Lessons from the Pros

Real Estate Article

Mortgage-Backed Securities and Non-Conventional Loans

Bloomberg reported that the FDIC (Federal Deposit Insurance Crop) has filed suits in New York federal court suing JPMorgan Chase & Co. (JPM), Citigroup Inc., Bank of America Securities and Deutsche Bank AG over the sale of some MBS’s (mortgage-backed securities).  The FDIC is acting as receiver for two failed banks that allegedly lost a claimed $77 million on securities backed by residential mortgages.  The FDIC alleges the defendants misled the investor banks in the registration statements for the securities.

MBS’s are an asset-backed security that represents cash flow from various mortgage loans.  These loans are packaged together and sold at market.  MBS’s are made up of conventional loans (those backed by Freddie and Fannie) and non-conventional loans.  I thought this would be a good opportunity to review what non-conventional loans are.

Non-conventional loans are a broad term describing loans that do not take the traditional form; in short they aren’t loans that would be accepted by either Fannie or Freddie.  Non-conventional financing includes loans such as Interest Only Mortgages (IO), Option Adjustable Rate Mortgages (Option ARM’s), Subprime Mortgages and AltA Mortgages.  Let’s take a look at each one of these loans individually.

Interest Only Mortgages (IO): These loans have two options, one is the interest-only option where the borrower CAN choose to pay an interest-only payment.  This interest-only payment is usually only available for between three and ten years. After the interest-only payment option is exhausted the borrower’s payment will increase to principal and interest fully amortized.  This loan is a good investment vehicle for those that know how to handle it and can use it to get the best results.

Option Adjustable Rate Mortgage (Option ARM):  This is the type of  loan on which the interest rate adjusts monthly and the payment resets annually, with borrowers offered options on how small or large a payments they can make.  The options include a principal and interest payment, an interest-only payment and a minimum payment that is usually less than the interest-only payment.  The minimum payment option results in a growing loan balance which is called “negative amortization.”

The selling point of this loan was the low minimum payment in year one.  The low initial payment enticed some borrowers into buying more costly homes than they would otherwise be able to afford.

For those borrowers that elect the minimum payment option the major risk became the “payment shock,” a sudden and sharp increase in the payment for which the borrower was unprepared.

Subprime Mortgage: This is the type of loan that is normally made to borrowers with low credit ratings.  As a result of the borrower’s low credit rating (below 600), a conventional loan is not available in a lender’s view.  The borrower is viewed as having a larger-than-average risk of defaulting on the loan.  Lending institutions charge higher interest on subprime loans in order to compensate themselves for carrying more risk.

Alt-A: A classification of loan where the risk profile falls between prime and subprime.  The borrowers that typically use these loans have clean credit histories, but there will generally be some issue that increase its risky profile.  These issues can include higher loan to value (LTV), debt to income ratios or inadequate documentation of the borrower’s income.  These loans are attractive to lenders because the rates they can charge are higher than rates on conventional loans, but the borrower tends to be less risky.

Although these non-conventional loans are certainly harder to find these days than they were five years ago, some of them are still available and can be utilized if managed correctly.

Hope this helps you better understand non-conventional loans and what makes up a section of the MBS’s that come to market. There are many more regulations that now govern MBS’s so they can be a sound investment.

Diana D. Hill


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