Bank of New York unit decides to pay less for 'no-cost' loan.

Reacting to a problem dogging many mortgage lenders, Bank of New York Co.'s mortgage unit has decided to get tough with "no-cost" home loans.

Arcs Mortgage, Calabasas, Calif., has decided to lower the premiums it pays other lenders when buying no-cost mortgages.

With these loans, all closing costs are folded into the interest rate. The company also plans to raise the rates that its retail agents charge consumers for the loans, said Howard Levine, president of the unit.

No-cost mortgages have become increasingly popular, especially in California, because they allow cash poor consumers to purchase houses or refinance mortgages with little out-of-pocket expense.

Prepayment Perils

The loans, however, carry clear perils for the mortgage industry. Lenders and analysts say the loans are partly responsible for the high prepayment rates that have been hitting servicing portfolios and mortgage-backed securities.

While some observers lauded Arcs' move, lenders voiced doubts about whether it was the beginning of a trend.

"You've got to be competitive price-wise or you won't get business, especially from correspondents," said Brian Casper, chief financial officer of CrossLand Mortgage Corp., Salt Lake City. "People are trying to get as much refinancing business as possible before the party ends."

Mr. Levine, however, is standing firm.

"We will price our loans for economic value, and if someone else wants to undercut us, let the business be theirs," he said in an interview.

The company is reducing by 25 to 50 basis points the premium it pays for loans from "correspondents" -- other mortgage banks, banks, and thrifts. The premiums, which are intended to reflect the value of servicing rights attached to new loans, typically range from 0.75% to 1.5%.

Two-Way Pinch

Arcs plans to trim its retail rate on no-cost loans by about 13 basis points, Mr. Levine said.

Mortgage banks have felt the pinch of no-cost mortgages in two ways.

First, mortgage-backed securities with the interest rate profile of no-cost mortgages sell at a discount, thus lessening revenue from loan sales. Also, the servicing value of such mortgages is dropping as prepayment expectations for these securities rise.

"Economically, this is the right thing to happen," Linda Lowell, an analyst at Paine-Webber Inc., said of Arcs' move. "What the market has perceived the no-cost loan to do is to change the breaking point when a drop in rates causes a sharp rise in prepayment."

Mr. Levine, meanwhile, maintains that making no-cost loans more expensive for the consumer is only the first step.

"I wouldn't be surprised if Wall Street wakes up and requires that these loans be segregated in pools," he said.

He compared the situation to the builder loans of the mid-1980s. After it became apparent that loans sponsored by property developers had sharply different prepayment and default characteristics than other mortgages, they were pooled separately.

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