Standard & Poors, a provider of independent credit ratings, risk analysis and investment research, recently turned its attention to the proliferation of new mortgages in the subprime market.

The loans pose an unknown level of risk for both securities investors and consumers.

At a mid-April educational industry conference to present perspectives on the role that the capital markets play in the development of the housing market, the issue of creative mortgages permeated many panel discussions including "The Housing Finance Secondary Market," "How the Housing Market Affects Mortgage Credit Risk," "Investor Perspectives on Interest Only Loans," "The Housing Market's Impact on Prime Mortgages," and a "Sub-Prime Researchers' Roundtable."

The conference, "Housing Finance Summit" in Amelia Island, FL, was conducted by Opal Financial Group, a New York City-based financial industry conference planner.

"Originations of interest-only, negative amortizations, and 40-year amortizations have proliferated the market recently. While there have been interest-only and negative amortization loans in the prime sector for years, the presence of these types of loans in the subprime realm is largely the market's response to increasing borrower affordability and to maintain origination volume," said Standard & Poor's credit analyst Susan Barnes, a managing director in the S&P's Residential Mortgage Backed Securities group.

The subprime market is a growing and ever-more significant sector of the mortgage market (especially if rates rise and home continue to become less and less affordable) which often caters to first-time borrowers with little credit history, with lower incomes, with no home owning experience and with other financial conditions that make them a greater risk for lenders.

The loans themselves pose a greater risk because they cost more or defer costs or both. The subprime market has also spawned growth in predatory lending -- purposely presenting lower income, minority, older and less-informed, borrowers with loans they can't afford.

Subprime loans, however, offer more and more borrowers the ability to land a mortgage that may have been impossible in the prime market. What's more, most surveys report the vast majority of home owners continue to live with less risky fixed-rates on conventional 30-year mortgages that were closed with 20 percent down.

That's changing. If a time arrives when there are too many risky loans and the economy hits a recession many home owners could default on the American Dream and take the economy down with it.

• Interest-only loans, for instance, allow the borrower to rely solely upon market appreciation for equity growth. Should a home owner become unemployed before accruing enough equity, or values plummet, or both, a forced home sale could come with the family forced to make up the difference in cash to close the deal -- or face foreclosure.

• Forty-year mortgages, designed to lower monthly payments and allow more borrowers to qualify, were recently panned because the lower monthly payment comes at the expense of higher interest rates and greater cost over the term of the loan, when compared to 30-year loans. Over the life of 40-year loan, the extra cost amounts to hundreds of thousands of dollars more than a 30-year loan.

• Negative amortization loans, another tool used to lower the monthly payment and help more buyers qualify, even in the prime market, are often avoided because the loan balance grows during the negative amortization period if extra payments aren't made to compensate.

• Likewise low- and no-money down loans, equity loans that push a borrowers' total mortgage indebtedness higher than the value of the home and other forms of "creative" financing all come with inherent risks.

Borrowers who use such loan products may be playing a game of Russian roulette with their home ownership life, given that the level of potential risk for the special mortgages is relatively unknown.

"Despite these risks, there isn't any performance information available on any of these products just yet because they are still very new to the subprime market. Due to the time lag associated with delinquencies and losses in RMBS pools, and the nature of these risks, it will be several years before the product performance is tested. It is anticipated that all risks associated with these loans have been adequately covered. However, monthly performance data will be closely scrutinized as the products mature," said another S&P credit analyst, Ernestine Warner.

Published: April 14, 2005

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A journalist for 35-years, Broderick Perkins parlayed an old-school daily newspaper career into a digital news service offering editorial content and consulting services. Perkins' San Jose, CA-based DeadlineNews Group includes the flagship news site, DeadlineNews.Com, offering real estate, personal finance and consumer journalism, and a backshop, the Deadline Newsroom.