HURRY, HURRY! STEP RIGHT UP!

DURING A SPEECH TO THE Credit Union National Association in February 2004, Federal Reserve Chairman Alan Greensp4n proclaimed the virtues of adjustable rate mortgages (ARMs). He told the group tjhat if households were willing to manage the additional interest rate risks associated iwith ARMs, then those loans might serve them better, making the traditional fixed rate mortgage "an expensive method of financing a home."

What a difference 18 months can make. By this past summer, Greenspan was talking about housing market froth. During testimony before Congress in July, he described the rise in the use of interest-only loans and other forms of ARMs as "developments of particular concern" and warned that "their use could be adding to pressures in the housing market." His comments about the mortgage industry have grown increasingly critical since.

No wonder the debate rages on about what changes in the mortgage market will mean for housing. New and more widely available creative mortgage instruments, coupled with an influx of capital into the mortgage market and historically low interest rates, have made it possible for more people to own homes.

But Greenspan's shift reflects widespread concern that some of those homeowners will default when their loans adjust at higher interest rates. Many in the home building and mortgage industries think those fears are exaggerated, but analysts caution that it's difficult to predict what will happen, and federal banking regulators are sufficiently troubled that they are preparing new rules for issuing mortgages.

DIZZYING CHANGES

The banking industry has come far from the housing busts of the late 19805 and early 19905, when it also weathered the savings and loan crisis, says Bert Ely, a banking consultant in Alexandria, Va. "The solvency of the industry is much greater," he says. "It's subject to higher capital levels and much tougher regulation."

Frank Nothaft, Freddie Mac's chief economist, sees changes in the industry, too. He describes the wide availability of credit, made possible by the growth of the secondary mortgage market, as "strikingly different today" Freddie Mac and its sister company, Fannie Mae, buy mortgages from lenders and package and sell them as bonds to investors. Banks use Fannie and Freddie's money to bankroll new loans.

For investors, real estate has been a winning venture since the stock market fell five years ago. Domestic and global institutional investors have redirected large portions-as much as 20 percent-of their portfolios toward real estate, says Gary Painter, director of research at the University of Southern California Lusk Center for Real Estate. California's state employee pension system, CaIPERS, gained 12.7 percent during fiscal year 2005, due largely to a 38 percent jump in the value of its real estate holdings.

That availability of credit has been a boon for home buyers looking for mortgages. "It has been a key factor in taking some of the cyclicality out of our business," says John Landon, co-chairman and CEO of Meritage Homes Corp. "Now, it's not a matter of whether you can get a loan, it's a matter of what you pay. It's a huge driver in our current housing business."

GETTING CREATIVE

Many of today's most popular mortgage products were actually developed more than 20 years ago. ARMs were introduced in California in 1974 and expanded nationally in 1981, "the moment of the highest mortgage yields since the Civil War," says Michael Youngblood, managing director and director of asset-based securities research at Friedman, Billings, Ramsey and Co., an investment bank. The high interest rates that persisted in the early 19805 encouraged creative financing, he adds.

With as many as 200 types of mortgages now available, buyers are able to match their monthly payments to fit their budgets. Low interest rates, coupled with products designed to lessen monthly payments, such as interest-only mortgages or loans with multiple payment options, have enabled buyers to afford higher-priced homes. "Some of the ARM products are agreat way for the consumer to offset increasing sales prices," says Dan Klinger, president of K. Hovnanian American Mortgage.

Not surprisingly, nontraditional mortgages have caught on in California, where home prices have grown 103 percent since 2ooo, according to the Office of Federal Housing Enterprise Oversight's House Price Index. Brian Hanly, CEO of Roseville, Calif.-based Syncon Homes, says 35 percent of his buyers choose loans that do not require down payments, up from less than 20 percent five years ago. Two-thirds of his customers choose interest-only loans, he adds. (Nationally, 28.5 percent of new mortgages in 2005 were interest-only through June, according to LoanPerformance, a mortgage research firm and a subsidiary of First American Real Estate Solutions.)

Buyers choose the alternative mortgages largely-but not only-because of affordability, Hanly says. "Buyers are savvy. If they don't have to pay more, why would they? If banks are offering it, buyers are going to say, 'Why not?' "

TOO BIG A GAMBLE?

Why not, say some industry observers, is that buyers may find it difficult when the interest-only period ends and they must begin to also pay principal, likely at higher rates. It could also be worse for homeowners who choose option ARM loans-which allow them to pay less than the interest due each month-when they must begin to pay principal as well as the deferred interest.

"Homeowners are more extended, but as long as their income continues to grow and unemployment stays low, they can handle it," Ely says. "If you choose negative amortization (allowed with an option ARM), you are gambling that your equity in the home isn't going to shrink. I'm not sure how many people fully appreciate what that gamble is."

But Hanly believes his buyers are aware of the risks and says they could qualify to buy, on average, 15 percent more. "They're not always going to bite off more than they can chew. There are some people stretching a bit, but it's not as bad as the newspapers would make it out to be."

The risks associated with interest-only mortgages have been exaggerated, says Paul Calem, vice president of product research with LoanPerformance. In 2004, 30.9 percent of all purchase mortgages (as opposed to refinancings) were interestonly, up from 13.4 percent in 2003. Most interest-only loans, Calem says, go to buyers purchasing homes that are priced above the limit for lower, conforming mortgage rates ($359,650 in 2005) and who are looking for another way to reduce their monthly payments; most also make substantial down payments.

Though Calem says interest-only mortgage risk is marginally higher than the risk with other products, he says, "there's no evidence that people are making the wrong choices for themselves."

RISKYBUSINESS

Conflicting evidence exists, however, that banks may be allowing more wrong choices than in the past. An annual survey of lender underwriting released in July by the Office of the Comptroller of the Currency, one of five federal banking regulators, found that lenders have eased their residential lending standards.

Other studies reveal banks maintaining their underwriting standards. The two most recent Federal Reserve Senior Loan Officer Opinion Surveys, conducted each quarter, found that residential lending standards hadn't weakened since January. For the first time, the July survey included questions about nontraditional mortgages. About one-third of the respondents said that less than 5 percent of their mortgage originations in the last year could be characterized as nontraditional; another 41 percent said that nontraditional loans constituted between 5 percent and 25 percent of their new mortgage loans.

Nothaft says that Freddie Mac has become more comfortable buying such alternative mortgages as low down-payment loans because it has learned more about the risk associated with that type of mortgage and can set parameters for borrowers through its automated underwriting system. "The borrower applying for a low down-payment loan doesn't necessarily have more credit risk. Twenty years ago, we didn't have the consumer credit databases that have emerged to allow lenders to quickly access information on a whole variety of credit experiences," he says.

Advances in mortgage underwriting technology are praised across the industry. But some continue to caution about the additional risks nontraditional mortgages may carry Federal banking regulators which include the Federal Reserve in addition to the Office of the Comptroller of the Currency-are preparing to issue guidance about mortgage originations. In August, the National Association of Realtors and the Center for Responsible Lending kicked off a consumer mortgage education campaign. "These mortgages can be devastating for families who are stretching their budget to buy a home," Mike Calhoun, the Center for Responsible Lending's general counsel, said when the program launched.

Builders have an interest in their buyers' not overstretching to afford a new home, too. CTX Mortgage Co., which provides mortgage services for Centex Corp. in addition to closing about 50,000 retail mortgages annually, issues interest-only and option ARM loans only if the borrowers can qualify at an interest rate higher than today's prevailing rate, to protect against their being unable to make payments when the loans reset. "We don't want to put someone in a Centex home and have them default. It hurts the subdivision," says Tim Bartosh, president and CEO of CTX.

DOWN ONTHEIR LUCK

Industry experts are watching delinquency and foreclosure rates closely The delinquency rate stood at 4.34 percent at the end of the second quarter of 2005; ? percent of loans were in the foreclosure process.

Given the increased use of ARMs-their share of all mortgages hit nearly 40 percent in 2004, according to LoanPerformance-and their higher rate of delinquencies, some industry observers are forecasting a rise in defaults. Doug Duncan, senior vice president and chief economist of the Mortgage Bankers Association, acknowledges that reality, but he puts it in perspective. Just 15 percent of all homeowners have an ARM (with 35 percent owning debt-free and 50 percent with fixed-rate debt). Of the ARM holders, about half are high-income borrowers or seasoned ARM users whose behavior the industry understands.

"That leaves about half that group that either are middle-income or lower-income and haven't gone through the whole interest-rate cycle with an ARM product," Duncan explains. "It will not surprise us if we see some modest increase in delinquencies in those categories. But it won't surprise us if we don't-the economy may override the aging of the portfolio."

FORTUNETELLING

Nothaft expects 3O-year fixed rates will rise to about 6.2 percent in 2006. Adjustable rates likely will move higher more quickly, as the Federal Reserve is expected to continue to increase the federal funds target rate.

Facing those forecasts, builders' lending partners are taking steps to lock in current low rates. GMAC Mortgage Corp.'s "Builder Power" program will protect a borrower's interest rate for as long as 24 months during the construction of a new home. "It protects the builder because the buyer will still buy the home even if the economy changes," says John Brawner, vice president for the national builder division of GMAC Retail. Countrywide Financial, the nation's top mortgage company, also offers a builder rate cap program. "It's an expensive thing to offer," says John Richardson, senior vice president of Countrywide's builder sales support. "But it offers protection for both sides."

Regardless of what happens with interest rates, many builders expect their industry to look slightly different in 18 months. Hanly recalls when the "sweet spot" of his market was less than $400,000. "Now the stuff under $500,000 is disappearing. People just can't continue to afford that," he says. His strategy for future success: concentrating on higher-density, lower-priced homes for entry-level and first-time moveup buyers.

On the other coast, the average price point for Sarasota, Fla.-based Lee Wetherington Homes is $750,000. With nearly a third of his buyers paying with cash, CEO Lee Wetherington says he doesn't have much interest-rate sensitivity Still, he expects the rate of price appreciationwhich hit 20 percent in Sarasota last yearto slow. "I think in 2006 it will drop off dramatically. There's not going to be a bubble {bursting}, but a strong slowdown of appreciation."

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