Getting at some bugs in shifting-rate mortgages

Few consumers watch interest rates more closely than home buyers. A 1 or 2 percent rise in the rate can mean the difference between qualifying for a mortgage or not.

Since the beginning of the year, interest rates have risen faster and higher than most people expected. Were it not for adjustable-rate mortgages, nicknamed ''ARMs,'' many people looking to buy this summer would never get beyond the Sunday paper's real estate section.

These mortgages are good for buyers, but there is some question as to how good they are for savings-and-loan institutions, which rely on mortgage lending for their bread and butter. As a concept, banks and thrifts view ARMs as the best thing since federal deposit insurance. ARMs keep lenders and borrowers from being locked into an outdated, fixed interest rate for a long period of time. They have become so popular that they now make up 66 percent of all new mortgages, compared with 25 percent a year ago.

But the way some ARMs are structured today, they could mean trouble. ''I think all the restructuring going on, with the new powers (given S&Ls by Congress), is very nice as far as thrifts are concerned,'' says James Montgomery , chairman and president of Great Western Savings & Loan Association in Beverly Hills, Calif. ''But the most important thing by far is the ARM.'' Mr. Montgomery says these mortgages are helpful only ''if they are constructed intelligently.''

This is not always the case. It has been discovered that adjustable-rate mortgages have a 40 percent higher default rate than fixed-rate mortgages, although the overall rate of mortgages in arrears is miniscule (1.28 percent). This happens mostly with poorly designed ARMs luring borrowers with very low first-year, ''teaser'' rates, and loan qualification based on those rates. When the rates are increased at the end of the first year, some buyers find they can't meet payments.

Another problem is that bankers may not be able to adjust the rate on ARMs lent last year enough to meet the surprisingly large increase in market rates that has occurred over the same period. In other words, they may not be able to increase mortgage income fast enough to cover the rise in expenses. This shrinks earnings.

''One concern is that many of the adjustable rates put on in the last year won't be profitable over the next few years because the cost of funds to the industry will be higher,'' says Timothy Howard, senior economist at the Federal National Mortgage Association (Fannie Mae). ''If interest rates stay at their present level, most industry analysts, including myself, see the industry losing a good deal of money (next year).'' Mr. Howard sees it breaking even this year.

It is easy to understand that a savings-and-loan will lose money if it lends at a 13 percent rate fixed for 30 years and the rate it has to pay for new money goes up to 15 percent. But even if a bank lends at an adjustable rate - one that changes yearly and is pegged to a one-year US Treasury note - it can be strapped. This is because the rate a bank is paying in interest for its funds can go up overnight, but the rate it receives in interest from its ARM mortgage loans is adjusted less quickly - usually yearly. That lag creates an imbalance between assets and liabilities and the bank loses money.

Howard explains that bankers can keep this from happening this year because they will get so much from one-time, up-front fees on new mortgages. But bankers can't reap these fees in the second year or any other year of the mortgage, and if interest rates don't behave - that is if they don't come down - next year will be tough, he says. ''Loan (origination) fees last year were running at a very high rate,'' he says. ''That growth clearly can't continue.''

To get a handle on these two problems of default and inability to keep up with high-flying rates, a number of banking institutions are setting up guidelines for ARMs. Both Fannie Mae and Freddie Mac (the Federal Home Loan Mortgage Corporation) have drawn up rules this summer, saying they will buy only adjustable-rate mortgages that don't employ the ''teaser'' concept and that have certain caps and qualification standards. Mortgage insurers are also getting stricter, increasing premiums on ARMs.

ARMs are still generally viewed as strong asset and fee generators by the industry, though. ''By and large, most ARMs seem to be structured and underwritten prudently,'' says Eric Hemel, chief economist of the Federal Home Loan Bank Board. ''Naturally, we're concerned about the exception.''

So is Mr. Montgomery, the California banker, who recently testified before a subcommittee of the House Banking Committee to talk about the structure of ARMs. He would like to see the industry adopt the structure used by his bank, a large, profitable one that helped pioneer ARMs in the mid-'70s. The key, he says, is to create a loan that will never cause ''payment shock'' to a borrower.

Great Western does this through ''negative amortization,'' a controversial banking concept. Montgomery's 250 California branches put a cap on yearly payments, not on interest rates, for borrowers. Interest rates are adjusted monthly, and each payment is redistributed, with part paying off principal and part interest - depending on what the new rate requires. That keeps payments low , but it also stretches out the length of the loan.

The rate is tied to the ''cost of funds'' index for banking. Montgomery contends consumers can relate a cost index rise to a subsequent rise in their mortgage rate better than they can a rise in Treasury bills, an index many bankers use.

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