FDIC Summer Outlook 2006

From the FDIC:

FDIC Summer Outlook 2006(PDF)

The U.S. mortgage market, which for decades was dominated by fixed-rate mortgages, now includes innovations such as nontraditional mortgages, simultaneous secondlien (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.

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.
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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.