Bad Credit Mortgage Loans Coming Back to Haunt Credit Worthy Consumers, Too

We’ve talked at length about the difficulty bad credit home loan lenders and companies have been facing recently.

But now there are signs that the pain is spreading upward.

At issue are mortgages made to people who fall in the gray area between “prime” (borrowers considered the best credit risks) and “subprime” (borrowers considered the greatest credit risks).

A record $400 billion of these midlevel loans - which are known in the industry as “Alt-A” mortgages - were originated last year, up from $85 billion in 2003, according to Inside Mortgage Finance, a trade publication. Alt-A loans accounted for roughly 16% of mortgage originations last year and subprime loans an additional 24%.

The catch-all Alt-A category includes many of the innovative products that helped fuel the housing boom, such as mortgages that carry little, if any, documentation of income or assets, and so-called option adjustable-rate mortgages, which give borrowers multiple payment choices but can lead to a rising loan balance.

Refinancing Adjustable-Rate Loans Becomes Harder for Borrowers
Borrowers who take out Alt-A mortgages are considered less risky than subprime borrowers because of their higher credit scores. However, as the housing market cooled and loan volume declined, some lenders lowered their standards for Alt-As. Now a rising number of borrowers who took out these loans are running into trouble.

Data from UBS AG show that the default rate for Alt-A mortgages has doubled in the past 14 months.

“The credit deterioration has been almost parallel to what’s been happening in the subprime market,” says UBS mortgage analyst David Liu. The UBS report contrasts with testimony Federal Reserve Board Chairman Ben Bernanke gave to Congress last week. “Our assessment is that there’s not much indication that subprime issues have spread into the broader mortgage market,” Mr. Bernanke said.

To be sure, defaults have remained very low in the prime market - and despite the uptick in bad loans, the problems in the Alt-A sector aren’t as severe as those that have roiled the subprime market.

Appromiately 2.4% of Alt-A loans are at least 60 days past due, according to UBS, which looked at mortgages that were packaged into securities and sold to investors. That is well below the 10.5% delinquency rate for subprime mortgages. (During the housing boom, delinquencies were low for all types of loans because borrowers who wound up in trouble could mortgage refinance or sell.)

Some borrowers who took out Alt-A loans in recent years are starting to feel the strain.

Johnny and Shirley Johnson, retirees in Cleveland, took out an option ARM when they refinanced their $92,700 mortgage in July 2005. The loan carried a 3.5% introductory rate that began moving upward a few months later. The couple, who live on a fixed income, are currently making the minimum payment on their loan. But they are afraid they won’t be able to keep up with their loan and other debts once their monthly mortgage payment adjusts upward later this year.

“We don’t want to lose our home,” says Ms. Johnson.

The couple is working with Acorn Housing Corp., a nonprofit group that provides housing counseling, in an effort to conduct mortage refinancing into a 30-year fixed-rate mortgage. Though the monthly payment would be higher, the new loan would protect them against future increases.

Housing counselors and bankruptcy attorneys say they are seeing an increase in troubled borrowers who previously had a good credit report.
“We have clients with 720-plus credit scores, and they are in awful products,” says Jennifer Harris, executive director of the Home Loan Counseling Center in Sacramento, Calif. Some of these borrowers took out option ARMs with low introductory rates and are likely to fall behind when their monthly payment resets at a higher level, she adds.

To continue reading this Wall Street Journal article, click here.