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Housing Defaults: The Next Wave

So, as you’ve probably read or heard in the the news, evidence that the American housing market is stabilizing is beginning to present itself. Data from the National Association of Realtors showed that the number of signed contracts to buy previously owned homes climbed 6.7 percent in April (granted that not all signed contracts will turn into closings since financing could fall through, it’s still better to have more contracts than fewer). Furthermore the Mortgage Bankers Association’s index of applications to purchase a home gained 1.1% in the week ending June 5th (though total mortgage applications fell and refinancesdropped off with the now higher interest rates). Finally, the fact that rates are higher itself suggests more confidence in the housing market – if there was no demand for loans, rates would keep falling. So, we’re on the path to real estate recovery, no? Well, no. Not so fast.

We have all heard of the recent run up in foreclosures that started two years ago. One would think that with all the economic turmoil we’ve had over the past two years and the fact that we’ve seen so many foreclosures already, maybe we’ve flushed most of the bad loans and things get better from here. In fact, as the chart below shows, we are indeed experiencing a steady decline in the number of subprime mortgage resets (and thus foreclosures since not all borrowers who reset will be able to afford the new payment) – the blue line.

From March 2009 to December 2012

From March 2009 to December 2012

¬†However, what should be a cause for concern are the yellow and orange lines – Options ARMs and Alt-A loans, respectively. Many people are familiar with Alt-A loans (they’re basically loans that are riskier than conventional mortgages, but not as risky as subprime mortgages). However, not as many people are as familiar with Option ARMs, which is of particular concern since they could be the next wave of foreclosures.

An Option ARM is something like a negative-amortizing mortgage. A negative-mortgage is one in which rather than the loan amount being reduced with each payment, it’s actually increased. For example, suppose you borrow $200,000 and your mortgage payment is $1,000/month. In a typical mortgage $800 of that $1000 may be for interest and the other $200 would pay off principal. Now consider the situation where someone wants to buy a house but can’t afford the $1,000/month mortgage payment. As an alternative, they get into an Option ARM that allows them to make payments of $250/month (yes, the difference between a conventional and option ARM mortgage can be that much!). What’s actually happening here is that they still owe $800 in interest, but since they’re only paying $250/month, the remaining $550 of unpaid interest gets added to the balance of the loan, bringing our hypothetical loan to $200,550 after the first month. Now, since the principal balance is higher, the interest due will be more than $800 next month. But, the borrower still pays $250, so they add an amount greater than $550 to their unpaid balance the following month.

Whereas in a conventional mortgage you pay down the loan a little bit each month, with the amount of pay-down increasing each month, an option ARM results in you increasing the loan a little bit each month, with the amount of the increase, increasing each month. You can see how this can turn into a troublesome situation very quickly, especially in an environment of falling home values. Our borrower continues to happily make his/her $250/month payment (usually completely oblivious to the fact that their loan balance is increasing) until one of two events occurs: 1) they go a certain amount of time specified in the loan agreement at which point they’re forced to start repaying principal, or 2) their loan balance reaches some predetermined amount (think 150% of the original loan balance – in our example $300,000) at which point they’re forced to start repaying principal. Either way, even if interest rates haven’t moved (heck, even if they’ve come down), since the loan amount is so much larger and they now have to pay the complete amount of interest and principal, their payment will radically spike – let’s say from $250 to maybe $3,000. So now the family that bought the home but couldn’t afford the $1,000/month has to pay $3,000/month. In most instances their income is not likely to have gone up enough to make this new mortgage affordable.

So, the family has a higher payment than they can afford, has experienced depreciation of their home, and has a loan balance that’s much higher than where they started, and likely much higher than the value of the house. They’re screwed, and this story does not have a happy ending.

As the chart above shows, the number of Option ARM resets will significantly increase until about the end of 2011. This means that there will be many properties that have depreciated (or even have had the good luck of not depreciating), but are married to loans that are considerably larger than they were at closing. This will most certainly result in more foreclosures, and thus further downside pressure on housing prices.

I certainly wish the worst were over in terms of housing, but unfortunately that just doesn’t seem to be the case. This is yet another example of creative financing, greedy lenders after fees, and uninformed consumers causing considerable damage.

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