ARMs Now Unattractive

"Housing markets around the nation are cooling, mostly as the result of the Federal Reserve's drive to push up interest rates. That has slowed price increases in most of the country and reduced demand for risky types of financing that caused former Fed Chairman Alan Greenspan to worry about ``froth'' in the housing market."

"Sales of new homes fell 10.5 percent in February, the biggest drop since 1995, and sales of existing homes slipped in five of the last six months, leaving a record 3 million unsold houses on the market. Sales will fall further this year and price gains will slow, predicts the Washington-based National Association of Realtors. High-end properties and markets that had the biggest increases during the boom are cooling the most."

'``The markets that were the high flyers over the past couple of years have more adjusting to do,'' says Jeff Lyons, general manager of RealEstate.com, a consulting firm in Charlotte, North Carolina."

"Signs of the cooling market aren't hard to find on Bradford Street in Boston's South End, where Victorian townhouses are listed for as much as $4.5 million."

'``Last year, houses were snapped up as soon as they were put on the market, so you never even saw a sign,'' says Kenneth Kinna, 41, a film producer who owns a 10-room townhouse in the neighborhood. Now there are three ``For Sale'' signs on his block."

"The trend is most pronounced in affluent neighborhoods in the Northeast, where prices soared the most during the real- estate boom. Median prices for existing homes in the Northeast were up 5.2 percent in February from a year earlier, compared with almost 18 percent in the previous 12-month period, according to the Realtors group."

"The Fed, which last May warned that easier credit was fueling home price speculation, has since increased short-term interest rates seven times, most recently on March 28."

"Rising rates have reduced demand for riskier forms of financing."

"Partly as a result of the Fed's 15 consecutive increases in interest rates, adjustable-rate and interest-only loans, closely tied to short-term rates, are on the decline. Such loans were popular with buyers trying to stretch their dollars and with speculators seeking to minimize the cost of buying property for short-term profit."

'``That's probably a good thing,'' says former Fed Governor Edward Gramlich, who left the Fed in August."

'``When you raise rates, and we knew what we were doing, one of the consequences is fewer people getting involved in riskier short-term mortgage products,'' says Gramlich, now interim provost at the University of Michigan in Ann Arbor."

"For much of its 77 years in Santa Monica, First Federal Bank of California led an unremarkable existence."

"Nowadays First Federal is stirring up more excitement, on account of its emphasis on making relatively risky home loans. In fact, to listen to some Wall Street skeptics you might conclude that this sleepy savings and loan has taken a figurative dive off the end of the Santa Monica Pier."

"First Federal ran into trouble in the early 1980s, when runaway inflation forced it to pay as much as 20% on some certificates of deposit — far more than its loans were earning, and a formula for disaster for any lending institution. It went public to survive, selling stock to raise capital. And like many California thrifts at the time, it switched to adjustable-rate mortgages, which are less risky for lenders because they require borrowers to pay more when market interest rates rise."

"To attract customers for this then-novel product, First Federal and other adjustable-rate lenders adopted the option ARM. Variations of option ARMs have been First Federal's bread and butter ever since."

"They are attractive for people whose incomes are high but irregular, and for young workers expecting sizable raises. As home prices have spiraled higher over the last two years, all kinds of borrowers have flocked to the mortgages because they are easier to qualify for than fixed-rate loans."

"Critics accuse First Federal and other West Coast thrifts of overindulging borrowers' lust for artificially low initial payments. By generating so-called exotic or nontraditional mortgages, they warn, these S&Ls have allowed speculators to buy homes they can ill afford — and will be unable to resell when the mortgage payments rise and home prices take a tumble."

'"I think this spring you will see housing prices crack," said Richard X. Bove, a banking analyst with investment bank Punk, Ziegel & Co. That, he added, "is going to be terrible" for people with mortgages that let them pay less — sometimes a lot less — than the full monthly payment during the early years of the loans. After those payments are reset to their full amounts, "I think you're going to see a wave of defaults," Bove said."

"In a recent interview at First Federal's modest headquarters in downtown Santa Monica, Heimbuch, Giraldin and Goddard acknowledged that their loans bent once-traditional rules. The thrift allows borrowers to defer interest payments, for example, and often waives the requirement for them to produce pay stubs or other proof of income."

"Regulators, consumer advocates and skeptical investors have raised questions about the deferred-interest loans, formally known as payment-option adjustable-rate mortgages, or option ARMs for short."

"Option ARM borrowers can choose to pay less than the full interest due each month, but there's a trade-off: The difference is added to the loan balance and the full monthly payments must be made starting at a later time, often after five years."

"These full payments also can be triggered if the loan balance rises enough, to 110% or more of the original amount. In an environment of rising interest rates, borrowers in certain circumstances could see their payments as much as double if this occurred."

"Many lenders larger than First Federal offer option ARMs, including rival thrifts like Oakland's Golden West Financial Corp., parent of World Savings, and Downey Financial Corp. in Newport Beach. Seattle-based Washington Mutual Inc., the largest S&L by far, and Calabasas-based Countrywide Financial Corp., the nation's largest mortgage lender, have helped to popularize option ARMs across the country. But First Federal has taken to them like few others."

"Of all the home loans that Washington Mutual held at the end of 2005, 52% were option ARMs, the company said in its annual report to the Securities and Exchange Commission. Golden West and Downey said more than 90% of their loans were option ARMs. At First Federal, 100% of residential mortgages were option ARMs."

"First Federal has benefited from this trend, doubling in size from $4.8 billion in assets at the end of 2003 to $10.5 billion at the end of 2005. "Low doc" and "no doc" loans also fueled its boom — by the end of last year, 4 of 5 First Federal borrowers got credit without having to document their earnings, their assets or either."

"As home prices have soared, more borrowers are taking the deferred interest option. At the end of 2005, First Federal's borrowers had deferred $62.5 million in interest payments, up from $5.6 million in just a year."

"The biggest potential threat is that a major economic downturn would put large numbers of Californians out of work. Bove, the Punk Ziegel analyst, believes this is likely to occur because businesses, reacting to sky-high property prices, will move jobs to states where their workers can more easily afford homes."

"Nontraditional mortgages have drawn attention from federal bank regulators, who in December proposed rules designed to rein in use of these loans at institutions that can't demonstrate strong safeguards against their higher risks."

"Edward Leamer, director of UCLA Anderson Forecast, which issues quarterly economic projections for California. "I never understood why (Federal Reserve Chairman Alan) Greenspan was encouraging people to go into short-term mortgages, because of the risk they entailed."'

In February, 51.9 percent of all California home buyers took out an ARM, down from 63.7 percent in January, 68.7 percent in December and 70.9 percent in November, according to La Jolla-based DataQuick Information Systems. State ARM use crested last May at 73.7 percent. Cory Reid, president of the East Bay chapter of the California Association of Mortgage Brokers, has witnessed the same trend locally.

"Some observers believe a reduction in adjustable-rate mortgages could exacerbate the housing slowdown, since the tool is widely credited with helping marginal buyers purchase a home -- especially in a high-priced market like the East Bay."

"The spread between adjustable and fixed-rate mortgages is narrowing: A 30-year fixed rate stands at 6.34 percent, while the rate is 5.93 percent for a 5-year ARM, according to Freddie Mac. In the past few years, the difference was typically a full point or higher. In other words, the benefit of an adjustable rate mortgage is declining, even as the risk of an upward jump in interest rates is increasing."

'"The adjustable-rate mortgages aren't attractive anymore," said Stephen Levy, senior economist with the Center for Continuing Study of the California Economy in Palo Alto. He believes this waning allure is a big reason why the market has slowed as much as it has already."

"With adjustable-rate mortgages, the interest rate can fluctuate at specific intervals -- often one year, five years or seven years. If interest rates continue to rise, as the Federal Reserve has hinted, so will borrowers' monthly payments. When home prices are rising, buyers can often refinance to lower their costs. But appreciation is flattening and some economists believe prices could even decline, which could leave borrowers stuck paying a rate they can't afford."