By Peter Coy When Federal Reserve Chairman Alan Greenspan told Congress on June 9 that "the apparent froth in housing markets may have spilled over into mortgage markets," he was surely talking about mortgage markets like San Diego's.
BusinessWeek Online has obtained the first-ever measurement by metro area of the increasing popularity of interest-only mortgages, and it shows that San Diego rates No. 1, by number of "IOs" in 2004. In metro San Diego, 47.3% of all mortgages required interest payments only in their early years. The survey covered the top 50 metro areas in the U.S. and measured by the total number of mortgages issued. Atlanta, San Francisco, Denver, and Oakland, Calif., followed close behind San Diego. Milwaukee turned in the lowest number, just 4.8% interest-only loans last year.
FRENZIED MARKET. The data come from LoanPerformance, a San Francisco-based real estate information service. Although LoanPerformance also has statistics for the first few months of 2005, those numbers are too small to make them reliable (see the ranking of all 50 metro areas) below).
Greenspan isn't the only one worried about the sharp rise of interest-only mortgages, which accounted for less than 2% of all loans as recently as 2001. The concern: that they're helping supercharge already overheated housing markets. Because no payment of principal is due in the early years, interest-only loans offer lower monthly payments (even though the interest rate is slightly higher) than conventional ones. Based on the initial monthly payments, borrowers may be able to buy a more expensive house than they might otherwise afford.
Trouble is, when borrowers do have to start making principal payments -- after anywhere from 2 years to 10 years -- the monthly payment could jump by up to 50%, or even more if the index for the adjustable rate rises as well.
UNDER SURVEILLANCE. BusinessWeek Online has also obtained new data from Fannie Mae and Freddie Mac that lend credence to the LoanPerformance numbers. They show that, in April, going by dollar volume, interest-only loans accounted for 35% of the adjustable-rate mortgages in securities sold by Fannie Mae and 39% of the adjustable-rate loans in securities sold by Freddie Mac. That represents a sharp increase for both giants, which buy mortgages from lenders and then repackage them as securities for sale to investors.
As recently as January, 2004, only 10% of adjustable-rate mortgages in securities sold by Fannie classified as interest-only. And Freddie didn't sell any securities with interest-only loans at all until last December. (Amy Crews Cutts, deputy chief economist of Freddie Mac, provided the statistics to BusinessWeek Online.)
Freddie Mac -- which uses a computer model to decide which mortgage loans to buy from the original lenders -- says it views with skepticism the rise of interest-only loans. "It is something that we are paying attention to very closely," says Cutts.
ARMS RACE. With mortgage rates remaining low despite Federal Reserve rate hikes, home prices keep going up. The Office of Federal Housing Enterprise Oversight says single-family home prices rose 12.5% from the first quarter of 2004 through the first quarter of 2005. Nevada led the nation with a 31.2% increase.
For people worried about a bubble, the increasing popularity of so-called option ARMs look even scarier. Option ARMs have teaser rates as low as 1% and give borrowers four different choices of how much to pay every month. The minimum-payment option is so low that it may not even cover all the interest due. Whatever isn't paid gets added to the principal, a phenomenon called "negative amortization" that many credit-card users know all too well.
Cutts says Freddie Mac doesn't buy option ARMs from lenders -- but she believes there's a "secular shift" toward them and away from ordinary interest-only loans.
ECONOMY CAN TAKE IT. Keith M. Schemm, a mortgage broker in Santa Clara, Calif., says option ARMs are "pretty dangerous loans to do" for many families. "The problem," he says, "is there's such a frenzy in the marketplace to buy a home."
In his testimony before the Joint Economic Committee on Capitol Hill on June 9, Fed chief Greenspan voiced his own concerns about the increased use of interest-only loans and their variants. Despite his worries about mortgages, in the end, Greenspan maintained his view that even if home prices decline from their current elevated levels, he believes the economy can withstand the fallout. Here's hoping.
Interest-Only Loans Across the U.S.
Interest-Only Mortgages As Share of Total, 2004
Orange County, Calif.
West Palm Beach-Boca Raton
Salt Lake City
Riverside-San Bernardino, Calif.
Fort Lauderdale, Fla.
Fort Worth, TX
Data: LoanPerformance LLC
Coy is Economics editor for BusinessWeek in New York