By Andrew Olszowy

This piece is forthcoming in Communities & Banking.

Recent years have seen an explosion in alternative mortgage products. Although instruments such as interest-only loans, payment-option-adjustable-rate mortgages (ARMs) and reduced-documentation (“low doc” or “no doc”) mortgages have existed in various forms for a long time, their widespread usage is new. According to the Mortgage Bankers Association, interest-only loans, for example, comprised 23 percent of all U.S. mortgages for the first six months of 2005 -- up from 17 percent in the prior six months.

In addition to the risk to consumers, there are risks to lenders, and the rapid growth of alternative products has caught the attention of federal regulators. In late December 2005, regulators released proposed joint guidance to financial institutions on how to manage the risks presented by nontraditional mortgage products. Are their concerns warranted? When does taking a reasonable risk cross over into gambling?

How Alternative Mortgages Work
Although people like the flexibility of alternative mortgages, flexibility may come at a price. Both the lender and the consumer are obliged to manage complex layers of risk.

A typical 30-year fixed mortgage is like a two-wheel bicycle -- fairly basic transportation. The rider needs to learn how to balance and must be careful not run into anything. Even in that case, the rider usually walks away with just a few bruises. But an alternative mortgage is more like a sports car. The sports car accomplishes the same objective as a bicycle – transportation – but it is a much more complex device, requiring specific knowledge and the ability to manage multiple tasks simultaneously. If something goes wrong, the stakes are higher.

Similarly, alternative mortgages are fairly sophisticated. The borrower must weigh multiple considerations. What is my current income? Will I have at least this much income as long as I have mortgage payments? Will interest rates go up or down? Can I be certain housing prices will appreciate? Many borrowers cannot foresee long term answers to such questions.

The Popularity Puzzle
So given their complexity and long-term uncertainty, why have these products become so widespread? Probably the most significant factor has been the state of the housing market. With homes in certain markets appreciating more than 100 percent over the past five years alone, affording a home has become increasingly difficult.

In such steeply appreciating markets, alternative mortgages and low initial payments are attractive to buyers. In fact, some financial institutions have been promoting alternative mortgages as “affordability” products, potentially misleading consumers about the products’ potential costs and raising the concern of regulators.

Although some borrowers do expect to increase their income as payments increase, regulators worry that many others have no exit strategy and are essentially gambling on housing prices continuing to appreciate. They may be counting on cashing in on the home’s equity and quickly refinancing with another interest-only loan or option-ARM.

If the real estate market slows, however, or takes a significant downturn, refinancing may not be an option. Even worse, if the loan had been experiencing negative amortization, an increased loan amount coupled with a softening real estate market could mean the borrower owes more on the house than it is worth – a scenario that is making regulators anxious.

What Lies Ahead?
The quickly appreciating real estate market has created an unprecedented boom in alternative mortgages. No one, however, can anticipate the effect of a significant downturn, as such a volume of these products has never been stress-tested in the marketplace. A downturn could hurt both consumers and financial institutions holding a sizable portfolio of such loans.

Comments late last year from the Comptroller of the Currency John Dugan and former Federal Reserve Chairman Alan Greenspan highlighted the regulators’ increasing concern. Dugan stated that option-ARMs are increasingly becoming “the primary way to afford the large mortgages necessary to buy homes in many housing markets.” He also expressed concern that the use of alternative mortgages to “penetrate the sub prime market cannot be far behind.”

Greenspan hinted that the proliferation of alternative mortgages may be creating a Catch-22 situation in housing markets by “adding to the pressures in the marketplace.” He stated, “Some households may be employing these instruments to purchase a home that would otherwise be unaffordable.” Rather than choose a more affordable home or wait for the market to cool, some borrowers do appear to be using alternative mortgages to purchase homes they cannot afford. That may be contributing to “froth” in the housing market, as Greenspan would say, by artificially maintaining inflated prices.

Adding to regulators’ apprehensions is a practice called layering. Layering occurs when a financial institution combines several alternative or exotic features in one loan product. For instance, an option-ARM may also have a low-doc feature: The lender does not demand the usual documentation and, instead of verifying the applicant’s income, accepts what the applicant states as income.

Layering obviously results in increased risk to both parties. The typical lender compensates for this added risk by raising the loan’s interest rate. But if the consumer has an interest-only loan or option-ARM, that can actually lead to worse payment shock down the road – and an increased likelihood of default.

Be Cautious
So what do regulators suggest? Basically, all parties should proceed with caution. In December, federal regulators proposed guidance asking that financial institutions follow prudent lending practices with alternative mortgage products. Regulators said that lenders should consider the borrower’s ability to repay the debt, should not rely on credit scores as substitutes for verifying an applicant’s income, and should focus more on the borrower’s ability to repay rather than the collateral value. Also, if lenders intend to layer the risks rather than simply increase the interest rate, they should look for higher credit scores, lower loan-to-value and debt-to-income ratios, and other mitigating factors.

Regulators also strongly encourage lenders to educate consumers with comprehensive product information, promotional material, and discussions. They should address the pros and cons of a product so that the consumer can make an informed decision when choosing the appropriate product.

Lending institutions should also review their procedures pertaining to alternative mortgages to ensure regulatory compliance. Alternative mortgages are subject to consumer protection laws and regulations. Most notably, the Truth in Lending Act, implemented through Regulation Z, requires that certain disclosures be provided for an advertisement, for an application, and when the interest rate changes. Section 5 of the Federal Trade Commission Act makes it illegal for lending institutions to employ any unfair or deceptive acts or practices.

And what should the consumers be doing? Consumers should ask questions to ensure their sufficient understanding of all the finer points and potential consequences of alternative mortgages:

Payment Shock
When does the introductory rate expire? When do payments begin to pay down the loan? How are the payments calculated? Can the lender give a maximum hypothetical example of what the payment might be?

Negative Amortization
Can negative amortization occur? When is it possible under the terms of the loan? (Ask the lender to provide a sample payment schedule to show the effect of negative amortization).

Prepayment Penalties
Is there a prepayment penalty on the mortgage? How much is it in plain terms, and how is it incurred?

Cost of Reduced Documentation Loans
Is there a price difference between a low-doc loan and a standard loan? What is it?

Overall, alternative mortgages can be a useful tool providing flexibility to both the consumer and the lender. The increased inherent risk associated with them, however, does require that both parties proceed prudently. Lenders should ensure that their underwriting standards accurately compensate for increased risk and carefully assess borrowers’ ability to repay. Lenders should also initiate an open dialog prior to application explaining not only the benefits, but also the potential risks. Consumers should ask questions to ensure their full understanding of the mortgage product what their payments will be over the life of the loan. Neither party should gamble on the possibility that housing markets will continue to appreciate rapidly. If all involved parties proceed carefully and cautiously, potential problems can be avoided down the road.

Andrew Olszowy is the Managing Examiner of the Consumer Affairs Supervision and Regulation unit at the Federal Reserve Bank of Boston.