Tuesday, May 27, 2008

Week of April 14, 2008--Non-traditional Mortgages


One reason for the huge, double-digit increase in home prices from 2003-05 was the growing popularity of so-called “non-traditional”, or adjustable rate mortgages. They were popular in part because interest rates were lower than the inflation rate of that time, which meant no effective interest rate was being charged. And since interest rates were at an all-time low, many borrowers didn’t realize that their ARM indexes could double, bringing up the underlying real interest rate to more than 8 percent in some cases.

Whether fully understood by borrowers or not, nontraditional mortgages are still popular. According to the trade journal Inside Mortgage Finance, nontraditional mortgages accounted for about one-third of all mortgage originations in 2006. A mortgage can be nontraditional because of these features or because of the way it is underwritten (for example, "low-doc [documentation]" and "no-doc" loans).

In a traditional mortgage, the first payment the borrower makes is the same amount as all subsequent payments. Whereas in nontraditional mortgages the study explains, "the borrower faces two payment regimes: an initial regime with low payments and a second regime where payments increase to fully amortize the loan and to compensate the lender for the cost of capital and riskiness of the loan."

But banks are cutting back on most non-traditional programs—at least those with no-doc and low-doc underwriting. So many borrowers of these mortgages can only hope their indexes continue to come down, which is possible if the Federal Reserve continues to drop their overnight and discount rates to member banks.

Economic activity pointed to some slight improvement in industrial production and the Conference Board’s Index of Leading Economic Indicators (LEI). Consumer incomes were still flat after accounting for inflation in March, though retail sales also picked up slightly.

LEI—The Conference Board’s March index of future business activity increased slightly for the first time in 5 months. Its coincident index that tracks the same 4 components used by the National Bureau of Economic Research to designate a recession was stronger. The components--industrial production, personal income, and manufacturing and trade sales increased in March, while payroll employment declined.

RETAIL SALES—Year-over-year sales rose 2 percent, mostly due to higher gasoline prices, but were flat after inflation. Internet and mail order sales were the biggest component, up 2.1 percent.

Inflation is eating away at the U.S. consumer. The higher energy and food prices are the main obstacles to a recovery. Inflation normally subsides during a slowdown, but that hasn’t happened yet. Crude prices have risen 70 percent in 1 year, according to Business Week, “robbing” 1.4 percentage points from U.S. gross domestic product growth. This is in fact what has brought the economy to a standstill.

It remains to be seen if all non-traditional mortgages will be banned. Wall Street is marking down the valuations of those banks still issuing them, including Washington Mutual, Countrywide Financial and Wachovia Bank. If so, it will cut off mortgage credit to a large segment of the self-employed, for which these programs were designed.

© Copyright 2008

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