updated 6/17/2005 6:40:24 PM ET 2005-06-17T22:40:24

Federal banking regulators are preparing to warn lenders about the risks posed by the growing popularity of new kinds of adjustable-rate home mortgages that could leave borrowers facing steeper payments if interest rates rise or facing foreclosure if home values flatten or fall.

The Office of the Comptroller of the Currency, which regulates national banks, is considering a warning called a "guidance," which is a directive to lenders that would specify the kinds of loans and borrowers that would draw regulatory scrutiny because they are riskier. The OCC is reviewing interest-only loans that allow buyers to defer paying off the principal on the loan, as well as "option ARMs," or adjustable-rate mortgages that permit borrowers to decide how much to pay each month but leave them at risk of losing their homes if they do not pay enough.

These loans are proliferating in high-cost housing markets such as Washington, where buyers are using them to keep payments low enough that they can afford homes.

"We've noticed the rapid growth of interest-only loans and the growth of payment-option ARMs, and we thought it was worthy of more study," said Barbara Grunkemeyer, deputy comptroller for credit risk at the OCC. "We're doing our homework at this point to gain a better understanding" of how the loans are performing, she said. "We'll get something out on it, but not before the fall."

Grunkemeyer said the OCC is trying to distinguish where the mortgages are being marketed appropriately and where they are not. She said that the new kinds of mortgages were developed to meet the needs of "high-income, high-net-worth individuals who wanted to pursue other investment opportunities" and that they pose little risk when borrowers have substantial assets.

"The last thing we want to do is to come out with a half-baked guidance that puts a damper on a good product," Grunkemeyer said. She said the OCC is seeking to avoid a "knee-jerk reaction."

But she said the growth of the loans has raised concern because they "introduce new risk by shifting from the bank to the borrower more of the credit risk."

In congressional testimony last week, Federal Reserve Chairman Alan Greenspan said the "dramatic increase" in some of the newer kinds of loans raised "particular concern." Economists and housing experts have warned that some consumers who get these loans could find themselves confronting sharply higher monthly mortgages, leading to home foreclosures, which could become a costly burden to lenders if home values stagnate or drop.

"Our concern is [whether] people really comprehend the exposure they could face down the road when the payments change," said Jef Kinney, Fannie Mae's vice president for business and product development.

Government action could stall the rapid growth of interest-only and option ARM products, which have surged in popularity across the country. In the Washington area, more than a third of home buyers are using interest-only loans, up from about 2 percent five years ago.

Another popular new variant is the option ARM, which allows borrowers to decide how much they want to pay each month above a basic minimum but leaves them at risk of losing their homes if they pay less than the full interest due each month and find their mortgage balance increasing rather than falling. According to UBS AG, an investment banking firm, more than 50 percent of borrowers who took option ARM mortgages in 2004 are making minimum payments. Their mortgage balances are rising each month, which is called "negative amortization."

Regulator restrictions "would probably slow down the explosive growth of the market," said David Liu, a mortgage strategy analyst with UBS in New York. "The trend is very much unsustainable. If the government steps in, it would slow it down."


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