CHART 1

CHART 2


Before 1980, institutional lenders were subject to strict interest rate ceilings on their deposits, established by the Federal Reserve’s Regulation Q. This regulation provided for higher ceilings on thrift institution deposits than on commercial bank deposits, securing S&Ls’ funding advantage.² The late 1970s inflationary environment opened an unsustainable gap between income generated by assets and short-term funding costs, thereby undermining S&Ls’ theoretical foundation that had provided economic stability for them in the past. Further, as inflation soared, depositors fled from S&Ls to higher-yielding opportunities outside the regulated banking system. The resulting disintermediation helped set the stage for the enactment of the Depository Institutions Deregulation and Monetary Act of 1980, which mandated a six-year phase-out of the Regulation Q interest-rate ceiling and created the money market deposit to enable FDIC-insured institutions to compete with brokerage houses for wholesale funds.³ Although it helped S&Ls retain deposits, the elimination of Regulation Q ended their favored status in the U.S. mortgage market.⁴

The enactment of the Alternative Mortgage Transaction Parity Act in 1982 eliminated regulatory disparities between state- and federal-chartered mortgage banks by granting state-chartered institutions the authority to issue alternative mortgages, including the use of variable interest rates and balloon payments, regardless of state mortgage lending laws.⁵ This legislation increased the supply of mortgage credit. The Tax Reform Act of 1986 then stimulated demand for mortgage debt by retaining the deduction for home mortgage interest while eliminating the deduction for nonmortgage consumer debt, such as car loans and educational loans. The tax-deductible status of debt secured by homes made mortgage debt a more attractive after-tax financing option than nondeductible consumer debt (see inset box, “Substituting Mortgage Debt for Consumer Debt,” next page).

Impact of Mortgage Securitizations
Following the elimination of Regulation Q, control of the mortgage market shifted dramatically in the 1980s from savings institutions to banks and to federal government-sponsored enterprises (GSEs), which played a major role in the creation of mortgage-backed securities (MBS). These securitizations further opened the U.S. mortgage market to investors, introducing considerable new liquidity.⁶ By 2005, almost 68 percent of home mortgage originations were securitized.⁷ This reliance on securitization underscores its importance as a risk-management tool that allows lenders to shift mortgage credit risk and interest rate risk to investors who have greater risk tolerance.

A significant development in the mortgage securities market is the recent and dramatic expansion of “private-label” MBS, which are securitized by entities other than the GSEs and do not carry an explicit or implicit guarantee. Total outstanding private-label MBS represented 29 percent of total outstanding MBS in 2005, more than double the share in 2003.⁸ Of total private-label MBS issuance, two-thirds comprised nonprime loans in 2005, up from 46 percent in 2003.⁹ With the increased exposure to private-label MBS and a large share of higher-risk nontraditional mortgages being securitized in this sector, investors appear willing to assume greater risk in their search for yield.

Recent Innovations in Mortgage Products
The U.S. mortgage market, which for decades was dominated by fixed-rate mortgages, now includes innovations such as nontraditional mortgages, simultaneous second-lien (or piggyback) mortgages, and no-documentation or low-documentation loans.¹⁰ Nontraditional mortgages allow borrowers to defer payment of principal and, sometimes, interest and include interest-only mortgages (IOs) and adjustable-rate mortgages (ARMs) with flexible payment options (also called pay-option ARMs, or POs). Although perceived as fairly new, many of these loan types are a repackaging of existing products, marketed again in the 2000s in response to growing demand. For example, record-high fixed rates in the late 1970s and early 1980s stimulated innovation in the form of various types of ARMs. Some of today’s pay-option ARMs are a reincarnation of negative amortization loans that were popular in the 1980s, but then fell out of favor in the early 1990s when rising interest rates and falling home prices in certain areas left some borrowers owing more than their homes were worth.

Since 2003, strong home price appreciation and declining affordability have helped drive growing demand for nontraditional mortgage products that can be used to stretch home-buying power.¹¹ Aided by new computer models and an easing in lending standards, many lenders have accommodated this demand by expanding the variety of nontraditional mortgage products offered while also extending loans to borrowers with less-than-stellar credit histories. As a result, by 2005, nonprime lending, comprised of subprime and Alt-A (low- or no-documentation) loans, accounted for about 33 percent of all mortgage loan originations, up from almost 11 percent in 2003.¹²

Rapid growth also has occurred among some of the higher-risk mortgage alternatives within the nonprime arena. As recently as 2002, IOs and pay-option ARMs represented only 3 percent of total nonprime mortgage originations that were securitized. However, the IO share of credit to nonprime borrowers has soared during the past two years to 30 percent of securitized nonprime mortgages, while the pay-option product jumped to a similar share in less time (see Chart 3). Furthermore, the low- or no-documentation share of subprime lending has grown significantly since 2001, from about 25 percent to just over 40 percent.

CHART 3


Lenders continue to diversify mortgage offerings as they compete to attract borrowers and accommodate prospective homebuyers’ financing needs. Many banks now offer 40-year mortgages, which are gaining in popularity as an alternative to IOs and pay-option ARMs. The extended amortization period reduces monthly mortgage payments, thereby stretching a buyer’s purchasing power, and allows equity to build from the first mortgage payment.

Risk Layering among Nontraditional Mortgage Products Raises Concerns
Nontraditional loan products can be appropriate for financially savvy borrowers with low credit risk. Indeed, many of these products have been offered for years to such borrowers, and credit quality generally has been good. What has changed, however, is how these loans have been marketed and used in recent years. Lenders have targeted a wider spectrum of consumers, who may not fully understand the embedded risks but use the loans to close the affordability gap.¹³

The degree to which mortgage market innovation, fueled by significant MBS liquidity, boosted home sales last year is unknown. Anecdotal evidence suggests that affordability and financing played a strong role in extending the volume component of the mortgage credit cycle last year. For example, there is a correlation between nontraditional mortgage loans and home price growth. An analysis of state-level data from Loan Performance Corporation shows the penetration of IOs and pay-option ARMs for nonprime borrowers into areas with strong price appreciation and reveals a strong positive relationship between the concentration of such loans and home price growth (see Chart 4). This analysis illustrates the recent development of borrowers increasingly using IOs and pay-option ARMs to purchase homes they might not otherwise have been able to afford. A June 2006 study by Harvard’s Joint Center for Housing Studies also confirms this trend.¹⁴

CHART 4


Analysts are concerned that higher-risk borrowers are more likely to be affected by a major payment shock during the life of their mortgage and may be more likely to default. Compounding this possibility is the fact that the increasing availability of mortgage credit is occurring at a time when mitigating controls on credit exposures have weakened. Evidence of loosening underwriting standards was noted in the Office of the Comptroller of the Currency’s annual survey of credit underwriting practices at nationally chartered banks.¹⁵ A telling result of the 2005 survey was the significant extent to which banks had relaxed underwriting standards for home equity and first mortgage loans (notably, the first time in the survey’s 11-year history that a net easing has been reported) by allowing lower minimum credit scores, reduced documentation in evaluating the applicant’s creditworthiness, and simultaneous second-lien mortgages.

As a result, risk layering appears to have become more prevalent. For example, there is growing evidence of nonamortizing IOs and pay-option ARMs being made to borrowers with little or no documentation to verify income sources or financial assets (see Table). When one loan combines several such features, the total risk is heightened. The risk compounds in the case of a high loan-to-value ratio of a first-mortgage loan that is combined with a second-lien mortgage because, historically, as combined loan-to-value ratios rise, defaults have tended to rise as well.

Mortgage Loan Performance Trends
Even in stressful times, mortgages have been among the best performing assets held by banks and thrifts. In the early 1990s, a time of serious dislocation in housing markets in California and the Northeast, FDIC-insured institutions reported exceptionally low net charge-off rates of less than 1 percent nationwide on home equity and residential mortgage loans compared to other loan types, ranging up to 12 percent for commercial and industrial loans. Mortgage charge-off rates barely budged during the 2001 recession, and large and small banks alike survived the recession with only a slight decline in credit quality.

In recent years, the combination of strong home price appreciation and a low interest rate environment has benefited homeowners and stimulated strong mortgage demand. FDIC-insured institutions are reporting exceptionally strong asset quality, and charge-off rates are at historic lows. On a quarterly basis, one-to-four family mortgage charge-off rates are in the single digits (in basis points) and considerably lower than in earlier stress periods (see Chart 5). The loss rate also is well below historical averages. The same is true for home equity lines of credit (HELOCs), although this may in part reflect their rapid growth of more than 40 percent during 2004.¹⁶

CHART 5


The sustainability of solid mortgage performance and historically low losses among FDIC-insured institutions is at the forefront of current industry analysis. How long can such favorable conditions last, especially in light of recent developments?

There are growing signs that mortgage loan performance may have peaked. The increase in risk layering in residential mortgage lending as well as recent market and institutional developments support this perception. Lenders themselves exhibit modest concern about nontraditional mortgage loan quality, as reported in the Federal Reserve Board’s quarterly survey of senior loan officers. Almost 41 percent of respondents believe credit quality on nontraditional loans is likely to decline in 2006, compared with 12 percent who view similar worsening in traditional mortgage loans.¹⁷

Outlook for Nontraditional Mortgages
The growing popularity of nontraditional products may have moved the mortgage credit cycle into uncharted territory. Industry analysts are uncertain how loans such as IOs and pay-option ARMs might perform in periods of rising rates or in stagnant housing markets. Recent media attention has highlighted the risk of payment shock when interest rates are adjusted, or reset, for IOs and hybrid ARM products. Despite favorable delinquency and default trends thus far, analysts fear that the current rising interest rate environment, combined with cooling home price appreciation, will limit borrowers’ options when they face large monthly payment increases. Homeowners who have not built up sufficient equity to either cover the cost of refinancing or pay down additional debt could face delinquency, particularly within the subprime markets.¹⁸

A recent Fitch analysis warns that the payment shock associated with subprime IOs of 2005 vintage is strong even if rates do not rise. When rates do reset, these loans’ high margins and low initial rates will make the monthly payment increases significantly greater than the increase from principal. Despite favorable performance of previous years’ subprime IOs, the ratings agency expects subprime IO loan delinquency rates to increase, because those borrowers may not be able to keep up with payment increases, especially if the housing market softens.¹⁹

Although some analysts emphasize borrowers’ susceptibility to increasing monthly payments, others foresee a more balanced outcome. A national analysis of mortgage payment reset undertaken by First American Real Estate Solutions suggests that mortgages originated or refinanced before 2004 have built sufficient equity as a result of strong home price appreciation and are not as likely to default.²⁰ This study also puts the volume of potential loss associated with interest rate resets into perspective, finding that the volume of ARM defaults is relatively small compared to overall mortgage originations. The majority of homeowners will not be significantly adversely affected by reset.

Regulatory Guidance for HELOCs and Nontraditional Products
To address potential concerns associated with risk layering and changes in mortgage lending practices, federal bank regulators issued guidance in May 2005 on home equity lending and proposed guidance in December 2005 on nontraditional mortgages.²¹ While acknowledging that nontraditional IOs and pay-option ARMs may benefit some borrowers, the proposed guidance targets lending to borrowers who qualify for loans according to initial minimum payments but who may have difficulty making future payments as a result of delayed or negative amortization. Furthermore, the proposed guidance addresses a number of specific issues—including product development, underwriting compliance, and risk-management functions—to help lenders and customers address the uncertainty raised by non-traditional mortgage products.

Some lenders contend that the loans discussed in the proposed guidance are made only to borrowers with high credit scores and larger down payments. Comments also suggest that the guidance, as proposed, could penalize legitimate lenders and limit market competition.²² However, investors at a recent housing finance symposium did not share this view—MBS investors voiced concern about easing underwriting standards, calling them “lax” and “too lenient,” particularly in subprime markets where the weakest borrowers are choosing ARMs.²³ These varied opinions aside, the challenges of today’s complex mortgage market call for an approach that encourages sound underwriting without inhibiting innovation, which regulators recognize has created opportunities for millions of homeowners.

Conclusion
The mortgage credit cycle has changed dramatically during the past several decades. More than other lending types, mortgage lending practices have been shaped by government influence and product innovation. More recently, rapid home price escalation has constrained housing affordability in many regions of the country, contributing to rising demand for non-traditional mortgages as borrowers try to maximize purchasing power. Mortgage originators have found ways to accommodate borrower demand, offering new mortgage products and extending loans further along the credit spectrum.

These developments in the mortgage cycle have led to increased credit risk held by both homeowners, as they have sought to stretch affordability during an unprecedented housing boom, and by investors seeking yield. The benign credit landscape of recent years may have encouraged increased risk taking.
Based on historical experience, and despite recent strong performance, a gradual rise in delinquency and foreclosure rates could occur over the next few years. Mortgage delinquencies are likely to increase over time as rising interest rates and the expiration of below-market teaser rates result in higher monthly payments for many borrowers. Some households with limited financial assets, lower incomes, or an inability to refinance due to poor credit, lack of appreciation, or high leverage may not be able to accommodate these higher payments. Finally, if a recession or other severe economic shock were to send local home prices and incomes sharply lower, or interest rates sharply higher, this additional stress could contribute to higher mortgage losses.

However, banks and thrifts will head into the next phase of the mortgage credit cycle from a position of strength. In recent years, the industry has generated record earnings and reached near-record capital levels. Given a gradual transition to higher delinquency and foreclosure rates and assuming only modest potential declines in collateral values, it does not appear at this time that deteriorating mortgage credit performance would present unmanageable risks to most FDIC-insured institutions.

Cynthia Angell, Financial Economist
cangell@fdic.gov

Clare D. Rowley, Economic Assistant
CRowley@fdic.gov

¹ Alex Nackoul, “Mortgage Brokering: A Short History (part 1 of 2),” Scotsman Guide Residential Edition, March 2006, http://www.scotsmanguide.com/default.asp?ID=1299.
² R. Alton Gilbert, “Will the Removal of Regulation Q Raise Mortgage Interest Rates?” Federal Reserve Bank of St. Louis, December 1981, http://research.stlouisfed.org/publications/review/81/12/Removal_Dec1981.pdf.
³ Disintermediation is an excess of withdrawals from an FDIC-insured institution’s interest-bearing accounts over its deposits in these accounts. It occurs when rates on competing investments, such as Treasury bills or money market mutual funds, offer the investor a higher return. For more information, see: FDIC, History of the Eighties—Lessons for the Future (Washington, DC: FDIC, 1997), http://www.fdic.gov/bank/historical/history.
⁴ Alan Greenspan (speech, Mortgage Markets and Economic Activity Conference, sponsored by America’s Community Bankers, Washington, DC, November 2, 1999).
⁵ Department of the Treasury and Office of Thrift Supervision, 12 CFR Parts 560, 590, and 591, No. 2002-43, Alternative Mortgage Transaction Parity Act; Preemption.
⁶The two main GSEs, Fannie Mae and Freddie Mac, buy mortgages to create MBS that are then sold to investors. The GSEs help improve housing affordability for lower- and middle-income Americans by (1) allowing originators to respond more quickly to fluctuating mortgage demand and lower mortgage rates and (2) passing on their risk-free funding advantage to mortgage holders.
⁷ John Bancroft, ed., Inside MBS & ABS, May 26, 2006, http://www.imfpubs.com. The securitization rate includes MBS securitized by the GSEs as well as by “private” entities such as banks, thrifts, and investment firms.
⁸ A growing portion of total outstanding private-label MBS is held by FDIC-insured institutions. These holdings accounted for 19.6 percent of their total MBS holdings in 2005, up from 12.9 percent in 2003. However, it may be that these institutions carry only the best-rated tranches in their private-label MBS holdings and therefore have limited risk.
⁹ Bancroft, Inside MBS & ABS, April 14, 2006.
¹⁰For more information, see the Appendix, “Overview of Nonprime Mortgage Lending and Nontraditional Mortgage Product Terms.”
¹¹ For more analysis on the recent housing boom, see the FDIC’s FYI articles on “U.S. Home Prices: Does Bust Always Follow Boom?” issued February 10, 2005 (revised April 8, 2005), http://www.fdic.gov/bank/analytical/fyi/2005/021005fyi.html, and May 2005, http://www.fdic.gov/bank/analytical/fyi/2005/050205fyi.html.
¹² John Bancroft, ed., Inside Mortgage Finance, February 24, 2006, http://www.imfpubs.com.
¹³ Pay-option ARMs have been offered for years primarily to meet the needs of borrowers with uneven income streams during the year, such as the self-employed or those who receive year-end bonuses. Some producers of nontraditional mortgage loans are marketing products that may not be suitable for some borrowers. Sales pitches appeal to a homebuyer’s affordability squeeze and highlight the “benefits” of the minimal payment option: greater monthly cash flow, maximized buying power, and the ability to afford a bigger house than a buyer thought possible.
¹⁴ Joint Center for Housing Studies of Harvard University, The State of the Nation’s Housing 2006 (Cambridge, MA: Harvard University, June 2006), http://www.jchs.harvard.edu/publications/markets/son2006/index.htm.
¹⁵ Office of the Comptroller of the Currency, “Survey of Credit Underwriting Practices, 2005,” http://www.occ.treas.gov/cusurvey/scup2005.pdf.
¹⁶ Rapid loan growth can mask increases in nonperforming loans. Because delinquencies or losses generally do not appear for some time after loans are originated, growth in the numerator of the ratio of nonperforming loans to total loans may show up later than growth in the denominator.
¹⁷ Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices, January 2006.
¹⁸ James R. Hagerty, “At the Doorstep: Millions Are Facing Monthly Squeeze on House Payments,” Wall Street Journal, March 11, 2006.
¹⁹ Suzanne Mistretta, “Rating Subprime RMBS Backed by Interest-Only ARMs,” Fitch Ratings Structured Finance, March 9, 2006.
²⁰ Christopher Cagan, “Mortgage Payment Reset: The Rumor and the Reality,” First American Real Estate Solutions, February 8, 2006.
²¹ The federal bank regulatory agencies include the Office of the Comptroller of the Currency, Federal Reserve Board, FDIC, Office of Thrift Supervision, and National Credit Union Administration. For the home equity lending guidance, see “Credit Risk Management Guidance for Home Equity Lending,” May 2005, http://www.fdic.gov/news/news/press/2005/pr4405a.html. For the proposed guidance on nontraditional mortgage loans, see “Interagency Guidance on Nontraditional Mortgage Products,” December 2005, http://www.fdic.gov/news/news/press/2005/Guidance_on_non_traditional_mortgages.pdf.
²² Kenneth R. Harney, “Should Risks Beget Rules?” Washington Post, April 8, 2006.
²³ Bancroft, Inside MBS & ABS, April 7, 2006.

Substituting Mortgage Debt for Consumer Debt
Consumer credit growth has historically been positively correlated with job growth. However, this relationship appears to have broken down in the late 1980s (see Chart 1). One of the factors contributing to the breakdown may be the phenomenon of substituting mortgage debt for consumer debt. This debt substitution phenomenon began 20 years ago when the Tax Reform Act of 1986 eliminated interest deductions on consumer loans but retained interest deductions on mortgage debt, making mortgage debt a more attractive source of financing.

CHART 1

In recent years, the combination of low interest rates and rapidly appreciating housing values resulted in a surge of mortgage equity withdrawals. Mortgage debt grew by nearly $4 trillion from year-end 2000 to year-end 2005, with an estimated one-half of this growth resulting from the refinancing of existing mortgages.¹ Many homeowners who refinanced were able to take advantage of the low mortgage interest rates, taking cash out and still reducing their monthly payments. A 2002 Federal Reserve survey found that approximately 25 percent of mortgage refinance funds were used to pay for consumer expenditures.² The switch from consumer debt to mortgage debt is evident in that growth in home equity lines of credit (HELOCs) outstripped growth in credit card debt, even though the average interest rate for credit cards declined (see Chart 2).

CHART 2


Although growth in HELOCs continued to outpace that of credit cards, HELOC growth fell from 40 percent in 2004 to 8 percent in 2005. Rising interest rates and slowing home price appreciation may make home equity lending and cash-out refinancing less financially advantageous, which in turn could reinvigorate growth in other forms of consumer lending, such as credit cards.

Lynne Montgomery, Senior Financial Analyst
lmontgomery@fdic.gov

¹ Based on data from the Federal Reserve Board and from the 2001–2005 annual average “percent refinancing” share of the total dollar volume of new mortgages reported by the Mortgage Bankers Association.
² Glenn Canner, Karen Dynan, and Wayne Passmore, “Mortgage Refinancing in 2001 and Early 2002,” Federal Reserve Bulletin, December 2002,

http://www.federalreserve.gov/pubs/bulletin/2002/1202lead.pdf.
The legislative changes and increased use of securitization during the 1980s significantly altered the mortgage market by facilitating product innovation and expanding mortgage credit availability. The increased liquidity provided by securitization allowed lenders to offer credit to more borrowers, because lenders were no longer limited to lending on their deposit base. Lenders not only could increase their underwriting of traditional mortgages, but also were able to develop new mortgage products to appeal to borrowers seeking nontraditional features.

Appendix
Overview of Nonprime Mortgage Lending
and Nontraditional Mortgage Product Terms
Subprime Lending
Subprime lending refers to higher-interest loans that involve elevated credit risk. For example, borrowers with Fair Isaac and Company (FICO) credit scores below 620 are generally viewed as higher risk and thus ineligible for prime loans unless they make significant down payments. While many subprime borrowers score above this threshold, they are still considered high risk because of other issues regarding down payment, income documentation, or credit standing. Conventional and subprime loan interest rates have a typical spread of less than 2 percent.
Alternative-A Mortgage
An Alternative-A, or Alt-A, mortgage can be made to borrowers who have marginal to very good credit where traditional underwriting guidelines for standard complying loans have been expanded. Alt-A mortgages may include those with (1) no credit score or credit scores higher than subprime, (2) nonowner-occupied homes, (3) a loan-to-value ratio greater than 80 percent and no mortgage insurance, or (4) high debt-to-income ratios that are not considered subprime.
Interest-Only Mortgage
In a nontraditional, interest-only (IO) mortgage, the borrower is required to pay only the interest due on the loan for the first few years, during which time the rate may be fixed or fluctuate. After the IO period, the rate may be fixed or fluctuate based on the prescribed index; payments consist of both principal and interest.
Payment-Option Adjustable-Rate Mortgage
A payment-option adjustable-rate mortgage (ARM)—also known as a flexible-payment ARM, pay-option ARM, option ARM, or PO—is considered nontraditional in that it allows the borrower to choose from a number of payment options. For example, the borrower may choose either a minimum payment option each month based on an introductory interest rate, an IO payment option based on the fully indexed interest rate, or a fully amortizing principal-and-interest payment option based on a 15- or 30-year loan term plus any required escrow payments. The minimum payment option can be less than the interest accruing on the loan, resulting in negative amortization. The IO option avoids negative amortization but does not allow principal amortization. After a certain number of years, or if the loan reaches a certain negative amortization cap, the required monthly payment amount is refigured to require payments that will fully amortize the outstanding balance over the remaining loan term.
Reduced Documentation
A reduced-documentation loan feature is commonly referred to as a “low doc/no doc,” “no income/no asset,” “stated income,” or “stated assets” feature. When applied to mortgages, a lender sets reduced or minimal documentation standards to corroborate a borrower’s income and assets.
Simultaneous Second-Lien Loan
A simultaneous second-lien loan, also referred to as a “piggyback loan,” is a lending arrangement where either a closed-end second lien or a home equity line of credit is originated at the same time as the first-lien mortgage loan, usually taking the place of a larger down payment.
Sources: FDIC; Edward M. Gramlich (speech, Financial Services Roundtable Annual Housing Policy Meeting, Federal Reserve, Chicago, Illinois, May 21, 2004); and Office of the Comptroller of the Currency, Federal Reserve Board, FDIC, Office of Thrift Supervision, and National Credit Union Administration, proposed “Interagency Guidance on Nontraditional Mortgage Products,” December 2005.