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The Mortgage Trap


Nicki Randolph, a San Francisco real estate agent, hasn't been scared off by talk of a housing bubble. Although she already owns both a home and a condo in Palm Springs, Calif., Randolph just closed on a third property -- dropping more than $1 million on a 1,400-square-foot loft in the heart of San Francisco. How does she juggle so many properties in the overheated California market? Lots of leverage, thanks to banks all too willing to provide ever more. To finance her loft purchase, Randolph took out a mortgage that lets her pay only interest for the first five years -- a tactic that helps her ease into the hefty monthly payments. "Fears that the market is going to crash are way overstated," she says confidently. "It's a seven-mile-by-seven-mile city and a premier place people want to live. You have to be more aggressive here because the prices are so high."

PRESSURE KEEPS BUILDING

Randolph's story is a familiar one -- and it shows the lengths to which buyers are willing to go to snatch up real estate as well as the extremes lenders will stretch to accommodate them. As prices continue to skyrocket in much of the country, banks and lenders are cranking out an ever-growing array of products ranging from no-money-down or interest-only mortgages, to special "Payment Power" loans that allow homeowners to defer monthly payments altogether twice a year. Such creative financing is letting even marginal buyers purchase houses with price tags that used to appeal only to the rich and famous. In the process, banks and mortgage companies appear to be taking on more risk than ever before -- and if rates rise sharply or prices tumble, many of their customers could find themselves in deep trouble, too.

All those innovative mortgage products are a sure sign that lenders are doing everything they can to keep the housing boom going and to capitalize on yet another round of falling interest rates that no one expected. There are plenty of other signs of frenzy as well. Home appraisers complain that mortgage originators are demanding the optimistic appraisals needed to close on loans. "They started warning me to 'be a team player' and to 'hit the number' they needed to seal the deal," says Robert Burnitt, an appraiser in Midlothian, Tex. Enticed by juicy commissions from all those deals, others are jumping into the mortgage biz. Among them are John Switzer, an 18-year-old high school grad from New Bern, N.C., who put off college so he could start work as a mortgage rep for Houston-based Franklin Bank Corp. (FBTX) "Right now, mortgages are a little more interesting" than college studies, he says.

Yet nothing screams "frenzy" louder than the huge popularity of innovative -- and risky -- mortgage products that allow buyers to stretch for those million-dollar studios and multimillion-dollar suburban colonials. With interest-only mortgages now offered by everyone from ditech.com to Washington Mutual Inc., such loans now account for 20% of all new mortgages, up from under 5% two years ago. Option adjustable-rate mortgages, or "option ARMs," have also become all the rage in superheated markets such as California and Washington, D.C. With an option ARM, borrowers can choose among three different payment plans each month, continually changing what they fork over as their budgets shift. The options: a regular payment of both principal and interest, just the interest, or one that may not even cover the interest -- so the overall balance owed on the mortgage could continue to grow.

The question is, will the proliferation of interest-only and option ARM mortgages leave many buyers strapped down the road, causing higher default rates? David Liu, a mortgage strategist for UBS (UBS) in New York, notes that after similar products were introduced in the red-hot California market in the late 1980s, they ultimately incurred a default rate that was three times as high as conventional mortgages when the local economy went into recession in the early '90s. Already there are signs that current option ARM borrowers are straining to make their monthly payment: Liu notes that among a bundle of mortgages originated by Washington Mutual and securitized into the secondary market last year, fully 60% of borrowers made only the minimum payment this past March. "That's definitely a sign that people are stretching,"says Liu.

There's plenty of other evidence suggesting that homebuyers and their lenders are climbing out on a limb. According to a survey of homebuyers released last November by the National Association of Realtors, 25% of those polled were able to get a mortgage with no money down, vs. 18% in early 2003 and virtually none in the late 1990s -- a trend that could leave many of these new homeowners under water if home prices take even a small dip. At the same time, lenders are extending far more loans to borrowers who have had credit problems in the past. According to the Mortgage Bankers Assn., the share of new loans made to so-called subprime borrowers -- usually lower-income individuals with spotty credit histories -- rose to 28% in the second half of 2004, a sharp jump from the less than 5% of all lending that subprime represented back in 1994. "I think there are going to be some blowups," says Bert Ely, a bank consultant based in Alexandria, Va. "These are people who are most vulnerable to job loss."

If the housing market swoons and homeowners get into trouble, the mortgage industry won't be far behind, many critics worry. "I'm very nervous about the risk of higher foreclosures down the road," says Stuart A. Feldstein, president of SMR Research Corp., a mortgage research firm in Hackettstown, N.J. And on June 9, Federal Reserve Chairman Alan Greenspan revealed his unease when he warned Congress that "the apparent froth in housing markets may have spilled over into mortgage markets." He noted that the increasing use of interest-only and other "relatively exotic" mortgages are "of particular concern."

SAFEGUARDS

Lenders insist that worries about their standards are overblown. They maintain that, thanks to the advent of automated underwriting during the 1990s, their ability to analyze statistical trends in lending is far better than before, enabling them to better price loans according to risk. "Underwriting is still more of an art than a science, but we're making it far more of a science," says Joe Anderson, a senior managing director at Countrywide Financial Corp. (CFC), a Calabasas (Calif.) mortgage lender. And lenders note that they've instituted more safeguards since the last housing boom in the 1980s, such as requiring that borrowers have several months of liquid assets to assure that they can keep paying their mortgages in the event of a job loss. "On a scale of 1 to 10 -- with 10 being the worst-case scenario -- my concern level is only around a 2 right now," says D.C. Aiken, senior vice-president for pricing and products at HomeBanc Mortgage Corp. (HMB), a large lender in Atlanta.

Still, regulators are redoubling their efforts to make sure the banks are right. The Federal Reserve and other bank regulators recently ordered lenders making home-equity loans and lines of credit to do a more in-depth analysis of borrowers' income and debt levels and their ability to repay loans -- instead of relying heavily on credit scores, as many lenders have been doing. And regulators say they're busily drafting similar guidelines for mortgage lending as well. State regulators are also starting to rein in hyper-aggressive lenders. In Illinois, legislators passed a bill that would give a state agency the power to review mortgage applications in lower-income areas to determine whether borrowers should be required to attend loan counseling -- paid for by the loan originator -- before receiving the loan. That, lawmakers figure, will discourage brokers from extending loans to high-risk borrowers who have a high probability of ending up in foreclosure.

Of course, Nicki Randolph and many more like her who have used lenders' aggressive mortgage offers to expand their fledgling real estate empires aren't normally thought of as high-risk borrowers. But if interest rates and housing prices don't follow the rosy script that Randolph and so many others are banking on, a whole lot of homeowners could be caught in a painful trap.

By Dean Foust, with Peter Coy in New York, Sarah Lacy in San Mateo, Rishi Chhatwal in Atlanta, and bureau reports


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