With last month’s elections and the Democrats’ upcoming control in Congress, predatory home mortgages are back in the spotlight.  Congressman Barney Frank, the incoming chair of the House Financial Services Committee, has made clear that a federal anti-predatory lending law is high on his agenda, and industry representatives and consumer activists are scurrying to draft bills.  Given the recent attention on the Hill, we decided to devote our guest entries this week to residential mortgages.  Our heartfelt thanks go to Bob Lawless and his colleagues at Credit Slips for inviting us to make a guest appearance.

Today, we focus on a persistent myth: that if subprime customers just comparison-shopped, they would not end up with predatory loans.  In our humble view, no matter how smart customers are, it is impossible – totally impossible – for them to engage in informed comparison-shopping in the subprime market.  Policymakers have a hard time grasping this fact because it is so easy to comparison-shop in the prime market.  However, price revelation works differently in the subprime market, making meaningful comparison-shopping impossible.

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The Mortgage Bankers Association recently released its semi-annual survey on home loan originations. The press release reports that interest-only loans and payment-option loans continue to grow. In the first half of this year, 26% of all mortgage loan originations (based on dollar volume) were interest-only loans. Another 15% of dollar volume were "payment-option" adjustable-rate loans.

The Mortgage Bankers Association press release refers to these loans as "so-called ‘non-traditional’ products. Others have labeled them "exotic" mortgages. It strikes me that these labels minimize the extent to which these loans dominate today’s home lending economy. Interest-only and payment-option loans are too common to be marginalized as "exotic," and given the increasing frequency of these loans in recent years, American homebuyers have arguably already created new traditions. Perhaps we should label them what they are–risky. Terminology matters to consumer perception. Consider the trend toward renaming no-documentation mortgages. Originally called "NINA loans" (nice, friendly-sounding acronym for no-income/no-asset), they are now often mocked as "liar’s loans" (making clear the potential for deception).

Federal regulators recently released a report about interest-only and payment-option mortgages, querying consumers "Are they for you?" The brochure offers three examples of consumers who may benefit from an interest-only or payment-option home loan: people who are certain their income will increase (about to graduate from law school, perhaps?); people who have substantial equity in their house and will invest elsewhere the money that they would put toward principal payments; and people who have irregular income (such as commissions) and want flexibility in making their payments. Frankly, I’m not sure about the wisdom of these risky home loans even if you fall into these categories. I do know that the population falling into these categories is not nearly big enough to account for the 2006 originations.

Mark Whitehouse reports in this Monday’s Wall Street Journal about the rising number of defaulting homeowners hitting the skids as those once-darling floating rate/interest-only loans start to rise (the current lull by the Fed notwithstanding).  What’s the silver lining?  Why the propitious news for derivatives traders who have gobbled up new contracts that hedge against sub-prime mortgage defaults!  Yes, that’s right, the good news is you can make a buck on the foreclose of that guy down the street.  I guess at least someone’s figured out how to bet on the Don’t Come Line in the crapshoot of life.

The Denver Post just published a fourth article in its well-researched series on foreclosures in Colorado.  The articles focus on the extreme conditions in Colorado – the state with the highest foreclosure rate in the nation – but many of its themes apply across the across the county. The series tells of recently-built neighborhoods in which one-fourth of the homes have been foreclosed.  It discusses the increasing proportion of interest-only and adjustable-rate mortgages, which account for an astonishing 43.6 percent of mortgages in Colorado. The national rate of 26.7 percent may seem small in comparison, but it too has skyrocketed in recent years. (In 2001, fewer than 2 percent of home loans were interest-only mortgages. Adjustable-rate mortgages accounted for about 14 percent of the market as recently as 2003.)

The Post also did some original empirical research of its own, and the results suggest that the state’s rates of foreclosures and its rates of high-risk mortgages are not unrelated. The newspaper studied all the foreclosure notices filed this August in three Colorado counties which have been particularly hard hit by the foreclosure boom.  Of the nearly 1,000 notices it examined, it found that, when excluding mortgages based on certain federally insured loans that require a small down payment, over seventy percent of the underlying loans were no-money-down. This means that the families became homeowners with no equity in their homes.

This series also tells a Colorado version of a story that has been documented nationally by the Consumer Bankruptcy Project.  The families in the Post articles take on mortgages with payments that are barely affordable when times are good. When something goes wrong, these families are forced into foreclosure.  Here that “something” ranges from divorce to surgery following a car accident to pay cuts to neighborhood covenants that required the new owner to landscape the property.  The Post’s research comports with the Consumer Bankruptcy Projects national findings in one other key respect.  Although a negative life event may be the immediate catalyst that sends a family into crisis, it is the family’s underlying financial structure – too much debt, too few assets (in this case, home equity) – that leaves it so vulnerable in the first place. As the reporters wrote in the most recent article in the series:  “In interviews with dozens of homeowners in foreclosure, The Post found that life events such as job loss, medical problems and divorce often precipitate a default. But lack of equity, which gives homeowners options when they face financial problems, was a factor in nearly all cases.”

Federal Reserve researchers have a new paper in the Federal Reserve Bulletin evaluating the 2005 Home Mortgage Disclosure Act data (if the prior link doesn’t work for you, try this).  For now, I would particularly direct readers’  attention to the analysis of piggyback lending on pp. A135-A138.

In today’s New York Times, Vikas Bajaj and David Leonhardt offered a creative explanation for how home sales could be slowing and inventories building while home prices continued to nudge upwards:  incentives.  They report that in a weakening market sellers are giving rebates on prices, either in goods, services or outright cash.  In other words, the records may show that the house sold for $350,000, but the effective price was $343,000. 

The reasons for this ruse are partly psychological (individual sellers who think: "I don’t want to lower the price!") and partly economic (builders who think:  "I don’t want the people who already signed contracts for homes in this subdivision to know that the new guys can get in for lower prices.") 

Back in the day (say, 1972) when the median first-time home buyer coughed up an 18% downpayment, a few bucks of incentives probably wouldn’t have mattered.  But with the median first time homebuyer today making a ZERO down payment, a little rebate means the mortgage starts out in the red.  Bajaj and Leonhardt note at the end of the article that the mortgage companies try to police the rebates, but c’mon, does anyone think that really happens?  Besides, by keeping the prices high, the comparables stay high as well, giving everyone an inflated appraisal on which to base that 100% financing. 

Here’s one more little piece of evidence why everyone on this list should be selling their mortgage-backed securities (if anyone on this list ever had any mortgage-backed securities):  The valuation numbers are phony.  Maybe just a little phony in this case, but at 100% financing, a even a little bit phony is going to come out of the investor’s hide. 

As housing values continue to deflate, those of us who teach mortgage foreclosure law will have many attentive students. 

An earlier post by co-blogger Melissa Jacoby (Turning Stucco Into Sand) commented on homeowners who file bankruptcy. That demographic seems likely to grow in light of rising interest rates and falling home prices. New mortgage products, including interest-only loans and adjustable rate mortgages in which the initial rate is the floor, leave consumers bearing all the risk of these market fluctuations. Higher loan to value ratios are positively correlated with foreclosure, and yet today’s first-time home-buyers put down only 3 percent when they purchase a house.

What do these trends mean for financial advisers, educators, advocates, and even parents who are concerned with ensuring financial success and security for today’s young people? While more research is certainly needed, an article in USA Today offers one possible answer—rent! (“For Some, Renting Makes More Sense”, 1A, Aug. 10, 2006) The traditional advice to buy a home as soon as possible and stop “throwing away money on rent” may need to yield to the costs and risks of modern mortgages. The USA Today article examines the gap between the median mortgage payment and the median rent in several housing markets. It finds that many consumers would have a couple of thousand extra dollars each month if they rented. The national gap between mortgage payment and rent was calculated at $816 monthly. If families put this money into tax-advantaged retirement programs or into an emergency fund would they be better protected from financial failure? Is a home no longer the best way to achieve financial security? Does the government do too much to promote homeownership at the expense of urging and enabling families to save for retirement, purchase insurance, or save?

By the way, the Wall Street Journal had an interesting piece on Tuesday on NINA mortgages (no income/no asset verification) loans and some of the “red flags” created by that lending product. (‘Stated Income’ Home Mortgages Raise Red Flags, Wall Street Journal, D2, August 22, 2006).