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More sharks in home loan waters
Report: S&P tightens risk criteria on increasingly popular option ARMs, citing growing default risk.
June 22, 2005: 9:08 AM EDT

NEW YORK (CNN/Money) - The risk of default is growing for some home loans as mortgage-lending standards loosen, said Standard & Poor's Ratings Services, which responded by tightening risk criteria for those home loans, a newspaper report said Wednesday.

The ratings company said the tightening applies to loans that are bundled into mortgage-backed securities for sale to investors as well as option adjustable-rate mortgage loans, or option ARMs, The Wall Street Journal said.

Option ARMs give borrowers flexibility to reduce their initial monthly payments and have surged in popularity in recent months as rapidly rising house prices have made it more difficult for many Americans to afford homes and led buyers to seek ways to hold down monthly payments, the newspaper said.

Some economists fear that option ARMs and other loans that reduce initial payments are fueling house-price inflation by enabling people to bid more for homes than they could if they were taking out conventional loans, said the Journal.

Option ARMs and similar loans are among "the only things left that are keeping home prices rising," Stuart Feldstein, president of financial-services market-research firm SMR Research Corp., told the newspaper. Other factors include low interest rates and low inventories in many places.

Sticker shock

Under option ARMs, borrowers can make payments that cover the interest and chip away at the principal, pay only the interest due that month, or make minimum payments that don't cover all of the interest due -- which increases the balance of the loan, the Journal said.

But the borrower has to pay the interest and principal eventually, and monthly amounts due can soar if interest rates rise and the borrower paid only the minimum amount in the early years of the loan, according to the report.

Michael Stock, an analyst at S&P in New York, told the Journal that some borrowers will face increases in their monthly payments of 50 to 90 percent, and those whose income proves insufficient may default.

To account for the additional risks presented by option ARMs, S&P will require more "credit enhancement" for mortgage securities backed by option ARMs, meaning a larger slice of each issue of such securities will be rated below triple-A, the Journal said. The holders of the lower-rated portions of such securities issues are the first to absorb any losses that result from defaults, according to the report.

Another ratings company, Fitch Ratings, is also tightening its criteria for option ARMs, said the newspaper.

S&P is a unit of McGraw-Hill (down $0.07 to $43.47, Research).  Top of page

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