Babette Heimbuch has a theory on who will bear the brunt of a real estate downturn, if it comes.


Heimbuch, chairman and chief executive of FirstFed Financial Corp., the Santa Monica-based parent of First Federal Bank, thinks it will be borrowers who stretched themselves thin to purchase multi-million dollar homes.


"The first thing that goes is your $2 million houses because there are fewer people who can afford them, so they will lose value faster and sooner," said Heimbuch, a 23-year veteran of FirstFed Financial.


This scenario envisions no such drop in value on more modest homes, where First Federal does the bulk of its business. Its residential mortgages have an average loan of $380,000.


Thanks to aggressive lending on the more affordable end of the market, First Federal's assets jumped to $8.4 billion at the end of the first quarter, from $5.2 billion one year earlier. Over the same period, the stock has jumped 32 percent to $54.40 a share.


But what if home price declines hit lower-end properties as interest rates rise? First Federal's customers could find themselves upside down.


At least 50 percent of First Federal's loans are high-risk, adjustable rate mortgages known as option ARMs. These offer lower monthly payments to borrowers, as much as 20 percent below interest-only loans. But the catch is that in the first five years, the loan accrues negative amortization that is, the mortgage payment is smaller than the interest due, which causes the loan balance to increase.


Federal Reserve governors have warned that greater use of such loans is fueling real estate speculation, leading to rapid increases in home prices.


The concern is that if home prices fall as interest rates rise, some borrowers would end up owing more than the value of their home.


"Some segment of consumers who are taking out these mortgages are largely unaware of the risk to their equity from a drop in home prices," said Fred Cannon, an analyst at Keefe Bruyette & Woods in San Francisco.


Interest-only loans are particularly popular in housing markets like California, where prices have risen dramatically. When houses are not affordable, potential homebuyers typically sit on the sidelines. But a wide range of loan products has allowed sub-par borrowers to own a home.


In Los Angeles, interest-only loans, which includes option ARMS, accounted for 40.1 percent of mortgages taken out to buy houses last year, up from 17.1 percent in 2003 and 7.7 percent in 2002, according to LoanPerformance in San Francisco, a unit of First American Residential.


The California Association of Realtors estimates that 17 percent of households statewide can afford a median-priced home using a conventional 30-year fixed rate mortgage.


Cannon also has grown cautious on several banks that offer low-documentation loans, including First Federal, Downey Financial Corp. in Newport Beach, parent of Downey Savings and Loan, and Golden West Financial Corp. in Oakland, parent of World Savings Bank.


Cannon has an "underperform" rating on FirstFed and cautions investors about the "power of the minimum payment," that are typical of the loans and have been a big lure for borrowers. He thinks such loans typically go to consumers with poor credit histories and cash flow problems.


"I'm not sure investors realize the inherent risk here," he said. "If home prices keep going up, everything is going to be fine. But if they break, there will be significant credit losses."


First Federal added 40 new account executives last year, up from 10 at the beginning of 2004. They solicit real estate brokers who have clients looking for loans. Heimbuch also hired Richard Grout, a former executive vice president and director of retail banking at Downey Savings, to oversee an expansion that will add between five and seven new locations to First Federal's 29.


But for all the growth, First Federal has started setting aside provisions for loan losses in the past two quarters, after years of not doing so. FirstFed began doing low-documentation loans primarily for entrepreneurs and the self-employed who were unable to verify their income. As competition for loans heated up, the bank extended its interest-only products.


"Soon it got to be where anyone could get them and that's what's scary to people," she said, acknowledging that "the bank examiners would prefer we do it the old-fashioned way."


*Staff reporter Kate Berry can be reached at (323) 549-5225, ext. 223, or at kberry@labusinessjournal.com .

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