Hybrid Adjustable Rate Mortgage Recasting Will Cripple The Housing Market
We are hearing a lot lately about how the subprime lenders are dying due to the default rate inherent in loan programs which are primarily adjustable rate with lax income verification and/or credit requirements. This is where most people who don’t have a subprime loan start nodding off…snoozzzzZZZZ.
I can hear them now, “Hell, serves them right. Those bad credit folks should have never thought about home ownership until they fixed their credit. I’m not going the cry for the lenders either. They definitely should have known better. Anyway, what they did doesn’t effect me.”
Well, if that’s you, you’d better Wake Up! This subprime melt down will cost you a bundle too!
How Does a Subprime Mortgage Melt Down Hurt Me?
Here’s how:
These hybrid adjustable rate mortgages will cause an avalanche of foreclosures which could easily cripple the housing market!
Since the housing market lately is responsible for keeping the economy growing, you could easily lose your job at the same time you lose $50,000 of home value especially if your job is directly related to housing. This makes it impossible to sell your home once you discover you can’t keep up with the mortgage payments. Now your home is added to the list of foreclosed homes and the cycle perpetuates insuring an ever softening housing market.
Of course, without a job (or a lesser job) you aren’t buying much other than staples…no big screen TVs, no expensive dinners, no new cars. So now those folks who aren’t employed by the housing industry, but who build and sell big screen TVs, expensive dinners, and new cars are now effected. As restaurants close and car companies layoff workers, the overall economy goes further in the tank. Simultaneously the laid-off auto worker loses his home to foreclosure and he had never even heard of a subprime hybrid mortgage..and the cycle perpetuates insuring not only a housing market melt down, but a country wide recession.
If you think I’m exaggerating, take a look at Detroit housing where homes are selling for less than an SUV .
Investment guru, Jim Rogers, supports my view of massive property defaults having much wider economic repercussions. He told Reuters on Wednesday,
“You can’t believe how bad it’s going to get before it gets any better. It’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops. Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it’ll be worse because we haven’t had this kind of speculative buying in U.S. history.”
When Will This Melt Down Happen?
To answer the question of timing we must look at another variable which contributes to the higher default rate is the fact many of these loans are originated without any down payment…100% financing. The 100% financing structure for subprime loans takes the form of an 80% first mortgage and a 20% second mortgage both adjustable rate loans .
These two loans will a have a period of 6 months to five years where the rate and payment stay fixed, only to start adjusting for the remainder of the loan after this “fixed” period ends. A loan with this fixed/adjustable period is called a hybrid loan…part fixed rate, part adjustable rate. This two loan structure was used by many aspiring home owners to purchase overpriced new builder homes that are since being sold by the builder at deep discounts insuring the homeowner is currently underwater on his home.
To time the defaults we need to look for when these “hybrid” ARMs cease being fixed and recast their rate increasing the payment pushing the borrower over the edge.
The chart below shows not only the subprime ARM recasting going forward, but all the other types of ARMs as well. The horizontal shows the number of months out moving forward from Jan 2007. The vertical shows loan volume in billions that recast that month.
You’ll notice that starting in May, reaching a pinnacle in September, and staying consistently high for the next 24 months, recasting ARM mortgage rates has yet to really even begin. The worst is in fact yet to come.
And once the wave of subprime ARM recasting subsides about 24-27 months out another wave of Option ARM recasting all the way out to 59-60 months.
Now it will take a few months for a borrower once his payment spikes up to realized he can’t make it and then it takes the lender 6-12 months to actually foreclose. So my estimation for a glut of foreclosed houses to return to an already sluggish market about September of 2008 extending for about 18 months. Two years later when folks think it can’t get any worse, the Option ARM defaults will start the next wave creating even more depressed prices all the way through 2012.
So What Do I Do Now To Protect Myself?
First, make sure you are NOT one of those folks with an ARM loan, hybrid ARM, or Option ARM. Refinance now into a fixed rate loan.
Second, if you can’t afford the fixed rate loan on your current home for the next 6-10 years even under the worst of times…downgrade to a home and mortgage amount that you can afford. If you are already in a low priced home, sell it and rent. The average home owner today spends $1800 on housing and the average renter spends $900…renting may cut your housing expense in half! If so, do it. According to Jim Rogers, you’ll be able to buy back your house in a few years for 50 cents on the dollar.
Third, plan for a layoff or reduction in income. Put 12 months of living expenses in a savings account just in case you find yourself in an extended job hunt. You may even want to start looking for a new job now especially if you are in a housing related industry. Why wait to get laid off?
We had one of our wholesale lenders this week call all their employees at noon on Tuesday and tell them all they are out of job! No warning, no nothing! Pack your desk and hit the road. When I called to say “We’ve a loan that’s scheduled to close Thursday. What now?”. The receptionist who had obviously just been crying said, “Sorry, you’ll need to take to another lender”.
Lastly, pay off all your credit card debt, turn in your leased car replacing it with a free and clear used car, and cancel all recurring expenses that aren’t absolutely necessary.
I recently even cancelled my cell phone service…crazy, right? Wrong! The best decision I’ve made since shorting New Century. We all talk ourselves into needing more things than we really do. I’ve been without cell phone service for 3 weeks now and I don’t miss it at all….go figure.
I know this sounds harsh, but reality is harsh at times. Sticking our heads in the sand won’t change it. Be ahead of the curve on this one folks. You’ll be glad you did!
Author: Rob K. Blake
Published March 24, 2007
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Wholesale Lender Email Reveals The Yield Spread Premium Lie!
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Fannie Mae HomeStay the Answer to Recasting Rate Woes?
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john c:
Thanks for stopping by…my take is a resounding, “I don’t know yet”. How’s that for skirting the question.
Seriously, it really could push the country into a protracted recession. Wall Street, including Cramer are downgrade this since recently he commented the entire home building sector is really not that big…the credit markets are very absorbent..etc…blah, blah blah.
Given he’s plowing the field for no housing and credit caused recession, I’m placing my money the other way.
I’ve been telling everyone we are a 1990’s Japan in the making …and here we are.
So I think the recession will hit…it will be protracted…10 plus years…and now I’m on the record.
Thanks again for your comments.
August 13th, 2007 at 7:35 pmHi Rob,
I saw Cramer’s rant where he said half the 14 million mortgages written in the past few years were exotic and would result in foreclosures & short sales. Do you think this is likely? If people have little equity in a home thats 20% underwater, have a painful mortgage and not so hot credit anyway, it’s a rational decision.
A housing meltdown might not create a national recession but it will certainly create localized recessions in places like FL where housing construction is a major industry - pushing housing prices down even more. thanks
John
August 13th, 2007 at 7:12 pmWow.
Well I agree with some of what you say in this post and I do think that a correction is in the works.
http://www.equityscout.com/housing-bubble-and-arm-mortgage-holders
But I’m not quite ready to sell my house, move to the mountains, and stock up on spam and ammunition. Companies like New Century got their come-uppance; they clearly were following a non-sustainable business model. But I’m equally sure that solid companies like Citigroup and Wells Fargo will step in to provide liquidity to the lucrative sub-prime market; albeit with some more conservative (read: responsible) policies.
Another thing to take into account is that real estate, by definition, is a collection of regional markets. There is no “national” real estate market. So although there are some broad economic factors that will touch markets from Detroit to Aspen, the final results in any of those market will rely, largely, on local conditions.
Real estate investors in, say, San Francisco or Miami have cause to be skittish; now might be the time to be sitting on the sidelines. But there exist opportunities in undervalued markets that didn’t skyrocket during the run-up. So I’d be cautious about painting the entire country with one brush.
April 9th, 2007 at 12:27 pmI agree about staying liquid. What are your thoughts about real estate investors cashing out of there properties (if they have equity) to weather the storm for the next couple years.
April 4th, 2007 at 5:57 amI am a beginner loan consultant I am trying to help a client out of a bad loan an 80/20 one at 12% AND THE OTHER 13% interest only, one that will not require seasoning and will loan on market value,it seems that the broker helped herself to a stand alone of 20,000, do you have any advise for me as to maybe a lead to find a descent lender that does not sell their loans,that is very confusing to my client it appears that since move in,in dec 2006 up todate her loan has been sold twice.ps love your column. lucille centeno
March 29th, 2007 at 2:35 pmJustin,
Ooops…I didn’t get the sarcastic “tone”.
Thanks for clarifying.
I ran across some information that may contradict and simulataneously support your position that we are seeing real wage growth and contained unemployment figures that effect spending.
Deloitte Research reports in their “Leading Index of Consumer Spending - March 2007, Carl Steidtmann says,
“With initial unemployment claims up in recent weeks, the labor market is showing some early signs of weakening, which could put pressure on consumer spending. Home prices continue to be weak; however, lower mortgage rates are giving a boost to mortgage applications…
“The coming months will show how the labor and housing markets evolve and their combined affect on consumer spending.”
“The index comprising four componemts-tax burden, unemployment claims, real wages, and real home prices- fell to 3.28% …from a month ago.”
Feb index was 3.58%, Jan. 4.06%, Dec. 3.68%.
I’m glad I found this index…it will help use gauge what’s coming…and it doesn’t look at single economic indicators…it has a basket of what I think are the most promising…indicators.
You are right to believe their is an effect of lower rates, but I’m afraid this time the problem is too big to be offset by lower rates.
I home owner underwater on his house can’t be helped by lower rates….that’s why “loan applications” could be up…but “closed loans” could be down…and that’s the more meaningful stochaistic.
Thanks for the comments!
March 27th, 2007 at 12:42 amRKB
See website: azcentral.com/business/articles/0326foreclosure-immig26-ON.html
WASHINGTON - Immigrants are emerging as among the first victims of a growing wave of home foreclosures as mortgage lending problems multiply here and across the country.
Nationally, 375,000 high-interest-rate loans were made to Hispanics in 2005, and nearly 73,000 of them are likely to go into foreclosure, said Aracely Panameno, director of Latino affairs for the Center for Responsible Lending. About 1.1 million homes in the United States are expected to go into foreclosure in the next six years, and many native-born Americans are likely to be stuck with burdensome loans. But immigrants are getting hit first in part because their incomes tend to be lower and many have lost construction jobs…
March 26th, 2007 at 2:10 pmI was being somewhat sarchastic. No, government spending is exactly the opposite of what we need. We need money in consumers’ hands to continue to purchase. We need money in investor’s hands to purchase property and invest. You are 100% right.
The housing market has several key advantages that most other investments don’t. First, is the interest deduction. Second is the capital gains exemptions for first homes as well as the ability to do a 1031 with profits.
I think we have several other issues going on too. First, the stock market is starting to recover meaning that investors believe they will get a better return on investment by putting money back into stocks and taking it out of real estate. Interest rates kept rising making mortgages more expensive and cutting into profits. And values climbed too fast, leaving the market prime for a correction.
I think there is a lot that the Fed can do to correct this problem as well as a lot that the Congress can do. First, they can change the way capital gains laws treat real estate, making real estate even more tax advantageous. Second, they can lower interest rates again, which makes real estate more attractive and might bring buyers back in. But the bigger issue is that real estate investors have left the overpriced markets and gone to places like Salt Lake City, Dallas, and Austin in search of markets with upside after taking their profits on the coasts and in Las Vegas and Phoenix, etc.
We still see wage and earning growth and unemployment is still very low. Note how the tax cuts in 2003 had such a large effect on the real estate boom, I think that the Fed can keep this situation from spiraling out of control by lowering rates and if rates come down, and money flows back into real estate, many of these folks will be able to either refi or there will be investors to buy these properties.
Most of these loans were made during the run-up in real estate prices so we can assume that not all of these folks will be upside down and as long as there are buyers, and prices don’t bottom out, it may not be as bad as it could get.
But you are right to say prepare for the worst. And your version of the worst is pretty accurate. It could happen, but at the same time, there are lots of opportunities for investors. Now is a very good time to rebalance your portfolio and my suggestion is get out of real estate and move from an aggressive stock portfolio to a more balanced portfolio. Hedge with bonds and make sure you limit spending and have plenty of liquidity on hand.
March 26th, 2007 at 12:16 amJustin,
Did you see that graph showing the billions and billions of ARMs mortgage set to recast between 9 months and 5 years from now?
The die is cast…nothing I say now can change that!
Sounding the alarm is needed so folks can put their affairs in order to weather the coming storm.
No one is talking about this…they think the Fed can bail them out. Not this time.
I think your post supposes that Govt. spending could possibly pull us out…but that won’t work either.
Consumer spending makes up 2/3rds of our economy. Without strong consumer spending we have no economy. The American consumer has now buried himself in so much debt he can’t spend.
Most of the consumer spending we’ve seen in the last 5 years that pulled us out of the 2001 recession was from home owners tapping their home equity with cash out and second mortgage refinancing. Dropping home prices put an end to that.
And of course, we had Govt. Spending at all time highs concurrently with the Iraq War costing us billions over the same time period.
So with the troops coming home soon (hopefully) lowering the Govt. spending portion of economic support and home values dropping weakening the consumers ability to drive the economy…does the economy have any fundamental support?
I can’t find it.
Maybe that’s why we are hearing grumbles about invading Iran?
March 25th, 2007 at 12:58 amBe careful Rob. Panic about impending crisis makes it a self fullfilling prophecy.
Last week, the market rallied in a massive way (2% jump in one day) due to the announcement that the Fed was considering lowering rates. This should scare the living hell out of all of us. Why does the Fed lower rates? Only one reason–the risks of a recession are greater than the risks of inflation. We are probably done with inflation for a while despite rising gas prices. Know why? Because home values are dropping which means that homeowners stuck with homes will start renting their properties for lower and lower rents just to pay the bills. There is no resale market, so it is either try to rent them and fight with everyone else doing the same or let them go back to the bank.
I don’t think that this will be a global recession on par with 2001, because that was made so much worse by 9-11. I have a plan for getting us through this recession though:
1. Raise individual tax rates back where they were before Bush’s tax cuts for the wealthy.
2. Increase the dividends taxes.
3. Increase the capital gains taxes.
4. Make sure that when the recession hits, all Americans have Universal Health Coverage
If we simply increase taxes and spend on new government programs, we can get through this together. Yeah, this has disaster written all over it.
March 24th, 2007 at 11:26 pmLeave a Comment