Alternative Mortgages: Risks to Consumers and Lenders in the Current Housing Cycle

Publication Date: December 2006

Publisher: Library of Congress. Congressional Research Service

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Research Area: Banking and finance

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Abstract:

Borrowers increasingly turned to alternative mortgages to purchase homes in 2001-2005, when mortgage rates remained historically low and homes appreciated rapidly in many markets. Signs of rising interest rates and slowing home sales raise concerns that the use of some types of alternative mortgages may exacerbate price declines and threaten the finances of consumers and lenders. The use of mortgages with adjustable rates, zero down payment, interest-only, or negative amortization features raise economic risk compared to traditional mortgages. If borrowers and lenders have not adequately evaluated these risks, then the financial system may be hit with unexpected losses.

Alternative mortgages offer some combination of adjustable rates, extremely low down payments, negative amortization, and/or optional monthly payments. The prudent use of alternative mortgages offers benefits. Buyers planning to move frequently could place less value on ensuring fixed payments in later years of a loan. During periods of exceptionally high interest rates, adjustable rates may suit consumers expecting rates to fall. People whose incomes depend on commission or bonuses may be attracted to mortgages with flexible monthly payments.

These benefits come with potential costs for the borrower and for the financial system. Adjustable rates shift the risk of rising interest rates from banks to borrowers. Low down payments increase the risk that borrowers will owe more than their house is worth if prices fall. A borrower owing more than the house is worth may be unable to sell or refinance the house. Some measures of interest rate risk and negative appreciation risk show geographic concentration. The use of alternative mortgages in these areas could make home prices more volatile and increase defaults. These risks are relevant because more than a trillion dollars of mortgages originated during the boom will reset their monthly payments in the next two years.

Federal regulatory agencies issued new guidance on alternative mortgages in October 2006. The guidance recognized that these products expose financial institutions to increased risk because the products have not been tested in a stressed environment. The agencies directed financial institutions to tighten lending standards and to improve disclosure to consumers.

This report describes alternative mortgages, summarizes recent regulatory actions, and provides an estimate of the geographic concentration of interest rate risk and negative appreciation risk. It will be updated if market developments warrant.