Non-Exploding ARM's

Setting the Record Straight on ARM's

It's easy to think that every adjustable rate mortgage ("ARM") burned the borrowers who took them out.

After all, aren't so-called "Option ARM's" supposed to be financial time bombs?

They are, but most ARM's don't function that way (at least, the ones most common outside of Southern California, Arizona, and Florida).

Option-ARM's

With an option ARM, the borrower effectively chooses to re-pay whatever they want --including virtually nothing -- for a prescribed period of time (usually 5 years).

Any shortfall is simply added to the balance of their mortgage.

So, an Option-ARM borrower who decided to make only tiny monthly payments could easily see their loan balance double, as all the accrued interest piled up on the (unpaid) principal.

As millions have now discovered, a mushrooming mortgage balance on a house that's rapidly losing value is a nasty combination.

Plain Vanilla ARM's

Fortunately, that's not how most ARM's work.

While the formula varies by lender, the plain-vanilla version typically features an initial teaser rate that's fixed for a prescribed period of time (often, 5 years). (FYI, big banks today are offering 5/1 ARM's at 3.625%, vs. fixed, 30-year rates just under 5%).

After that, the rate re-sets annually based on a predefined formula; popular ones include LIBOR ("London Interbank Offer Rate") or 10-year U.S. Treasury notes, plus anywhere from 2% to 4%.

Another feature of ARM's is a ceiling on how much the maximum upward bump can be over the life of the loan.

Sitting Pretty

So, where does that leave people who took out ARM's in 2005, that are re-setting in today's environment of infinitesimal interest rates?

In many cases, with rates that are re-setting lower.

Thanks, Ben! (as in Fed Chairman Ben Bernanke, whose appointment to a second term was just confirmed by the Senate yesterday).

P.S.: Another reason why ARM's have bit fewer people than you might expect: they sold their home before their interest rates re-set.

Given that the average homeowner moves every 7 years, statistically, a high percentage would retire their ARM loan before the 5 year re-set date ever arrived.

In fact, that's one of the strongest arguments for getting an ARM in the first place, i.e., why pay a premium for a 30-year mortgage when your time horizon is much shorter?

When Does 2 -1 = 0?

Housing Market Math, Circa 2010

When does 2 - 1 = 0?

When a two-income family that's "upside down" on their mortgage loses one of those jobs ("upside down" is Realtor-speak for owing more on your home than it's worth).

The first wave of foreclosures largely consisted of marginal borrowers -- putting very little (or nothing) down -- paying inflated prices in especially overheated housing markets.

By contrast, today's second wave of foreclosures disproportionately consists of homeowners who are financially stretched because they've lost their job(s).

That's from Bob Peltier, Edina Realty President & CEO, who spoke at City Lakes' weekly meeting this morning.

That unfolding, second wave of recession-driven foreclosures is likely to be one of the dominant stories of the 2010 housing market (as I've blogged previously, I'd add to that list Option-ARM's, strategic defaults, and the economy generally).

Banks & Foreclosures: Rational Actors or . . .

. . . Foot-Dragging Ostriches?

Just a heard a very thorough -- and harrowing -- overview of the foreclosure picture nationally from Rick Sharga, a senior executive at RealtyTrac.

His company compiles one of the most complete databases tracking foreclosures, so he's speaking from authority.

What does he see?

--The housing mess is going to persist longer than is currently projected, because rising unemployment is exacerbating the problems with dubious mortgages -- especially Option-ARM's -- originated when the housing market was flying high.

Think of it as two rivers merging into a mega-river.

So when does he expect to sound the "all-clear," signifying a return to "normal" housing market conditions?

Not before 2012, and perhaps 2013 (no, not a typo).

--Peel back all the confusing statistics, short-term noise, etc. and the current foreclosure numbers are staggering.

According to Sharga, prior to 2009, there's never been a month where the number of foreclosure notices exceeded 300,000. Just so far in 2009, there have already been seven such months.

--Conventional wisdom is that every 6-10 job losses result in one foreclosure. However, because there's typically a 3-6 month lag, there are lots more foreclosures in the "pipeline."

Foreclosure Pain: 4 More Years

More gloomy news:

--Foreclosure pain has metastasized, spreading from places like Southern California, Florida and Arizona to previously unaffected places like Portland, Boise, and the northern Virginia suburbs.

--A combination of logistical delays, federal intervention, and the banks' self-interest are keeping many would-be foreclosures off the market -- for now.

According to Sharga, a bank that forecloses on a home can expect to incur $100 a day managing it, paying the utilities, taxes, etc. That comes to about $36k a year.

Now assume that the bank originally lent the homeowner $600k, and that the home is currently only worth $300k. When the home sells in foreclosure, the bank stands to lose more than 8x its annual carrying charge.

What initially looks like ostrich-like behavior on the banks' part suddenly seem quite rational!

Option-ARM with 12 Zeroes?

The Mother of All Re-Financing Risks?

Taking on new debt is an action that has implications for the true cost of the U.S. government's financial rescue initiatives. This cost may have significant refinancing risk."

--Special Inspector General Neil Barofsky

Let's see . . . one of the main story lines of the housing bubble involves millions of borrowers scooping up easy, short-term money -- from creditors more than happy to dispense it -- based on the belief that they could easily refinance on favorable terms.

Unh-unh.

As we all now know too well, housing stopped appreciating, the credit spigot got turned off . . . and millions of homeowners got stuck with spiking mortgage payments.

Now, to mitigate the fallout from the housing bust, the U.S. government is issuing trillions in (for now) dirt-cheap, short-term debt.

Thank you, Alan Greenspan (it was Greenspan who said the Fed's job was to mitigate the fallout from burst bubbles, not to prevent them).

So what happens if all that debt can't be rolled over on easy terms?

Unlike individual households, the government can always print money to repay its obligations.

But creditors who are wise to that: a) refuse to lend; b) require rates significantly higher than zero (what the Fed is able to pay now); or c) both.

3 Keys to 2010 Housing Market

Which Way the "Move-up Market?"

I'm working on my 2010 letter to clients now, but here's a quick preview -- following are 3 factors that I think are key to next year's housing market (p.s.: if you want a copy of the letter in December, instead of February when I'll post it on this blog, send me an email at rosskaplan@edinarealty.com. If you bought or sold a house through me in the last few years, you're already on my mailing list):

One. Fate of the "move-up" market, or, "as the move-up market goes, so goes 2010 housing."

Thanks to the $8,000 tax credit for first-time home buyers -- plus cheap foreclosures dumped on the market by banks -- entry-level housing has been strong virtually all year. Perhaps too strong.

Just ask prospective Buyers and their Realtors what the choices are like below $200k in nicer areas of the Twin Cities right now.

Strength only at the bottom of the market doesn't make for a strong market, though.

So, everyone's looking for evidence that the higher rungs of the market will "join the party."

Other Shoes Dropping?

Two. Given how instrumental the $8,000 tax credit has been, there is a bit of a "waiting for the other shoe to drop" quality to the housing market at the moment.

Namely, everyone's waiting to see if demand tanks once the incentive(s) disappear. (That is, assuming that they do; there's rampant speculation that the tax credit will be extended in one form or another.)

However, assuming Nov. 30 really is it, there's some evidence that things will transition just fine: at least some Realtors are reporting that their clients are postponing their home searches till after Nov. 30.

Their logic?

Artificially-spiked demand is driving up entry-level home prices more than the $8,000 tax credit is going to save them.

Three. The other "other shoe" is a much-rumored second wave of bank foreclosures.

In particular, millions of so-called "option-ARM mortgages" (pay what you feel like -- at least for awhile) are due to re-set nationally in 2010.

The good news for the Twin Cities: these loans never became as popular here as they did in places like Southern FL, Southern CA, and Las Vegas.

The bad news: a continuing, lousy economy -- and in particular, high unemployment -- is hurting many other homeowners who got more conservative mortgages.

Bailout Math

Bailout Money Bolsters Banks
Against Prospective Losses?

"A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be. "

--Wayne Gretsky

It's a stretch to compare Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson to the incomparable Wayne Gretsky; their ad hoc and inconsistent handling of the credit crisis more often conjures up images of the Keystone Cops.

It's also the case that the lack of disclosure and accountability expected of the recipient banks is truly appallling, and to many (including me) offensive, given the hundreds of billions of taxpayer funds involved.

That said, if you're looking for a rationale for and defense of the bailout(s), however strained, here it is:

--Wells Fargo just bought Wachovia and its $150 billion portfolio of toxic mortgage loans (mostly option-ARM's and the like).

--Two-thirds of those loans, or $100 billion, are now expected to default.

--The loss ratio on the aforesaid defaults is expected to be 25%, or $25 billion.

So guess how much Wells Fargo has received in bailout funds to date? Yup: about $25 billion.

Thanks to Tyler Zimmerman, Edina Mortgage, and Josh Kaplan, City Lakes office manager, for the foregoing numbers and proofreading, respectively.