This story first appeared in the Los Angles Times
Most of the risky mortgages that triggered the financial crisis have disappeared from the marketplace, and lenders will have even more reason to avoid them because of a new federal crackdown on loose lending.
But one housing-bubble favorite — the interest-only loan — will remain a common offering to well-heeled home buyers, despite new rules from the Consumer Financial Protection Bureau. The rules, which took effect last week, exclude interest-only loans from "qualified mortgage" status, which protects lenders from liability over defaults.
Bankers don't seem worried about affluent clients missing payments. With high-end home prices on the rise, they have recently embraced jumbo mortgage lending, including interest-only mortgages. That trend continued this week as the banks reported earnings, with Bank of America Corp. saying 36% of its fourth-quarter mortgages were jumbo loans, up from 23% of originations in the first quarter.
In a conference call with analysts Wednesday, BofA Chief Executive Brian Moynihan said the bank is making non-qualified mortgages to the rich and holding the loans as investments rather than selling them.
"We'll meet the needs of our customers by using our own balance sheet," he said. "We do a lot of mortgages today through our wealth management business."
Because borrowers don't pay down the principal on interest-only loans, payments are lower for as long as the interest-only period lasts. The downside is far higher payments when that period expires, typically after five to 10 years.
Customers for such loans are often self-employed and capable of making big down payments and maintaining fat bank accounts. Banks believe such borrowers could afford traditional loans but want to maximize the cash available for other investments or ventures. Some borrowers just want the tax deduction available on the first $1 million a year in mortgage interest payments.
The Dodd-Frank regulatory reforms that Congress passed in reaction to the financial crisis imposed a common-sense requirement on mortgage lenders: They must ensure borrowers have the ability to repay.
To ease the burden of compliance, Congress ordered the consumer bureau, also created by Dodd-Frank, to define the new class of safer and easier-to-understand loans — qualified mortgages. Such mortgages can't include high-risk features such as negative amortization or interest-only payment provisions.
But careful underwriting of interest-only loans can ensure a low likelihood of default, said Wendy Cutrufelli, vice president of mortgage sales at San Francisco's Bank of the West, which announced last week that it would continue making such loans.
"Our risk group did an extensive review, analyzing performance by loan type," Cutrufelli said, and concluded that interest-only loans to certain customers are prudent for the bank.
No one disputes that interest-only loans contributed to the mortgage meltdown. Like loans with initial "teaser" interest rates — or pay-option mortgages that allowed the balance to rise instead of fall — interest-only loans were mass-marketed as an affordability product during the housing boom. They then soured in large numbers when it turned out borrowers couldn't or wouldn't pay them over the long term.
"Reason and sound judgment were absent when many banks and other mortgage businesses lent to consumers, without even considering whether they could pay back the money," CFPB Director Richard Cordray said at a hearing last week in Phoenix. "The supposedly rational market had become wildly irrational."
But interest-only loans made to wealthy borrowers have generally held up well, and many bankers have continued to write them for the jumbo mortgage market — loans too large for sale to Fannie Mae and Freddie Mac. The definition of a jumbo loan varies depending on county but is never higher than $625,500, such as in L.A. and Orange counties.
"These are very low-risk loans to very high-net-worth borrowers who are prospective clients for other bank services," said Rick Sharga, executive vice president at online real estate firm Auction.com.
Some lenders, such as Bank of the West, offer mortgages with an initial interest-only period to borrowers who need smaller loans. But most such borrowers don't have the large down payments and hefty reserves of cash or liquid assets that are now standard for interest-only loans. Cutrufelli said Bank of the West, a unit of France's BNP Paribas Group, writes only a handful of them.
San Francisco-based Union Bank, a subsidiary of Japan's Mitsubishi UFJ Financial Group, has offered interest-only loans for more than a decade, including a popular type of jumbo loan that has the rate fixed for the first 10 years before borrowers must start paying down the balance. Union will continue offering the loans to borrowers who can qualify, said Stuart Bernstein, executive vice president for consumer lending.
Other banks that will continue to offer jumbo interest-only loans include Wells Fargo & Co., JPMorgan Chase & Co. and City National, which makes a point of emphasizing to analysts how its portfolio of jumbo mortgages, including interest-only loans, experienced almost no defaults during the housing bust.
Cordray has argued that lenders who know their customers well should not be afraid to make loans outside the qualified mortgage box.
The banks say that describes how they handle interest-only jumbos. On a 30-year mortgage that requires payment only of interest for the first 10 years, Bank of the West qualifies borrowers based on the higher payments that kick in for the last 20 years.
Wells Fargo, the largest mortgage lender, says less than 10% of the jumbo mortgages it writes are interest-only. It requires borrowers with interest-only jumbos to make down payments of at least 25%, or have that much equity if they are refinancing, compared with 15% for those with amortizing jumbo loans.
The San Francisco bank sometimes makes interest-only loans to borrowers with debt-to-income ratios higher than 43%, which is the consumer bureau's standard for a qualified mortgage.
"But only for borrowers with very strong income and significant assets," said Brad Blackwell, executive vice president of Wells Fargo Home Mortgage. "We won't do a 45% or 48% debt ratio for a borrower who has no money in the bank — someone who hasn't shown an ability to save or manage their finances effectively."