- The Washington Times - Thursday, September 21, 2006

Federal regulators found serious problems with backloaded mortgages that enabled buyers to buy high-priced homes in Washington and other booming markets, after examining the portfolios of six huge banks that make half the mortgage loans in the United States.

Sandra Thompson, a director at the Federal Deposit Insurance Corp., testified yesterday that some borrowers were not qualified to make escalating payments required under the loans, and the banks loosened their standards considerably to enable buyers to qualify, including “layering on” risks such as requiring no down payment or proof of income.

The problems raise the risk of defaults and foreclosures as the housing market stagnates, she told the Senate Banking, Housing and Urban Affairs Committee in Congress’ first hearing on the new breed of mortgages, sometimes called “exotic” or “alternative” loans because they do not offer standard, fixed payments like those on 30-year mortgages.

Ms. Thompson said the bank insurance agency and other federal regulators soon will be issuing rules that prohibit banks from offering loans to consumers who cannot handle future payment increases and require more rigorous disclosures about the risks of the mortgages.

State banking regulators at the hearing said they would, as reported in The Washington Times, pass the federal rules along to the half of mortgage lenders, including state banks and mortgage brokers, not regulated by the federal bank agencies.

Exotic mortgage products such as “interest-only” loans and “optional payment [adjustable -rate mortgages]” took the mortgage market by storm when they started to be widely offered in 2003, jumping to become one-third of all loans issued nationally and half of the loans issued in high-priced markets like Washington in the past year, according to the FDIC.

All the mortgages have one essential characteristic: They allow borrowers to make minimal interest payments in the first few months or years, but at the cost of ballooning payments in future years that can double or triple the monthly bill.

Mortgage brokers often did little to warn consumers about the risks of exploding payments in marketing the loans, the regulators said. Brokers say privately they expect most borrowers to refinance the loans when the higher payments come due — yielding more business and fees for the brokers — or end up “house poor,” without the money to spend on just about anything but their mortgage if they are to avoid default.

The enticing but risky loans were an essential fuel feeding the housing boom that ended last year, the regulators said. During the housing boom, home prices doubled nationwide and tripled or more in Washington and other East and West Coast cities, an unprecedented run-up that many economists think constituted a housing bubble that is now bursting.

“The acceleration of the home price boom does appear to have been related to changes in the mortgage markets,” Ms. Thompson said. “The greater availability of flexible mortgage structures probably allowed price increases to outstrip growth in incomes,” while “high-priced homes probably induced at least some borrowers to use interest-only or payment-option mortgages in order to afford their homes.”

One important change in the market that facilitated the boom in exotic loans was the advent of large private pools of investors, often gigantic hedge funds marshaling the resources of both domestic and foreign investors, she said. These investor pools, many of which had much lower underwriting standards than banks, stepped into the void created by the withdrawal of Fannie Mae and Freddie Mac from the loan-pooling market since 2003.

The FDIC sounded a strong warning about the risks to both borrowers and lenders now that the housing boom has ended. Foreclosures already are rising this year among borrowers faced with sharply higher loan payments.

Orice Williams, director at the Government Accountability Office, Congress’ investigative arm, testified that it is too soon to tell whether exotic mortgages will lead to greatly increased defaults and foreclosures, but she said it is clear that better disclosures are needed to ensure consumers understand the loans and know what they’re facing.

Exotic loans have been “concentrated in regional markets on the East and West coasts in states such as California, Washington, Virginia and Maryland,” she said.

“A wide spectrum of borrowers may not fully understand their risks,” she said, because they often have complicated terms, the advertising emphasizes the benefits rather than risks, and the disclosures consumers do receive are hard to understand.

She said federal regulators should revamp the decades-old Truth in Lending Act to require disclosures that cover loan features that add to consumer debt burdens but are not understood by many consumers.

Sandra F. Braunstein, a director at the Federal Reserve, said the central bank is rewriting the Truth in Lending Act regulations to address exotic loans, but she did not indicate when the new rules would appear.

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