Alternative Mortgages: Causes and Policy Implications of Troubled Mortgage Resets in the Subprime and Alt-A Markets

Alternative Mortgages: Causes and Policy
Implications of Troubled Mortgage Resets in the
Subprime and Alt-A Markets
Updated October 8, 2008
Edward V. Murphy
Analyst in Financial Economics
Government and Finance Division

Alternative Mortgages: Causes and Policy Implications
of Troubled Mortgage Resets in the Subprime and
Alt-A Markets
Borrowers who used alternative mortgages to finance homes during the housing
boom have experienced rising foreclosure rates as housing markets have declined.
Some types of alternative mortgages may have exacerbated price declines and
damaged the finances of consumers and lenders. The use of mortgages with
adjustable rates, zero down payment, interest-only, or negative amortization features
raise economic risk compared to traditional mortgages. Because some borrowers and
lenders did not adequately evaluate these risks, housing finance markets have been
hit with significant losses and financial markets have been in turmoil. Policymakers
have responded with a housing rescue package (H.R. 3221 / P.L. 110-289). They
have also authorized the Department of Treasury to institute a Troubles Asset Relief
Program (TARP) to buy bad debts from banks (H.R. 1424 / P.L. 110-343).
Alternative mortgages offer some combination of adjustable rates, extremely
low down payments, negative amortization, and optional monthly payments. The
prudent use of alternative mortgages offers benefits. For example, during periods of
exceptionally high interest rates, adjustable rates may suit consumers expecting rates
to fall. People whose incomes depend on commission or bonuses may be attracted
to mortgages with flexible monthly payments.
These benefits come with potential costs for the borrower and for the financial
system. Adjustable rates shift the risk of rising interest rates from banks to borrowers.
Low down payments increase the risk that borrowers will owe more than their house
is worth if prices fall. A borrower owing more than the house is worth may be unable
to sell or refinance the house. The use of alternative mortgages in these areas may
have contributed to rising defaults and more volatile home prices. More than a
trillion dollars of mortgages originated during the boom will reset their monthly
payments by 2009.
Using its authority under the Truth in Lending Act (TILA) and Regulation Z, the
Federal Reserve issued on July 14, 2008, new rules for mortgage origination. These
rules apply to banks and to non-bank lenders. These rules would put some
restrictions on the use of prepayment penalties for mortgages with introductory
periods and requires disclosures for mortgages with adjustable rates. The House of
Representatives passed a bill to provide additional rules for underwriting practices
of alternative mortgages (H.R. 3221) but a similar bill has not as yet passed the
This report describes alternative mortgages, summarizes recent regulatory
actions, and provides an estimate of the geographic concentration of interest rate risk
and negative appreciation risk. It will be updated if market developments warrant.

Background ......................................................1
Events That Led to Unsustainable Mortgages............................2
Size and Timing of the Upcoming Mortgage Resets...................2
Resets Are the Result of Decisions Made in 2004-2007................3
Credit Quality of Resetting Loans Appears Weak.....................4
Features of Nontraditional Mortgages..................................6
Adjustable Rates..............................................6
Extremely Low or Zero Down Payment............................6
Interest Only..................................................7
Negative Amortization..........................................7
Federal Agency Actions on Alternative Mortgages........................7
Financial Regulatory Institution Guidance..........................7
October 2006 Inter-Agency Guidance..............................8
Issues and Comments.......................................8
Consumer Disclosure.......................................8
Prudent Practices..........................................9
Federal Reserve Revision of Regulation Z.........................10
Consumer Protection Hearings..............................10
Final Rule for Regulation Z.................................10
FHA’s Hope for Homeowners Program...........................11
Analysis of Nontraditional Mortgages.................................11
Payment Resets, Affordability Products, and Planned Refinances.......11
Reasons for the Resets: Booming House Prices and the Attraction
of Alternative Mortgages...................................14
Negative Appreciation: Consequences for Resets....................18
Interest Rate Risk.............................................20
Geographic Correlation of Falling-House-Price Risk and Interest
Rate Risk...............................................22
Recent Price Declines.........................................26
Conclusion ......................................................26
List of Figures
Figure 1. Alternative Mortgage Resets.................................3
Figure 2. Falling Interest Rates Fueled Housing Markets...................4
Figure 3. Underwriting Standards Weakened............................5
Figure 4. Comparison of Appreciation for 3 Cities, 1980-2005.............19
Figure 5. Mortgage Rate, Discount Rate, and Inflation, 1980-2005..........22

Table 1. Payment Reset for Interest-Only Mortgages.....................12
Table 2. Payment Reset for Adjustable Rates Mortgages..................13
Table 3. Payment Driven Loan Qualification...........................14
Table 4. U.S. House Price Appreciation, 1980-2005.....................14
Table 5. Annual House Price Appreciation, 2000-2006, by Metro Area......15
Table 6. Appreciation, Home Equity, and Loan to Value (LTV)............17
Table 7. Local Unemployment and Slowing Appreciation.................19
Table 8. Negative Appreciation, Equity, and Loan to Value (LTV)..........20
Table 9. Adjustable Rate Mortgages and Price Slowdowns................24
Table 10. Adjustable Rate Mortgages and the Market Risk Index...........25

Alternative Mortgages: Causes and Policy
Implications of Troubled Mortgage Resets in
the Subprime and Alt-A Markets
More than a trillion dollars of mortgages will have payment resets in 2007-
2009.1 A newspaper account of one resident of Garden Grove, California, illustrates
the problem. His monthly mortgage payment doubled and he learned that he owes
more than his house is worth because prices of neighboring houses fell by $140,000.2
It will be a struggle to maintain the higher payments on his resetting mortgage and
it is difficult to refinance while he is upside down.3 The Federal Reserve issued new
rules pursuant to the Truth in Lending Act (TILA) to help potential home buyers
understand the risks in alternative mortgages and to ensure that lenders follow safe
and sound practices. Unlike a regulatory guidance, Regulation Z applies to banks
and to non-bank lenders that operate in the subprime and Alt-A mortgage sectors.4
Mortgage delinquencies and foreclosures are rising and the prospect of coming
mortgage resets in declining housing markets suggests that defaults will rise even
Alternative mortgages are sometimes called nontraditional mortgages or exotic
mortgages. Alternative mortgages have some combination of variable interest rates,
extremely low down payments, interest-only periods, and/or negative amortization.
(Amortization refers to the gradual payment of the loan’s principal.) In some cases,
borrowers intended to refinance these loans or sell the houses relatively quickly. The
potential advantages of alternative features for these buyers often depended on the
expected path of interest rates and home appreciation. Significant disadvantages
became apparent, however, when interest rates and appreciation took what to some
was an unexpected turn. The sudden decrease in house price appreciation during
2006-2008 has caused problems for borrowers using alternative mortgages with
resets that are expected to occur in coming months.

1 “Facing the Fallout from Foreclosures,” Community Banker, November 2006. p. 40.
2 “Falling Prices Trap New Home Buyers,” Orange County Register, December 13, 2006.
3 When a borrower owes more than the collateral is worth, the borrower is said to be upside
4 Subprime borrowers typically have significantly lower credit scores or other indicators of
high risk while Alt-A borrowers have better credit but may have some other defect, such as
reduced income documentation.

House prices boomed from 2000 to 2005 in many parts of the country and then
suddenly ground to a halt in 2006. Since 2006, house prices have fallen in many
markets. Although adjustable rate mortgages are not new, their increased use during
the boom was counterintuitive to many economists because mortgage rates were
already low by historic standards. Other alternative features were not new but their
use by the general public increased during the boom. The increased use of alternative
mortgages by unsophisticated borrowers may have been a significant contributor to
the rise in mortgage delinquencies and foreclosures.
This report recounts recent events that led to increased foreclosures and the
forecast of higher foreclosures, explains salient features of alternative mortgages,
summarizes federal agency response, places the potential benefits and risks to
consumers and financial systems in the context of economic conditions, and assesses
the estimates geographic impact.
Events That Led to Unsustainable Mortgages
Size and Timing of the Upcoming Mortgage Resets
Mortgage defaults are rising and are expected to increase significantly. Housing
prices have slowed or declined in previously booming areas, and it is taking longer
to sell homes; troubled borrowers now find it more difficult to sell their property to
avoid foreclosure. Many borrowers took out loans with introductory periods that will
expire resulting in higher payments even if interest rates are low, and the
underwriting of these loans appears to be relatively weak. The combination of
mortgage payment resets and weaker housing markets could lead to even higher
mortgage defaults in coming years.
There are two periods of higher scheduled resets. Figure 1 shows that the first
period (January 2007 - September 2008) had a high proportion of subprime loans.
Month 1 in Figure 1 represents January of 2007; therefore, month 23 represents
November 2008, which has a low number of subprime resets. After November 2008,
the number of payment resets in the Alt-A and option ARM categories increases. Alt-
A loans are typically loans that would be considered low risk if everything in the loan
documentation turns out to be accurate; that is, the loan has an alternative way to
meet “A” standards, such as reduced income documentation. Informally, these loans
are sometimes referred to as “liar loans” because of the potential for fraud. An
option ARM is a loan that allows the borrower several options for any given month’s
payment, including paying less than the current interest due. If the borrower pays
less than current interest due then the loan negatively amortizes — the balance
increases and future payments rise.

Figure 1. Alternative Mortgage Resets

Resets Are the Result of Decisions Made in 2004-2007
Subprime borrowers often used alternative mortgages with two- or three-year
introductory periods, so-called 2-28s and 3-27s. A 2-28 originated in the second half
of 2005 resets in the second half of 2007. The 2-28 and 3-27 resets that occurred
through summer 2008, therefore, were originated in 2004 through 2006. The state
of the housing market and financial markets during 2004 through 2006 may provide
clues to the sustainability of these mortgages.
The housing market in many areas appreciated sharply in 2004 and 2005, but
then the rate of appreciation slowed in 2006 and has ultimately begun to fall. Rapidly
rising house prices build an owner’s equity, which improves the borrower’s risk-
profile and allows refinancing on better terms. Some borrowers and lenders may
have agreed to higher-risk loans in rapidly appreciating areas, anticipating that
continued house price increases would reduce the chances of default.
Interest rates in 2004 through 2006 presented borrowers with conflicting
incentives. On the one hand, Figure 2 shows that rates on 30-year fixed mortgages
were generally around 6% during 2004 through 2006, low by historical standards.
Borrowers had an incentive to use fixed rate mortgages to lock-in these low rates.
On the other hand, Figure 2 also shows that the gap between short- and long-term
rates was relatively large in 2004. The larger this gap, the more a borrower benefits
from an adjustable-rate mortgage, which tends to follow short-term rates. Also, the
benefit of an adjustable rate mortgage is greater if the borrower intends to quickly sell
the house or refinance the loan — which coincides with rapidly appreciating housing

The use of mortgage products with introductory periods and adjustable interest
rates arguably was a reasonable response to house price appreciation and interest
rates in 2004. By 2005, however, short-term interest rates were rising faster than
long-term interest rates. Yet, adjustable rates remained very popular. House price
appreciation slowed significantly in 2006, yet introductory periods remained popular.
The persistence of nontraditional terms could be evidence that some borrowers
intended to sell or refinance quickly — one indicator of speculative behavior.
Figure 2. Falling Interest Rates Fueled Housing Markets

Short Term Rates Decline Sharply During 2000-2004
9 99 0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
1985 1986 1987 1988 1 98 1 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20
Yield 10Yr TYield 1 Yr TFR Mortgage Rate
Source: Federal Reserve.
Credit Quality of Resetting Loans Appears Weak
As the reset dates of billions of dollars of subprime mortgages near, analysts
want to know the quality of the underwriting that was used when the loans were
originated. For 2-28s and 3-27s, this requires information on the risk-characteristics
of loans originated in prior years. Information from industry sources suggests that
non-agency subprime loans became more risky as the housing boom progressed. For
example, Figure 3 shows that the percent of subprime loans with low documentation
doubled between 2000 and 2005.5 Similarly, the percent of subprime loans that used
silent seconds to avoid private mortgage insurance (PMI) increased from almost none
5 “The U.S. Subprime Market: An Industry in Turmoil,” Thomas Zimmerman, UBS,
[http://www.prmi chapter_page s/da ta/files/1471_2576_zimmerman%20pr e s e n t ation

in 2000 to 25% of the subprime market by 2006.6 Figure 3 also shows the increased
use of subprime loans with interest-only periods, which require higher resets even if
interest rates do not rise.
Figure 3. Underwriting Standards Weakened

Securitized Subprime Loans with Selected Risk Indicators
2000 2001 2002 2003 2004 2005 2006
Low DocumentationSilent SecondsInterest-Only
Source: Compile by CRS from UBS data.
In summary, falling interest rates had two important effects on alternative
mortgage markets. First, lower mortgage rates initially helped bid up house prices
as households qualified for larger loans, which increased appreciation rates. Second,
the incentive to use adjustable rate mortgages increased because short-term rates
initially fell faster than long-term rates. House price appreciation and low interest
rates, which many expected to continue, encouraged the use of mortgages that reset
and have substantially higher future payments. Subsequent increases in interest rates
and slowing house prices have resulted in some unsustainable resets and the forecast
of more unsustainable resets. Understanding the choice of mortgages containing a
reset requires an examination of the features of nontraditional mortgages.
6 A silent second is a second loan. It is often used as a substitute for a downpayment so that
the first loan receives a lower interest rate. These loans are also sometimes used so that the
first loan will be below the conforming loan limit and eligible for purchase by Fannie Mae
and Freddie Mac, but then probably would not be found in this non-agency database.

Features of Nontraditional Mortgages
Discussions of alternative mortgages often focus on some combination of four
differences from traditional mortgages. Borrowers increasingly chose one or more
of the following features:
! adjustable rates,
! extremely low or zero down payment,
! interest-only payments, and
! negative amortization.
Adjustable Rates
There are many varieties of adjustable rate mortgages (ARMs). One of the
simplest forms offers an initial low rate, called a teaser, at the beginning of the loan
and then resets after an introductory period. The teaser rate may apply for one year
or for as little as one month. The mortgage contract may specify a reset interest rate
or may tie the rate to another interest rate by formula. The resulting interest rate may
itself be fixed or variable. Teaser rates should be distinguished from fully adjustable
rate mortgages. In principle, a 30-year fixed rate mortgage could have a one-month
teaser rate without materially affecting the costs and benefits of the mortgage
Excluding teaser rates, variable rate mortgages tie the loan to the economy. The
future mortgage rate on these loans typically depends on another future interest rate
observed in financial markets. The rate might reset each month, each year, or only
after several years. The home buyer’s mortgage payment would drop if the interest
rate dropped but would rise if the interest rate rose. Many adjustable rate mortgages
provide for a cap on the amount a rate can rise in any period or over the life of the
Adjustable rate mortgages can be tied to a variety of market interest rates. One
common reference rate is the London Interbank Offered Rate (LIBOR). LIBOR rates
are determined in the London market for unsecured bank loans. It is a rate that banks
charge each other for short term loans (less than 12 months). Typical adjustable rate
mortgages will specify a reset date at which time the mortgage rate will adjust to the
LIBOR or similar rate plus a predetermined markup.
Extremely Low or Zero Down Payment
Saving enough funds to meet the traditional 20% down payment can be a
significant barrier to otherwise credit-worthy potential home buyers. Furthermore,
the required down payment grows with the appreciation rate. If home appreciation
is growing faster than household income, then it will be difficult for first time home
buyers to save sufficiently. Lending programs gradually reduced the required down
payment options to 10%, 5%, and eventually 3% of the purchase price. There are
mortgages that take this process to its logical conclusion and allow buyers to
purchase with no money down. Some programs even roll in closing and other
acquisition costs for greater-than-100% financing.

A related practice is using a second mortgage to finance the down payment.
Sometimes called piggy back loans or silent seconds, the home buyer uses the second
loan to borrow the funds for a 20% down payment. This down payment is enough
to improve the interest rate and other terms of the first mortgage. However, the
second mortgage carries a higher interest rate and other less desirable features
because the first mortgage has prior claim on the collateral. Although the original
first-mortgage lender may be aware of the piggy back loan (and may have helped
arrange it), subsequent holders of the first mortgage may not be aware of the piggy
back loan because lenders often sell the loans they originate to the secondary
mortgage market.
Interest Only
An interest-only mortgage allows the home buyer to carry the loan balance for
a period of time without having to pay back any principal. The current mortgage
payment covers only the monthly interest due on the existing balance. Eventually,
the monthly payment must also cover the principal. If the duration of the mortgage
is not extended, then the payments will have to amortize the remaining balance over
a shorter period of time. Therefore, a homeowner choosing to pay only the interest
for a few months increases the monthly payment for later months.
Negative Amortization
Unlike interest-only mortgages which leave the loan balance unchanged, a
mortgage with negative amortization allows the borrower to increase the loan’s
principal by paying less than the current interest due. The remaining interest is added
to the loan balance. Future payments are then recalculated based on the increased
principal. The homeowner gets lower current payments but at the cost of greater debt
and higher future payments.
These four features of alternative mortgages are not mutually exclusive. There
are option mortgages which allow borrowers to choose each month to pay a fully
amortizing amount, an interest-only amount, or a negatively amortizing amount.
Interest-only mortgages that use an adjustable rate when the introductory period ends
are also common. The increased use of these mortgages and innovative combination
of features has drawn the attention of federal regulators.
Federal Agency Actions on Alternative Mortgages
Financial Regulatory Institution Guidance
Several federal banking agencies, including the Federal Reserve, the Office of
Thrift Supervision (OTS), the National Credit Union Agency (NCUA), the Federal
Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the
Currency (OCC), oversee mortgage originations by financial institutions. These
agencies are all part of the Federal Financial Institutions Examination Council
(FFIEC), and issued a joint guidance statement (the 10/06 Guidance) for alternative

mortgages on October 4, 2006.7 This guidance applies to federally regulated
financial institutions but not to many non-bank lenders in the subprime sector. In
addition to inter-agency guidance, the Federal Reserve revised Regulation Z under
the Truth in Lending Act (TILA) in July 2008. Regulation Z applies to all mortgage
October 2006 Inter-Agency Guidance
Issues and Comments. The FFIEC agencies are responsible for overseeing
both the consumer protection mandates of the Truth in Lending Act (TILA) and the
safety and soundness of their regulated institutions. The agencies recognized that
alternative mortgages have existed for some time but were concerned that products
with possible negative amortization were being offered to a wider spectrum of
borrowers by greater numbers of lenders. The 10/06 Guidance addressed three areas
of concern: underwriting standards, risk management, and consumer protection. The
10/06 Guidance specified that lenders must tighten underwriting standards to
manage risk. Lenders must also provide clear information to consumers to ensure
consumer protection, but the guidance explicitly rejected imposing the doctrine of
The comment period drew a range of views on the proposal that became the
10/06 Guidance. Some depository institutions and industry groups argued against
additional restrictions on alternative mortgages. They pointed out that alternatives
to the traditional 30-year fixed rate mortgage have been successfully used for many
years. Some argued that alternative mortgages contribute to market flexibility in a
changing economy. Some also argued that lenders had the incentive and the
capability to appropriately manage the risks.
Critics of alternative mortgages encouraged more stringent limitations. Some
argued that an agency guidance would not be effective enough because it would not
apply to lenders regulated at the state level. These critics argued for new federal
legislation. Some consumer groups argued that alternative mortgages were too
complex for unsophisticated borrowers to fully understand. Others argued that
expanded use of nontraditional mortgages could encourage speculation in real estate
and destabilize house prices.
Consumer Disclosure. The 10/06 Guidance addressed some of the
commenters’ consumer protection concerns. Lenders are to provide full disclosure
in plain language. Lenders were already required to give consumers considering9

adjustable rate mortgages an information booklet published by the Federal Reserve.
7 “Interagency Guidance on Nontraditional Mortgage Product Risks,” Federal Register, vol.

71, October 4, 2006, p. 58613.

8 The doctrine of suitability would impose a duty on lenders to ensure that a chosen
mortgage product was suitable to the borrower’s financial circumstances and goals.
9 The Federal Reserve publishes the Consumer Handbook for Adjustable Rate Mortgages
(CHARM Booklets). Regulation Z requires that consumers be given CHARM booklets in

The 10/06 Guidance now requires that consumers considering other nontraditional
mortgages be given similar information including examples of payment comparisons.
As of August 2007, the the FFIEC has not issued a mandatory interest-only or
negative-amortization counterpart to the adjustable rate booklet, although the Office
of the Comptroller of the Currency has a model booklet.
The Government Accountability Office (GAO) also made recommendations for
alternative mortgages. On disclosures, GAO found that “although federal banking
regulators have taken a range of proactive steps to address AMP [alternative
mortgage product] lending, current federal standards for disclosures do not require
information on AMP specific risks.”10 GAO recommended that the Federal Reserve
improve its regulations governing disclosures by requiring language that explains the
specific risks and features of alternative mortgages.
Prudent Practices. In addition to consumer disclosure, the 10/06 Guidance
addresses a number of lending practices that some commenters considered unsafe or
unsound. The use of alternative mortgages by less affluent borrowers raised concerns
that some home buyers would not be able to sustain payments if housing market
conditions changed. The 10/06 Guidance specifically addresses collateral-dependent
loans, risk layering, and third-party relationships.
The 10/06 Guidance stated that collateral dependent loans are an unsafe and
unsound lending practice. Collateral-dependent loans refers to the practice of lenders
to rely solely on the borrower’s ability to sell or refinance the property to approve the
loan. An example of this practice would be an interest-only loan to a person with no
down payment that resets after three or five years. In the first few years of the loan,
the borrower is expected to pay a high interest rate. When the loan resets, the buyer
is expected to refinance the loan, by which time appreciation could have provided a
down payment which would reduce the interest rate the buyer would be expected to
The 10/06 Guidance requires loans to be underwritten for full risk layering. To
understand risk layering, consider a mortgage with an optional negative amotization
feature. This option is the equivalent of extending the borrower additional credit
without additional underwriting. If the borrower chooses to pay less than current
interest in the current month, then the remaining interest is added to the loan balance.
For example, a borrower may be extended a $200,000 loan that could rise to a
$250,000 balance if the borrower pays the minimum each period. The 10/06
Guidance specifies that lenders consider a borrower’s ability to repay the maximum
loan balance assuming the borrower pays only the minimum monthly payment each
period. In the example, the lender would have to qualify the borrower for a $250,000
loan, not a $200,000 loan.

9 (...continued)
the shopping phase if they ask for, or are offered, adjustable rate mortgages.
10 U.S. Government Accountability Office, Alternative Mortgage Products: Impact on
Defaults Remains Unclear, But Disclosure of Risks to Borrowers Could be Improved, GAO-

06-1112T, September 20, 2006. p. 2.

The 10/06 Guidance also addresses third-party relationships and risk
management. Banks and financial institutions often do not originate or hold their
loans. Mortgage brokers may market the loans to consumers. Once originated, the
loans may be sold to investors in the secondary mortgage market. The guidance
requires covered institutions to have strong systems and controls for establishing and
maintaining third party relationships. While the industry worried that this would
require institutions to oversee the marketing practices of third-parties, the agencies
responded that an institution’s risk management system should address the overall
level of risk that third-party relationships create for the institution.
Federal Reserve Revision of Regulation Z
Consumer Protection Hearings. The Federal Reserve administers the
consumer protection laws that apply to all lenders, even non-bank lenders that are not
subject to agency guidances. The Federal Reserve used the notice and comment
rulemaking procedures to modify protections for consumers in mortgage transactions.
After a series of hearings had been held on the Truth in Lending Act and the Home
Owners Equity Protection Act, which the Federal Reserve implements through
Regulation Z, the Federal Reserve revised rules.
The Board heard testimony focusing on four questions regarding its HOEPA
authority: (1) should prepayment penalties be restricted to the introductory periods
of resetting loans; (2) should escrow accounts for taxes and insurance be mandated
for subprime loans (the practice is common in prime markets; (3) should limitations
be put on stated income loans, also known as low-doc loans or even liar loans; and
(4) should additional limits be placed on underwriting loans based on a borrower’s
ability to pay out of household income, rather than the value of the collateral?
Final Rule for Regulation Z. The Federal Reserve issued its final rule for
Regulation Z on July 14, 2008. Some of the changes made by the Federal Reserve
apply only to higher prices loans whereas others apply to all mortgage loans. In
addition, the Federal Reserve adjusted its definition of higher priced loans to account
for the effect of the gap between short-term and long-term interest rates, as well as
lowering the threshold for designation as higher cost.
The Federal Reserve made several significant changes to the rules that apply to
the origination of all mortgage loans secured by a principal dwelling. It bans
creditors and mortgage brokers from coercing a real estate appraiser to misstate a
home’s value. It also bans pyramiding late fees and certain other mortgage servicing
practices. In addition, lenders and servicers are required to credit borrowers’
mortgage payments as of the date of receipt and provide a statement. Borrowers
must receive a good faith estimate of the loan costs, including a schedule of
payments, within three days after application for all mortgage loans. Consumers
cannot be charged any fee until after they receive the early disclosures, except a
reasonable fee for obtaining the consumer’s credit history.
Some of the changes to Regulation Z apply only to higher priced mortgages.
These include prohibiting a lender from making a loan without regard to borrowers’
ability to repay the loan from income and assets other than the home’s value (so-
called collateral dependent lending). For higher price loans, the new rule requires

creditors to verify the income and assets they rely upon to determine the borrower’s
ability to repay the loan. It places a ban on prepayment penalties if the monthly
mortgage payment can change in the first four years. For other higher-priced loans,
a prepayment penalty period cannot last for more than two years. The rule also
requires creditors to establish escrow accounts for property taxes and homeowner’s
insurance for all first-lien mortgage loans.
FHA’s Hope for Homeowners Program
Policymakers enacted the Hope for Homeowners Program in July 2008 (H.R.
3221 / P.L. 110-289). This program allows lenders and borrowers to voluntarily
refinance troubled mortgages into an FHA-insured loan. To participate, borrowers
must certify that their loan was unaffordable as of March 2008 and lenders must
agree to write-down the principal of the loan to a more affordable level. The program
allows for up to $300 billion in FHA-insured loans in which the borrower would be
responsible for 90% of the new appraised value. The lenders would write-down the
loan an additional 4.5% to cover the one time premium and the first annual premium
of the FHA insurance. Therefore, the lender must agree to write down the loan to
85.5% of the current appraised value, and in some areas the current appraisal may be
significantly below the original loan balance. The FHA loan limit was increased in
high cost areas to as much as $625,000. The act also provided for more flexibility
for some of FHA’s underwriting criteria.11
Analysis of Nontraditional Mortgages
GAO estimates that interest-only and other alternative mortgages approached
30% of the mortgage market by 2005.12 Payments on these mortgages will reset to
higher levels in the next few years. Although such products were sometimes used in
the past by sophisticated borrowers as cash management tools, the recent housing
boom saw alternative mortgages offered as affordability products to less sophisticated
borrowers. Alternative mortgages were used by less wealthy borrowers in areas of
high expected appreciation. The concentration of mortgage resets in time and in
location can cause concerns for individual borrowers, for local real estate markets,
and for financial institutions.
Payment Resets, Affordability Products,
and Planned Refinances
The expanded use of alternative mortgages during the housing boom has created
a wave of mortgage resets due in the next few years as the introductory periods
expire. Not only do adjustable rate mortgages change their payments as interest rates

11 For a discussion of FHA and related reform proposals, see CRS Report RS20530, FHA
Loan Insurance Program: An Overview, by Bruce E. Foote and Meredith Peterson, and CRS
Report RS22662, H.R. 1852 and Revisiting the FHA Premium Pricing Structure: Proposedth
Legislation in the 110 Congress, by Darryl E. Getter.
12 Alternative Mortgage Products, September 20, 2006.

change, but interest-only mortgages increase their payments when the full
amortization period begins. Even if interest rates do not increase much further, the
increase in monthly payments is substantial for many borrowers.
Consider a $200,000 interest-only loan originated at a time when the prevailing
mortgage rate is 6.5%. The interest-only period lasts four years then the loan
amortizes over the final 26 years at the 6.5 percent rate. The monthly payments
during the interest-only period will be $1,083. The monthly payments increase to
$1,328 after four years. Even though the borrower will not be affected if interest
rates rise above 6.5 percent, monthly payments will still rise $245 per month. Table
1 compares this hypothetical interest-only loan to a similar fully amortizing fixed rate
mortgage. Although the early payments of the interest-only mortgage are lower than
the traditional mortgage, the later payments are higher.
Table 1. Payment Reset for Interest-Only Mortgages
Interest Only (I/O) Feature and Payment Increases
for $200,000 Loan at 6.5% Interest
Initial Reset ChangePercentage
P ayments P ayments Increase
Traditional 30 Year Fixed$1,264$1,264$00%
I/O, Reset Year 5$1,083$1,328$24523%
Source: Table prepared by the Congressional Research Service (CRS).
Unlike interest-only mortgages, adjustable rate mortgages could have declining
payments as well as rising payments. Adjustable rate mortgages were very common
in the 1980s when interest rates were high and many people expected mortgage rates
to fall. The concern with more-recent adjustable rate mortgages is that their original
rate was near historic lows so it is probable that the prevailing interest rate will be13
higher when they reset. (Interest rate risk will be discussed in greater detail below.)
Table 2 presents sample payment resets after three years for a $200,000 mortgage if
interest rates rise or fall by a few percentage points. If the interest rate was originally
6%, then the monthly mortgage payment is $1199. If interest rates rise to 8%, then
the monthly mortgage payment rises to $1449. On the other hand, if interest rates fall
to 4%, then the monthly payment would drop to $971.

13 Some adjustable rates are tied to short-term interest rates while traditional mortgages are
long term. Some sophisticated borrowers choose adjustable or fixed rate mortgages based
on the difference between short- and long-term rates, called the yield curve. For these
borrowers, the steepness of the yield curve, not the relation of current mortgage rates to their
long-term trend, would be the important consideration.

Table 2. Payment Reset for Adjustable Rates Mortgages
Interest Rates and Monthly Payments Fully Amortizing
$200,000 Loan, 30 Years Rate Resets After 3 Years
Interest RateMonthly Payment
Base Rate6%$1199
Source: Table prepared by the Congressional Research Service (CRS).
Sophisticated borrowers have used alternative mortgages to manage their cash
flow for a long time. Consider a person who can qualify for any type of loan and has
plenty of savings for contingencies. If the person must move frequently for work,
then the person might not care much about the size of later payments because the
loan will not extend that long. If a couple starts in a one-bedroom condominium but
expects to move when they have children, then they might not want a traditional
mortgage. If the person has other interest-rate-sensitive investments, then the person
might use the mortgage as a hedge. For example, the holder of adjustable rate bonds
would lose if interest rates fell but could offset part of that loss through an adjustable
rate mortgage.
Alternative mortgages were marketed as affordability products to lower income
and less sophisticated borrowers during the housing boom. This raises concerns that
some home buyers applied for more debt than they could qualify for using traditional
underwriting standards. Lenders may have qualified them for the greater debt through
these alternative products. In some cases, underwriting standards became more lax
even using traditional qualifying ratios because the process was based on the early
years of an alternative mortgage product’s payments. As a result, underwriters are
now qualifying people based on the maximum payment, called the fully indexed rate.
Consider again the $200,000 loan at 6.5% presented in Table 1. Traditionally,
lenders presumed that there was a cap on the percentage of household income
borrowers could devote to housing costs. If that cap was 28%, and the traditional 30-
year fixed rate mortgage had monthly payments of $1,264, then a borrower would
need an income of $54,177 to qualify for the traditional loan. A borrower with a
lower income could not qualify for that loan and presumably could not buy the house.
The interest-only loan presents an interesting qualifying issue. If households
can devote 28% of income to housing costs, then an income of $46,428 qualifies for
the early years of the loan. However, an income of $56,950 would be required for
the later years of the interest-only loan. Table 3 compares the income required to

support the monthly payment assuming that households can devote 28% to housing
costs. A borrower with only $46,428 might be tempted to take out a $200,000 loan
using the interest-only product and then refinance the house when the payment reset.
Table 3. Payment Driven Loan Qualification
$200,000 Loan Using 28% Qualifying Ratio
Loan TypePayment Qualifying Income
I/O Years 1-5$1,083$46,428
FRM 30 Years$1,264$54,177
I/O Years 6-30$1,328$56,950
Source: Table prepared by the Congressional Research Service (CRS).
A cash-constrained borrower’s ability to successfully execute the planned
refinancing would depend on the housing market. The borrower is relying on the
expected appreciation of the house itself to help pay for the house. This is an
example of a collateral-dependent loan which the 10/06 Guidance designates unsafe
and unsound. It is not known how many of the loans due to reset in the next two
years are collateral-dependent loans. The performance of these loans will depend on
the housing market.
Reasons for the Resets: Booming House Prices
and the Attraction of Alternative Mortgages
U.S. house prices appreciated rapidly in many regions during 2001 through

2005. Nationally, the Office of Federal Housing Enterprise Oversight (OFHEO)

house price index (HPI) rose 51% over the five-year period. Table 4 compares
appreciation during the recent boom to appreciation in other five-year periods. The
recent housing boom saw the fastest appreciation since 1980. The boom stands out
even more when it is adjusted for inflation. Real house prices rose 34% between

2000 and 2005.

Table 4. U.S. House Price Appreciation, 1980-2005
Nominal and Real Change in OFHEO House Price Index (HPI)
5-Year Increments
1980-85 1985-90 1990-95 1995-00 2000-05
Nominal HPI25%37%8%26%51%
Real HPI-8%14%-9%12%34%
Source: Office of Federal Housing Enterprise Oversight (OFHEO)

The distinction between nominal and real house prices is important. Mortgage
contracts are almost always specified in nominal terms. This means that a fall in the
real price might not cause a borrower to be upside down on the mortgage if inflation
is high enough to counteract the real price decline. This scenario occurred in the
early 1980s and the early 1990s. On the other hand, analysts considering the return
to housing as an investment often focus on real prices.14 Although real prices can
be important for long term trends in the composition of household savings, nominal
prices are more important for determining the stress on borrowers as their payment
reset date nears.
Prices rose even more rapidly in some markets. Table 5 compares the annual
appreciation rate of some U.S. cities during 2000 through 2006. The extremely rapid
rise in certain markets led to concerns that the 1990s stock bubble had been replaced
with a housing bubble.15 For example, Las Vegas house prices rose 34.9% in a single
year, 2004. Orlando’s house prices rose 32.7% in 2005. Seven of the cities listed in
Table 5 experienced five consecutive years of appreciation rates exceeding 10% per
year. Then in 2006, the housing market slowed dramatically, as shown by the
significant decline in the appreciation rate in each of the 31 cities listed in Table 5.
Table 5. Annual House Price Appreciation, 2000-2006,
by Metro Area
2000 2001 2002 2003 2004 2005 2006 AVG00-05
US National8.1%6.5%7.1%8.2%13.0%12.9%2.1%9.3%
West Palm Beach8.711.213.617.
Los Angeles8.910.514.319.327.023.64.417.3
Miami 9 .1 13.0 14.1 15.2 22.7 28.7 8 .4 17.1
Washington 11.7 11.3 10.9 14.0 24.2 22.3 2 .7 15.7
San Diego13.411.916.617.725.98.7-0.115.7
Las Vegas6.65.95.918.334.916.61.314.7
Orland o 8 .7 6.9 7 .9 9.1 20.4 32.7 5 .5 14.3
Phoenix 6 .5 5.4 4 .9 6.9 22.2 37.0 3 .8 13.8
New York10.810.911.311.816.316.61.913.0
San Francisco19.
Philadelp hia 7 .1 8.5 9 .6 11.3 15.9 14.2 3 .0 11.1
Boston 13.6 12.5 12.2 10.3 11.6 5 .9 -1 .2 11.0
Richmo nd 5.5 5 .3 6.5 8 .2 13.6 17.8 4 .3 9.5
Minneapolis 11.0 10.2 8 .3 8.7 9 .5 6.7 0 .3 9.1
Portland 5.0 4 .0 4.0 6 .0 12.7 12.6 7 .5 8.9
Chicago 6 .7 7.4 6 .3 7.7 11.1 10.8 2 .9 8.3

14 Robert Schiller’s critique of the housing market uses real prices and attempts to adjust for
changes in housing quality. See “Be Warned: Mr. Bubble is Worried Again,” New York
Times, August 21, 2005.
15 When asked about a national housing bubble, former Federal Reserve Chairman Alan
Greenspan replied that there was no national bubble but that some markets showed signs of
froth. Testimony before the Joint Economic Committee, June 9, 2005.

2000 2001 2002 2003 2004 2005 2006 AVG00-05
New Orleans5.
St. Louis
B i r mi ngha m 6 . 4 3 . 2 4 . 7 4 . 7 6 . 0 8 . 9 2 . 3 5 . 6
P ittsb ur gh 7 .4 4 . 8 4 .5 5 . 0 5 .3 5 . 6 0 .3 5 . 4
Denver 12.2 6 .2 3.3 2 .7 3.9 3 .5 1.0 5 .3
Kansas City6.
Buffalo 6.0 3 .8 4.2 5 .0 6.5 5 .4 2.4 5 .1
Nashville 5 . 2 2 .8 2 . 6 3 .7 6 . 2 9 .2 4 . 8 5 .0
Houston 7 .1 4.0 4 .6 3.4 4 .7 5.8 2 .8 4.9
Cincinnati 5.7 3 .8 3.5 3 .4 5.2 4 .2 0.9 4 .3
Dallas 7 .1 4.1 3 .7 2.1 3 .1 4.1 1 .9 4.0
Charlo tte 5.9 2 .4 2.9 2 .2 4.2 6 .1 4.4 3 .9
Cleveland 5 .6 3.3 3 .6 3.8 4 .0 2.6 -0.8 3 .8
Source: OFHEO HPI, calculated 1st Quarter to 1st Quarter
Markets with rapid appreciation reduce the ability of first-time buyers to save
for down payments. A 20% down payment on a $200,000 house is $40,000. If
prices rise 10%, then the 20% down payment rises to $44,000. The down payment
becomes a moving target. In areas with rapid home price appreciation, the required
down payment may be growing faster than household income. Potential first time
buyers may fear being permanently priced out of the market if they do not enter the
market as soon as possible.
While rapid home price appreciation may outstrip the savings of renters, an
owner’s home price appreciation actually increases household savings. Home equity
is a form of savings for home owners. Including the growth in home equity, savings
rise faster if the household is an owner in a rapidly appreciating market but the
household can’t become an owner until it has accumulated sufficient savings for a
down payment. A mortgage with a low down payment that is designed to be
refinanced after a few years could allow the prospective first-time home buyer to get
in to the market and take advantage of the house’s growing equity.
Rapid appreciation can reduce the time needed for credit enhancement. Lenders
typically require some form of credit enhancement if the value of the loan is more
than 80% of the value of the property. This loan-to-value ratio (LTV) of 0.8
corresponds with the traditional 20% down payment. One way that buyers with less
than 20% down enhanced their credit was through private mortgage insurance (PMI).
However, the PMI monthly premium counted towards the funds that underwriters
assumed households could devote to housing costs. The more quickly that a
household can lower LTV and eliminate the need for PMI, the greater the percentage
of the household’s total monthly payment can be devoted to paying off the loan.
In rapidly appreciating markets, the effect of growing equity on potential
savings and on the need for PMI made alternative mortgages with planned refinances

a potential affordability product. If first time buyers could just get into the rising
market, then the growing equity would provide sufficient savings to lower LTV and
eliminate the need for PMI by the time they had to refinance. Similar logic applies
if buyers replace PMI with a piggy back loan at a higher interest rate because the
need for the second loan at a higher rate is eliminated when equity rises.
Table 6 presents the growth of equity and reduction in LTV for a $200,000
interest-only loan for various appreciation rates. If appreciation rises 10%, then by
the beginning of year three the equity increases to $42,000 and the LTV falls to 0.79.
In this case, the buyer who put zero down and paid only interest would be able to
refinance into a loan without credit enhancement because the drop in LTV is the
equivalent of the 20% down payment. The time required to reduce LTV enough to
eliminate credit enhancement decreases as the appreciation rate rises.
Table 6. Appreciation, Home Equity, and Loan to Value (LTV)
Appreciation Contribution to Home Equity $200,000 House, Zero Down, I/O Loan Reset Year
Appreciation Rate (Annual Percent)
B e g i nning 0% LTV 5% LTV 10% LTV 15% LTV 20% LTV
Yea r Equit y Equit y Equit y Equit y Equit y
1 0 1 $ 0 1 .00 $ 0 1 .00 $ 0 1 .00 $ 0 1 .00
2 0 1 10,000 0.95 20,000 0.90 30,000 0.85 40,000 0.80
3 0 1 20,000 0.90 42,000 0.79 64,500 0.68 88,000 0.56
4 0 1 31,525 0.84 66,200 0.67 104,175 0.48 145,600 0.27
5 0 1 43,101 0.78 92,820 0.54 149,801 0.25 214,720 -0 .07
Source: CRS Calculations
The preceding discussion showed two ways that zero down payment and
interest-only mortgages could have been used as affordability products. First, if
qualification is payment driven, then lower-income borrowers could be qualified
based on the payments required during the introductory period of interest-only
mortgages. Table 3 showed that a household with $46,428 income could qualify for
the early payments of a $200,000 loan at 6.5% interest, even though that loan would
have traditionally required an income of $54,177 to qualify. Second, price
appreciation during the introductory period could lower LTV, eliminate the need for
credit enhancement, and allow the household to devote more funds to the house
payment. Table 6 showed that 10% annual appreciation can eliminate the need for
PMI by the beginning of the third year of payments.
Problems arose when the housing market weakened further. Some of these
borrowers are not able to refinance prior to their payment reset dates because their
houses failed to appreciate at the expected rate.

Negative Appreciation: Consequences for Resets
Borrowers using alternative mortgages to take advantage of appreciation are
exposed to the risk that house prices will fail to appreciate or even decline in price.
Recall that Table 5 showed that the rate of appreciation slowed across the country
in 2006. In some formerly hot markets, prices declined in 2006 and the first half of
2007. As payment reset dates approach, many borrowers who used alternative
mortgages as affordability products will wish to refinance. Their ability to refinance
is obstructed, in many cases, by the failure to achieve home equity through price
Local factors usually play a dominant role in determining regional house prices.
Because of the role the job market plays in household income, analysts assume the
local unemployment rate is important even in the absence of other information. For
example, David Lereah, chief economist for the National Association of Realtors,
emphasized the labor market in a presentation to residents of Charleston, SC. “Your
unemployment situation is very positive ... I really don’t know the local industries in16
Charleston other than tourism, but whatever it is, it’s doing a good job.” Although
Lereah went on to discuss migration patterns and other factors, the stress on labor
markets is unmistakable.
Because local economies often play such a crucial role in house prices, one
might think that the price risks embodied in low down payment mortgages is only a
problem if an area’s unemployment rises. While it is true that an increase in local
unemployment can help drive down house prices, it is important to note that prices
can fall even if the local labor market is healthy. The next sections show how
different metro areas can have divergent price trends but that the recent house price
slowdown is widespread and independent of local unemployment.
House prices in different metro areas do not always follow the national trend or
move in the same direction. Recall again the wide range of appreciation rates for the
cities presented in Table 5. San Diego’s houses appreciated over 15% per year
during 2000-2005, but Denver and Buffalo were closer to 5% per year. Figure 4
tracks house prices for San Diego, Buffalo, and Denver from 1980 to 2005. They do
not follow the national average nor do they follow similar patterns. Denver’s prices
rose more quickly in the early 1980s, when San Diego and Buffalo stagnated. San
Diego boomed in the late 1980s but then fell in the 1990s. Buffalo’s prices followed
a more stable trajectory. Differences in the local economies of the three cities
contributed to the divergent paths of home prices.
Many of the biggest house price slowdowns in 2006 cannot be attributed to
shocks to local job markets. For example, Boston’s appreciation rate dropped during
2004-2006 even though the Massachusetts labor market remained stable. Boston’s
appreciation rate fell from 11.6% in 2004, to 5.9% in 2005, and finally fell 1.2% in
the first three quarters of 2006. Yet the Massachusetts unemployment rate remained

16 “Realtors’ economist rates area ‘very healthy’” The Post and Courier, July 18, 2005, p.

close to 5% in all three years.17 Despite a relatively stable labor market, Boston’s
house prices stopped appreciating.
Figure 4. Comparison of Appreciation for 3 Cities, 1980-2005

0 98 3 98 9 99 2 99 5 99 8 00 1 00 4
1 98 1 1 1 1 1 2 2
U.S.BuffaloDenverSan Diego
Source: OFHEO House Price Index.
Table 7. Local Unemployment and Slowing Appreciation
Local Unemployment and Slowing Appreciation
Market Unemployment Appreciation
10/05 10/06 2005 2006
Phoenix 4.2% 3.4% 37.0% 3.8%
San Diego4.23.68.7-0.1
Los Angeles4.53.923.64.4
New York5.
Miami 3.7 3.5 28.7 8.4
Washington 3.0 2.9 22.3 2.7
Las Vegas3.
Orlando 3.1 2.8 32.7 5.5
Source: OFHEO and BLS
17 Bureau of Labor Statistics, Series ID LASST25000003.

The slowdowns in house price appreciation were widespread and occurred in
areas with healthy job markets. Table 7 compares local unemployment rate changes
to the slowdown in appreciation for several of the formerly hot housing markets.
Notice that the local unemployment rates were relatively unchanged in October 2006
compared to October 2005. Yet the rate of home price appreciation fell precipitously
in each market. Table 7 shows that the rate of appreciation experienced by home
buyers while they are choosing their mortgage can decline drastically even if the local
economy remains healthy.
Zero or negative appreciation in an otherwise healthy economy is a problem for
borrowers who made very low down payments. If they used a piggy back loan to
avoid PMI or used an interest-only loan and planned to refinance when they reached
an LTV of 0.8, then they may have become upside-down on the mortgage.
Borrowers with little savings are finding it difficult to refinance or sell a house before
the reset date because their LTV has not improved (i.e., declined). Table 8 shows
how declines in house prices affect the LTV of zero-down borrowers for a $200,000
interest-only loan.
Table 8. Negative Appreciation, Equity, and Loan to Value (LTV)
Negative Appreciation and Increasing Debt Burdens
$200,000 House, Zero Down, I/O Loan Reset Year 5


B egin Equi t y LTV Equi t y LTV Equi t y LTV Equi t y LTV Equi t y LTV
1 $0 1.00 $0 1.00 $0 1.00 $0 1.00 $0 1.00
2 $0 1.00 $-2,000 1.01 $-4,000 1.02 $-6,000 1.03 $-8,000 1.04
3 $0 1.00 $-3,980 1.02 $-7,920 1.04 $-11,820 1.06 $-15,680 1.08
4 $0 1.00 $-5,940 1.03 $-11,762 1.06 $-17,465 1.09 $-23,053 1.12
5 $0 1.00 $-7,881 1.04 $-15,526 1.08 $-22,941 1.11 $-30,131 1.15
Source: CRS Calculations.
If house prices depreciate 3% per year for two years, then the zero-down,
interest-only borrower presented in Table 8 will owe $11,820 more than the house
is worth. Recall that one reason a borrower might have been attracted to the interest-
only loan was because the borrower did not have the savings for a down payment.
When the introductory period ends and the reset date arrives, the borrower’s
payments will rise. In this hypothetical example of a $200,000 interest-only loan in
a period of 6.5% interest rates, Table 1 shows that the reset payment would rise $245
per month after four years. The borrower must either find an additional $245 per
month to maintain the current mortgage or $11,820 to cover the reduction in equity
and try to refinance even if interest rates do not rise.
Interest Rate Risk
Although the risk of slowing house price appreciation is already a reality,
interest rates are still relatively low. Problems could become more severe for

consumers that used adjustable rates if mortgage rates rise despite Federal Reserve
attempts to lower short term rates. A common form of alternative mortgage employs
adjustable interest rates. Adjustable rate mortgages shift the risk of rising interest
rates from the lenders to the borrowers. Table 2 showed how a rise in interest rates
could increase the payment on an adjustable rate mortgage. However, adjustable rate
mortgages allow borrowers to benefit when interest rates fall. The availability and
popularity of adjustable rate mortgages have changed with changing macroeconomic
When lenders held most of their loans in their own portfolio, fixed rate
mortgages imposed significant costs when interest rates rose. The lenders’ own costs
of funds depended on the short-term interest rates prevalent as time progressed.18
However, the lenders’ income from their mortgages depended on the interest rates
prevalent at the time the mortgages were originated. This is called borrowing short
and lending long. Rising interest rates increase the lenders’ cost of funds but the
lenders’ incomes do not rise. In response to strains on the banking sector as interest
rates rose in the late 1970s and early 1980s, Congress encouraged wider use of
adjustable rate mortgages.19
Mortgage rates are affected by conditions in the macroeconomy. Although the
Federal Reserve does not directly set long term interest rates such as mortgage rates,
Federal Reserve policy can determine short term interest rates and influence inflation.
The mortgage rate incorporates expectations of future inflation because mortgages
are repaid over long periods. Figure 5 compares inflation, mortgage rates, and the
Federal Reserve discount rate since 1972. The three are related but notice that the
steep rise in the discount rate after 2003 has resulted in only a minor rise in mortgage
rates during the same period.
The 1980s exemplify an environment conducive to adjustable rate mortgages.
Mortgage rates began to decline as the fear of inflation subsided. Expecting
mortgage rates to fall, more people turned to adjustable rates. For example, 61% of
the conventional mortgages originated in 1984 were adjustable.20 Mortgage rates
then declined from over 13% in 1984 to under 8% by 1993. Once mortgage rates
stabilized, the popularity of adjustable rate mortgages declined. For example, only
12% of mortgages originated in 2001 were adjustable rates. This relatively
longstanding response of borrowers to changing macroeconomic conditions
distinguishes adjustable rate mortgages from the use of interest-only mortgages as
affordability products described earlier.

18 Many lenders now sell their mortgages to investors in the secondary market reducing
exposure to rising interest rates.
19 Alternative Mortgages Parity Act, 1982. 12 U.S.C. sec. 3801.
20 Federal Housing Finance Board, 2006 Mortgage Market Statistical Annual - Volume 1,
p. 17.

Figure 5. Mortgage Rate, Discount Rate, and Inflation, 1980-2005

Inflation, Fed Discount, and Mortgage Rates
2 974 976 978 980 9 82 984 986 988 990 992 994 996 998 000 002 004
197 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2
Mrtg RateFed DiscountInflation
Source: Federal Reserve.
The pattern of adjustable rate mortgages during the recent boom suggests that
borrowers accepted interest rate risk at a time when interest rates were at historic
lows. Figure 5 showed that the mortgage rates prevailing in 2003-2005 represented
30-year lows. Consumers hedging against interest rate changes would be expected
to lock in the historic low rates by borrowing at fixed rates. Yet the share of
adjustable rates rose from 12% in 2001 to 34% in 2004, perhaps to take advantage
of the large gap between short and long term interest rates. Although still well below
the 61% share in 1984, the rising number of ARMs during a period of exceptionally
low interest rates means that consumers shouldered additional interest rate risk as the
boom progressed. There is evidence that this interest rate risk is concentrated in the
formerly hot markets.
Geographic Correlation of Falling-House-Price
Risk and Interest Rate Risk
Which regions are most vulnerable if a shortage of liquidity raises mortgage
rates? Concentrated risk is important for cities as well as for financial institutions.

The presence of distressed neighbors affects the price that other sellers can get for
their houses. If an area becomes concentrated with borrowers who are unprepared
for payment shock and at the same time become upside down on their loans, then
downward pressure can be put on housing prices. If this happens, then more
homeowners will become upside down on their loans, reinforcing the problem.
Exposure to the risk of rising interest rates is geographically concentrated in the areas
that may be exposed to the risk of falling house prices.
The Federal Home Finance Board (FHFB) conducts a survey of the use of
adjustable rate mortgages. The sample used for the survey excludes many important
categories of nontraditional mortgages such as negatively amortizing loans.
However, the survey can give some indication of the geographical concentration of
some types of alternative mortgages and the exposure of some areas to the risk that
inflation and interest rates will increase.
Table 9 uses FHFB data to show the use of adjustable rate mortgages and the
recent slowdown in appreciation for 12 metropolitan areas from different parts of the
country. The rates reported in Table 9 are unweighted averages of the five most
recent quarters in the FHFB survey.21 An area is more immediately exposed to rising
interest rates if a higher percentage of its loans will reset interest rates in the near
future. By this measure, Dallas and Houston are probably less exposed to the risk
that interest rates might rise in the near future while California cities appear more
exposed to interest rate risk.
In addition to a rise in interest rates for adjustable rate mortgages, regions could
suffer if their lenders and home buyers used low down payments and overestimated
the rate at which their houses would appreciate. Prior to the issuance of the 10/06
Guidance, some borrowers may have been using expected appreciation to get into
larger houses than they could have otherwise afforded. Table 9 shows the decline
in the rate of appreciation from 2005 to the first three quarters of 2006. To the extent
that some borrowers counted on the rate of appreciation prevailing at the time they
originated their loan to continue, a sudden deceleration in the rate of growth of prices
will delay the time that they can achieve an LTV of 0.8 and get better terms when
they attempt to refinance. Miami, California, and New York had comparatively large
drops in appreciation and could have home buyers who made large mistakes when
projecting appreciation rates.
Even though the appreciation rate might still be comparatively rapid, an
unexpected drop in appreciation could still foil the plans of a low down payment
buyer. For example, Miami’s 2006 appreciation rate is still relatively high at 8%.
However, if a zero-down Miami buyer in 2005 planned on appreciation of 20% per
year and chose a mortgage that reset after one year, the 8% appreciation rate would
not achieve the LTV of 0.8 to allow an improved refinance. The buyer wouldn’t be
upside down but would still pay more than expected costs because the loan might
have to be refinanced more than once. Fees are paid each time a loan is refinanced.

21 The FHFB combines some MSAs for reporting purposes so there is not an exact match
with the OFHEO price index.

Table 9. Adjustable Rate Mortgages and Price Slowdowns
Loan Resets and Price Slowdown by Metro
Share ofAppreciation RateFalling
Adj u s t abl e Appreciation
Rates ‘06‘05-‘06‘05‘06
Atlanta 31% 5% 2% -3%
Boston 29% 6% -1% -7%
Chicago 40% 11% 3% -8%
Dallas-Ft. Worth11%4%2%-2%
Denver 36% 4% 1% -3%
Houston 9% 6% 3% -3%
Kansas City16%5%1%-4%
Los Angeles57%24%4%-20%
Miami 36% 29% 8% -21%
New York30%17%2%-15%
San Diego62%9%0%-9%
San Francisco65%15%1%-14%
Source: FHFB and OFHEO.
Table 9 does not purport to measure the probability that a particular housing
market will suffer severe stress. Instead, it is a very simple indication of a region’s
exposure to interest rate and falling-house-price risk. Industry analysts use more
sophisticated methods to predict the probability that housing prices might fall in a
particular market. The United States Market Risk index (USMR) is one such22
The USMR index takes into account the local job market, recent price
acceleration, and the affordability index. Weak job markets and low affordability
tend to increase the risk of falling house prices. Stable recent appreciation tends to
reduce the risk of falling house prices. Table 10 presents the market risk index for
selected cities. A value of 100 implies a 10% chance that house prices in the area
will fall within two years.

22 Economic Real Estate Trends, Fall 2006 p. 7. The index is published by the PMI Group
which sells private mortgage insurance.

Table 10. Adjustable Rate Mortgages and the Market Risk Index
Metropolitan AreaShare of AdjustableRates 06PMI Risk Index
San Francisco65%587
San Diego62%603
Los Angeles57%590
Las Vegas51%540
Sacramento 48% 601
New York30%543
Virginia Beach29%413
Minneapolis 27% 393
Washington 22% 540
St. Louis21%133
Indianapolis 19% 63
San Antonio17%78
Kansas City16%109
Philadelphia 13% 179
Source: FHFB and PMI Group.
Table 10 shows that areas with lower risk of falling house prices as measured
by the PMI Group’s USMR index tend to have fewer adjustable rate mortgages. The
markets with a high percentage of adjustable rate mortgages are correlated with
higher risk of falling house prices. Statistical analysis shows that the relationship of

the risk of rising interest rates and the risk of falling house prices is positive.23 There
is a geographic concentration of mortgages vulnerable to rising interest rates and
risks to any borrowers who made low down payments.
Washington, DC, and Chicago are notable exceptions. Chicago has a relatively
high level of interest rate risk as measured by the share of adjustable rate loans but
a low level of falling-house-price risk as measured by the USMR. Washington has
a high risk of falling house prices but less interest rate risk.
A correlation of ARM share and the risk index does not imply causation. Nor
is this a test of a formal model of the determination of regional ARM shares. Table
10 merely shows that the interest rate risk inherent in adjustable rate mortgages is
correlated with the risk of falling house prices identified by PMI’s market risk index.
The regions using ARMs tend to be the regions most susceptible to changes in
macroeconomic conditions such as interest rate changes.
Recent Price Declines
The reversal in housing markets has been more severe than some regulators
expected. In late 2006, OFHEO Chief Economist Patrick Lawler, for example, said
“house prices continued to rise through the third quarter in most of the country, but
generally at only low or moderate rates. The transition from sizzling markets to
normal or weak markets has accelerated, and recent drops in interest rates have failed24
to stem precipitous price changes.” Although regulators may have been comforted
by a study by the FDIC that reinforced the view that a slowdown in housing does not
have to result in collapsing local markets, the result in 2008 has been falling house
prices across the nation. Of 46 instances of housing booms in U.S. cities since 1978,
21 experienced a subsequent housing bust. In other words, more than half of the
observations of housing booms were not followed by housing busts.25 The housing
busts that did occur were often associated with declines in the local area’s
predominant industries. In the present circumstances, however, housing markets
declined even in areas with relatively healthy economies.
Mortgages with adjustable rates and interest-only options have been more
widely used in recent years. Once only used by the financially sophisticated,
products with significant payment adjustments have been marketed to low-income
borrowers as affordable products. The performance of these products among lower-
income borrowers in the current stressed environment has been problematic.

23 Statistical analysis of the share of ARMs and the risk index shows a positive and
significant correlation. [coefficient =9.2, t-stat =5.7, R-Squared = 0.72, df=30].
24 OFHEO News Release, November 30, 2006.
25 U.S. Home Prices: Does Bust Always Follow Boom?, FDIC, February 10, 2005.

The Federal Reserve has issued changes to Regulation Z that may provide
improved disclosures for all mortgages, including those with alternative features. In
addition, other bank regulatory agencies have issued guidance covering alternative
mortgages, but these guidances do not apply to many non-bank lenders in the
subprime market. Lenders must disclose adequate information to consumers in plain
English. Lenders must take steps to manage the risks of alternative mortgages.
These steps include assessing borrowers’ capacity to pay the entire potential balance
of negative amortization loans and establishing risk management procedures for third
party loan partners. Lenders may not rely solely on the ability to sell the property to
qualify borrowers for a loan.
By choosing interest-only products, some consumers face the risk of falling
house prices as their reset period approaches. Their prospects do not appear good.
By choosing adjustable rate mortgages, some consumers have shifted interest rate
risk from lenders to themselves. The geographical distribution of alternative
mortgages suggests that falling-house-price risk and interest rate risk are concentrated
in the same regions. It remains to be seen if interest rates will remain low, but it is
clear that some consumers did not adequately prepare for slowing appreciation.
Rising numbers of bankruptcies among lenders suggests that many financial
institutions also failed to adequately assess relevant risks.