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1.4.4 The Role of Nontraditional Mortgages

One significant factor contributing to the foreclosure crisis was the expansion of the “non-traditional” or “alternative” loan product market. Such products include interest-only loans, payment option adjustable rate mortgages, and hybrid adjustable rate mortgages, such as “2-28s” and “3-27s.”85 With interest-only loans, the borrower is required to pay only the interest due on the loan for an initial period such as three or five years. During this time, the interest rate may fluctuate or be fixed. After the interest-only period, the borrower’s payments must include both principal and interest.

A payment option adjustable rate mortgage (ARM) is a nontraditional adjustable rate mortgage that allows the borrower to choose from a number of different payment options. For example, each month the borrower may be able to choose a minimum payment option that does not even pay all the interest on the loan, an interest-only payment, or a payment large enough to pay off the principal and interest over either fifteen or thirty years. If the borrower chooses the minimum payment option, the loan will negatively amortize. After a specified number of years, or if the loan reaches a certain negative amortization cap, the required monthly payment amount is recast to require payments that will fully amortize the outstanding balance over the remaining loan term.86

In “2-28” and “3-27” loans, also known as “exploding ARMs,” the interest rate is fixed at an artificially low rate for a brief period of two or three years. They then switch to an adjustable rate for the remaining twenty-eight or twenty-seven years, with rate increases as often as every six months.87

Significant payment shock is a common feature of all of these types of loans. Even if the interest rate index is unchanged, a 2-28 subprime ARM carries an average payment shock of twenty-nine percent over the teaser-rate payment. With interest rate increases, many borrowers have experienced payment shocks of fifty percent.88

From 2004 to 2007, these alternative mortgage products—especially interest-only loans—moved from a marginal role in the mortgage market to a place of dominance. In 2005, interest-only loans constituted twenty-seven percent of loans nationwide.89 Almost three-quarters of securitized subprime mortgages originated in 2004 and 2005 were exploding ARMs.90

The growth of these non-traditional mortgage products in an environment of low interest rates raises serious questions about how and why consumers received these products. Interest-only loans generally are suitable for households expecting significant increases in income, for those with fluctuations in income where the borrower is able to pay down principal during certain periods, or for investors seeking to maximize cash flow. Subprime borrowers generally do not fit any of these criteria. Many are on fixed incomes, and those with fluctuating incomes do not see substantial upswings in incoming funds. Accordingly, these loans could only be made to such borrowers if the lender dispensed with underwriting that analyzes whether the borrower can afford the loan beyond the initial teaser rate, if then. Indeed, roughly half of all subprime borrowers between 2004 and 2006 were given “stated income” loans (also called “no doc” loans), in which they were qualified for the loan based simply on statements on the loan application regarding their income, or “reduced documentation” (also called “low doc”) loans.91

Many lenders underwrote adjustable rate loans only for the teaser rate, making default highly likely.92 Even prime lenders do not underwrite the loan for the maximum possible payment, instead commonly focusing on the fully indexed payment at origination. The result is that neither consumers nor the market are taking the risk of interest rate increases into account, leading to major safety and soundness concerns. This is evidenced by Standard & Poor’s requiring increased credit enhancements for option-ARMs.93 Further, lenders do not disclose to the borrower that the borrower has not been qualified for the eventual payments she will need to make. In 2006, the federal banking regulators issued an Interagency Guidance on Nontraditional Mortgage Product Risks to address some of these problems,94 and in 2007 they proposed a second guidance on subprime lending.95 These documents, which serve as guides for bank examinations, only apply to financial institutions regulated by the federal banking agencies.96

Delinquency rates for subprime ARMs demonstrate the huge risk posed by nontraditional products. At the end of 2011, 34.45% of subprime ARMs nationwide were seriously delinquent, approximately twice the rate for prime ARMs.97 By the end of the third quarter of 2012, 19.30% of subprime ARMs nationwide were seriously delinquent, more than twice the rate for prime ARMs.98 In some metropolitan areas, over twenty percent of subprime mortgages were delinquent in February 2007.99 In 2006, one in every twenty-one households in Detroit experienced foreclosure.100 Foreclosures surged dramatically beginning in 2008 and, as of January 2015, more than 5.5 million households have lost their homes to foreclosure.101