, a $200,000 home with adjustable rate (ARM) non-traditional mortgage, an interest only ARM payment would rise by 54% and a payment option ARM payment would rise by 123% if the interest rate rose from 5.00% to 6.50%.

50. Question & Answers • For more information, please contact me at (202) 464-2712 or dberenbaum@NCRC.org Thank you for participating today!