Fed Officials Warn on Real Estate Values, Interest-Only Loans
2005-06-08 00:06 (New York)
By Craig Torres and Amy Strahan
June 8 (Bloomberg) -- Federal Reserve governors and other
U.S. banking regulators are growing concerned that easier credit
standards and greater use of interest-only loans are fueling home
price speculation, increasing risks to the U.S. banking system as
interest rates rise.
``Financial institutions may not be fully recognizing the
risk embedded in these portfolios,'' the Fed, the Comptroller of
the Currency and three other regulators warned in a May 16 letter
on home-equity loans to lenders and bank examiners. Fed Chairman
Alan Greenspan, who talked the same week of ``froth'' in the
housing market, will likely be questioned on the topic during
congressional testimony tomorrow.
``The new development is the volume of these interest-only
first mortgages we're seeing,'' acting Comptroller Julie Williams
said in an interview. ``Banks should be evaluating the risks of
these types of loans, not just based on the initial loan terms,
but based on the loan terms that may roll into effect over the
life of the loan.''
Central bankers and regulators say they are concerned at the
prospect of a real-estate bust that would cascade through the
banking system, causing even healthy banks to pull back on
lending. That would limit the ability of the Fed to influence bank
lending and the economy through interest-rate policy.
Real estate busts ``have a long duration and they affect
everybody,'' said Harvey Rosenblum, executive vice president of
the Dallas Fed. Banks have difficulty raising capital to make new
loans, and the capital they have is constrained by loan losses, he
said.
Flipping the Switch
``You have this downward spiral effect,'' Rosenblum said.
``When you are going through these kind of economic times, you
flip the switch to off,'' even at healthy banks.
For now, officials say, the banking system is healthy and
real estate prices are buoyant. U.S. banks' net loan losses
totaled $7.2 billion in the first quarter, the lowest total since
the third quarter of 2000, according to the Federal Deposit
Insurance Corp.'s quarterly report released in May.
So-called ``guidance letters'' such as the one issued May 16
are aimed at improving lending standards without interfering with
markets. Another letter, this one dealing with first mortgages, is
under discussion, Kevin Mukri, a spokesman for the Comptroller,
said.
Fed chairman Greenspan, who appears before the Joint Economic
Committee of Congress on Thursday, told the Economic Club of New
York May 20 that there is a ``good deal of speculation'' in real
estate markets, and ``we're also seeing it in the mortgage
market.''
Mortgage Rates
Fueling home-price speculation are mortgage rates near four-
decade lows. Rates on 30-year fixed mortgages have declined even
though the Fed has raised short-term rates 2 percentage points
since June 2004. At that time, 30-year fixed-rate mortgages
averaged 6.29 percent versus 5.72 percent last month.
Signs of speculation include second-home purchases for
investment, the ``heavy reliance on interest-only loans'' and the
use of adjustable-rate mortgages despite increases in short-term
rates, said Patrick Lawler, chief economist at the Office of
Federal Housing Enterprise Oversight.
Interest-only mortgages accounted for only 6 percent of
adjustable-rate mortgages in 2002. By the end of 2004 they
accounted for 23 percent nationwide, according to LoanPerformance,
a mortgage-data provider based in San Francisco.
Sales of investment properties rose 14.4 percent in 2004 to
1.8 million units, according to the National Association of
Realtors. About 80 percent of investment properties are single-
family homes, the association says.
Average Gains
Nationally, home prices averaged a 12.5 percent gain from the
first quarter of 2004 to the first quarter of 2005, according to
an index tracked by the Office of Federal Housing Enterprise
Oversight. Twenty-four states showed average home-price gains of
10 percent or more in the period.
Over the past four quarters, prices are rising faster than
any period since 1979, when the consumer price index rose to 13.3
percent, compared with 3.3 percent last year.
``In some markets -- I won't name individual cities in the
Southeast -- the activity in residential real estate looks pretty
speculative to me, and that makes me very uncomfortable,'' Atlanta
Fed bank president Jack Guynn said. ``There is a very good chance
that some lenders, some buyers and some builders will get
burned.''
The May 16 regulatory letter cited interest-only loans that
lower the initial out-of-pocket costs for homebuyers by letting
them omit monthly principal payments for a time. While interest-
only loans can extend the reach of buyers in markets where prices
are moving up, they also contain several risks. Interest-only home
equity loans rarely have locks or caps, unlike adjustable-rate
mortgages. And the principal eventually has to be paid back, which
can double or triple monthly payments.
Risk of Default
``When I took economics in World War II, and we were studying
the Great Depression, one of the reasons given were all the
interest-only loans that came due,'' L. William Seidman, who was
chairman of the FDIC from 1985 to 1991, said in an interview.
``They were an indication of an economy getting into unsound
lending. Ever since then it's been a rule that when you go into
interest-only loans, you're very substantially increasing the risk
of default.''
Richard T. Nadolski, senior vice president of mortgage loan
administration at North Shore Capital Bank in Brookfield,
Wisconsin, said the loans are very popular.
Bandwagon
``We started getting on the interest-only bandwagon about a
year ago, and it's gone from nothing to 30 percent'' of North
Shore's adjustable-rate mortgages, Nadolski said.
Bank of America, the third-largest U.S. bank, offers some
interest-only mortgages, according to spokeswoman Julie Davis.
``Our overall approach with any customer is to sit down with
them and try to identify their long and short-term financial needs
around purchasing a home,'' Davis said. ``How long are they going
to be in the home, what do they anticipate career-wise?''
The vast majority of Bank of America's mortgage loans are
regular, 30-year mortgages as opposed to adjustable rate
mortgages, Davis said.
``The interest-only loan has added about 10 percent to the
value of homes in California and other high-priced areas,'' said
David Akre, co-chief executive officer of New York Mortgage Trust
Inc., a real estate investment trust.
