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Adjustable-Rate Mortgages Make a Comeback

Adjustable-rate mortgages, one of the main culprits of the housing crisis, are back in vogue. But banks say this time is different.

Financial groups are sweetening terms to entice customers to take out these loans, known as ARMs, whose rates can jump after a few years. Some ARMs are cheaper, when compared with fixed-rate mortgages, than they have been in more than a decade.

The tactics are reminiscent of the period before the 2008 crisis, when ARMs exploded in popularity as banks and mortgage brokers touted their low initial rates to consumers.

Now, though, financial executives say they are focusing on borrowers with strong credit who are using the loans to take out large “jumbo” mortgages—and not so-called subprime borrowers, who used the loans to stretch their buying power as far as it could go.

ARMs comprised 31% of mortgages in the $417,001-to-$1 million range that were originated during the fourth quarter of 2013, according to data prepared for The Wall Street Journal by Black Knight Financial Services, formerly Lender Processing Services, a mortgage-data and services company. That is up from 22% a year earlier and the largest proportion since the third quarter of 2008.

On mortgages of more than $1 million, 61% were ARMs, up from 56% a year earlier.

“We’re seeing a shift back to ARMs,” says Mike McPartland, head of investment finance for North America at Citi Private Bank, a unit of Citigroup Inc. C +1.06% “My opinion is, it’s going to continue.”

Banks are betting rates will rise high enough for them to offset any interest they give up in the first few years. Borrowers are betting rates will either stay relatively low, or that they will sell their homes before their interest adjusts higher.

Last month, Richard Herrmann of Fairfax County, Va., refinanced out of a 30-year fixed-rate mortgage with a 4.875% rate into an ARM with a fixed interest rate of 2.875% for the first five years. The loan rate resets every five years. Mr. Herrmann, a 59-year-old engineer for the U.S. military, and his wife plan to sell their home in 10 years, so they are only expecting to incur one rate reset.

“It’s always a crapshoot with an ARM,” said Mr. Herrmann. “This seemed to be the best compromise.”

While lenders say this time they are employing tough lending guidelines and focusing on top-rated borrowers, there are signs they are broadening the pool of eligible customers.

Some smaller lenders such as credit unions are targeting retirees and other borrowers who are looking for superlow rates. And banks increasingly are offering interest-only ARMs, which require customers to make payments only on the interest for as long as 10 years, and which were among loans that caused problems for subprime borrowers during the crisis.

Bank of America Corp. BAC +1.57% and Citigroup say they have been originating more interest-only mortgages over the past year through their wealth-management and private-banking divisions.

The loans were last popular during the housing bubble and were fingered as a cause for many foreclosures, though the banks say they are only approving borrowers with excellent credit who can afford the principal and interest payments on such loans.

Citi Private Bank says about half of the ARMs it is originating are interest-only, and theBank of New York Mellon Corp.’s BK +0.56% wealth-management group says most clients who sign up for ARMs receive the interest-only feature.

Mortgage originations have been down across the industry, following a decline in refinancing activity after interest rates began rising last year.

“It’s only natural in this part of the cycle…that the banks are starting to rethink their conservatism,” said Todd Hagerman, an analyst at brokerage firm Sterne, Agee & Leach Inc. “There are ways that they can loosen the lending standards to generate more growth yet keep a pretty tight rein such that the risk profile of the company is not changing overnight.”

Many banks hold ARMs on their books rather than sell them to government-backed finance firms, as they often do with more conventional mortgages. That means that when the loans’ rates eventually reset, they stand to reap the benefits of larger interest payments from borrowers.

ARMs accounted for 37.1% of mortgages held on banks’ books during the fourth quarter of 2013, up from 35.8% in the same period a year earlier and 31.9% two years prior, according to Inside Mortgage Finance, a trade publication. It is the largest share since 2009.

The surge in ARMs comes seven years after the start of the housing crisis, when rising payments left borrowers at risk of falling behind on their loans or losing their homes. Between 22% and 25% of subprime ARMs were in foreclosure each quarter from the start of 2009 through 2011, according to the Mortgage Bankers Association.

Subprime borrowers traditionally have been defined as those with credit scores below 620.

Relaxed lending standards—which included loans to subprime borrowers and the sale of riskier products such as ARMs—were a leading cause of the financial crisis. When the U.S. economy tanked in early 2008, many homeowners with ARMs saw the value of their homes drop at the same time their payments were rising.

The profile of an average ARM borrower has changed substantially since then. The average credit score for borrowers who took out ARMs in the fourth quarter of 2013 was 762, compared with 693 in the same period in 2006, according to Black Knight Financial.

Banks are “making these loans primarily to borrowers who are well-heeled, so that reduces the risk enormously,” said Stuart Feldstein, president of SMR Research Corp., a mortgage-research firm in Hackettstown, N.J.

Certain types of risky loans have largely disappeared, such as so-called option ARMs, which allowed borrowers to make small monthly payments that could lead to a rising loan balance.

The average rate on one type of jumbo ARM was 2.91% for the week that ended March 7, or about 1.5 percentage points lower than for the 30-year fixed-rate jumbo, according to mortgage-info website HSH.com. That difference, which has mostly held since November, is the largest since 2003.

Rates on some of the most popular ARMs can increase by a maximum of six percentage points after the fixed-rate period ends, depending on how high their benchmark rate rises.

Source: Wall Street Journal

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