Thursday, July 20, 2006

Piggyback loans

"Piggyback" mortgage programs are one of the most popular ways to afford a home purchase in many high-cost markets like California. Their use may be curtailed, however because they are getting tough new scrutiny from Wall Street. In fact, bond market restrictions that took effect July 1 could raise interest rates and fees for some home buyers who expect to take out a piggyback this summer.
The name piggyback refers to the combination of a standard, conventional 30-year mortgage with a junior lien or second mortgage. The two loans are closed simultaneously and allow home purchasers to put little or nothing down while avoiding payment of private mortgage insurance (PMI) premiums.
PMI is required by most lenders whenever a borrower puts less than 20 percent down. In a piggyback plan, by contrast, a purchaser might combine a conventional first mortgage equal to 80 percent of the home value and a floating-rate home equity credit line equal to 15 percent of the property value. The purchaser would make a 5 percent downpayment to complete the deal.
Piggyback lenders frequently sell the first loan into the secondary market (to Fannie Mae, Freddie Mac, or private bond issuers), and retain the home equity credit line or second mortgage in their own portfolios. Loans that are sold into the secondary market usually end up in giant pools of mortgages that are converted into bonds for institutional investors.
Wall Street ratings agencies tell investors how risky the underlying mortgages in a pool are -- i.e., how likely they are to default and cut off the investor's income stream. The most influential of the ratings agencies in the mortgage arena is Standard & Poor's. Though consumers may be unaware, S&P's ratings and criteria often affect what rates and fees are charged to borrowers at the time of origination.
Recently S&P conducted an extensive analysis of nearly 640,000 piggyback first-lien mortgages contained in bond pools. Many of the mortgages helped fund home purchases in California and other high-cost areas between 2002-2004. S&P's findings amounted to a big dose of bad news for fans of piggybacks: First-lien mortgages connected with piggybacks are far more likely to go into default than stand-alone first mortgages of comparable size. According to S&P credit analyst Kyle Beauchamp, first mortgages that were originated as piggybacks are 43 percent more likely to go into default than standard first mortgages.
To counter the higher risk of nonpayment, S&P has begun imposing higher credit enhancements or pool insurance requirements on piggyback mortgages. That added cost to lenders selling loans to Wall Street, in turn, will be passed along to individual borrowers in the form of higher rates or fees.


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