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Fed Officials Warn on Real Estate Values, Interest-Only Loans

Fed Officials Warn on Real Estate Values, Interest-Only Loans

June 8 (Bloomberg) -- Federal Reserve governors and other U.S. banking regulators are growing concerned that easier credit standards and greater use of interest-only loans are fueling home price speculation, increasing risks to the U.S. banking system as interest rates rise.

``Financial institutions may not be fully recognizing the risk embedded in these portfolios,'' the Fed, the Comptroller of the Currency and three other regulators warned in a May 16 letter on home-equity loans to lenders and bank examiners. Fed Chairman Alan Greenspan, who talked the same week of ``froth'' in the housing market, will likely be questioned on the topic during congressional testimony tomorrow.

``The new development is the volume of these interest-only first mortgages we're seeing,'' acting Comptroller Julie Williams said in an interview. ``Banks should be evaluating the risks of these types of loans, not just based on the initial loan terms, but based on the loan terms that may roll into effect over the life of the loan.''

Central bankers and regulators say they are concerned at the prospect of a real-estate bust that would cascade through the banking system, causing even healthy banks to pull back on lending. That would limit the ability of the Fed to influence bank lending and the economy through interest-rate policy.

Real estate busts ``have a long duration and they affect everybody,'' said Harvey Rosenblum, executive vice president of the Dallas Fed. Banks have difficulty raising capital to make new loans, and the capital they have is constrained by loan losses, he said.

Flipping the Switch

``You have this downward spiral effect,'' Rosenblum said. ``When you are going through these kind of economic times, you flip the switch to off,'' even at healthy banks.

For now, officials say, the banking system is healthy and real estate prices are buoyant. U.S. banks' net loan losses totaled $7.2 billion in the first quarter, the lowest total since the third quarter of 2000, according to the Federal Deposit Insurance Corp.'s quarterly report released in May.

So-called ``guidance letters'' such as the one issued May 16 are aimed at improving lending standards without interfering with markets. Another letter, this one dealing with first mortgages, is under discussion, Kevin Mukri, a spokesman for the Comptroller, said.

Fed chairman Greenspan, who appears before the Joint Economic Committee of Congress on Thursday, told the Economic Club of New York May 20 that there is a ``good deal of speculation'' in real estate markets, and ``we're also seeing it in the mortgage market.''

Mortgage Rates

Fueling home-price speculation are mortgage rates near four- decade lows. Rates on 30-year fixed mortgages have declined even though the Fed has raised short-term rates 2 percentage points since June 2004. At that time, 30-year fixed-rate mortgages averaged 6.29 percent versus 5.72 percent last month.

Signs of speculation include second-home purchases for investment, the ``heavy reliance on interest-only loans'' and the use of adjustable-rate mortgages despite increases in short-term rates, said Patrick Lawler, chief economist at the Office of Federal Housing Enterprise Oversight.

Interest-only mortgages accounted for only 6 percent of adjustable-rate mortgages in 2002. By the end of 2004 they accounted for 23 percent nationwide, according to LoanPerformance, a mortgage-data provider based in San Francisco.

Sales of investment properties rose 14.4 percent in 2004 to 1.8 million units, according to the National Association of Realtors. About 80 percent of investment properties are single- family homes, the association says.

Average Gains

Nationally, home prices averaged a 12.5 percent gain from the first quarter of 2004 to the first quarter of 2005, according to an index tracked by the Office of Federal Housing Enterprise Oversight. Twenty-four states showed average home-price gains of 10 percent or more in the period.

Over the past four quarters, prices are rising faster than any period since 1979, when the consumer price index rose to 13.3 percent, compared with 3.3 percent last year.

``In some markets -- I won't name individual cities in the Southeast -- the activity in residential real estate looks pretty speculative to me, and that makes me very uncomfortable,'' Atlanta Fed bank president Jack Guynn said. ``There is a very good chance that some lenders, some buyers and some builders will get burned.''

The May 16 regulatory letter cited interest-only loans that lower the initial out-of-pocket costs for homebuyers by letting them omit monthly principal payments for a time. While interest- only loans can extend the reach of buyers in markets where prices are moving up, they also contain several risks. Interest-only home equity loans rarely have locks or caps, unlike adjustable-rate mortgages. And the principal eventually has to be paid back, which can double or triple monthly payments.

Risk of Default

``When I took economics in World War II, and we were studying the Great Depression, one of the reasons given were all the interest-only loans that came due,'' L. William Seidman, who was chairman of the FDIC from 1985 to 1991, said in an interview. ``They were an indication of an economy getting into unsound lending. Ever since then it's been a rule that when you go into interest-only loans, you're very substantially increasing the risk of default.''

Richard T. Nadolski, senior vice president of mortgage loan administration at North Shore Capital Bank in Brookfield, Wisconsin, said the loans are very popular.

Bandwagon

``We started getting on the interest-only bandwagon about a year ago, and it's gone from nothing to 30 percent'' of North Shore's adjustable-rate mortgages, Nadolski said.

Bank of America, the third-largest U.S. bank, offers some interest-only mortgages, according to spokeswoman Julie Davis.

``Our overall approach with any customer is to sit down with them and try to identify their long and short-term financial needs around purchasing a home,'' Davis said. ``How long are they going to be in the home, what do they anticipate career-wise?''

The vast majority of Bank of America's mortgage loans are regular, 30-year mortgages as opposed to adjustable rate mortgages, Davis said.

``The interest-only loan has added about 10 percent to the value of homes in California and other high-priced areas,'' said David Akre, co-chief executive officer of New York Mortgage Trust Inc., a real estate investment trust.

To contact the reporters on this story:
Craig Torres in Washington at
[e-mail]; Amy Strahan in Washington at
1835 or [e-mail]


LINK: http://www.bloomberg.com/apps/news?pid=10000103&sid=aUL.xb2JdoTw&refer=us