Reigning Foreclosures Create the Perfect Storm

 By Patricia L Johnson and Richard E Walrath

Just how bad is it?

• Subprime loans represented 8% of total originations in 2003 but increased to 20 percent in both 2005 and 2006 [1]
• Most subprime loans issued were hybrid adjustable rate mortgages (ARMs) – 2/28 and 3/27’s [1]
• Reports indicate more than half of all foreclosures at the end of 2006 involved subprime loans [1]
• Delinquencies on subprime loans are hitting wealthier areas as well as lower income areas.  In the Sacramento CA area, 60 day or more delinquencies on subprime loans hit 14.1% in December 2006 [2]
• It is estimated the cost of a foreclosure is $40,000 to $50,000 with some lenders reporting losing as much as 50 cents on the dollar [1]
• 60% of all subprime mortgages originating in 2006 were 2/28 and 3/27 ARMs [1]

Adjustable Rate Mortgages are just that – they’re mortgages that have adjustable rates.  It appears both buyers and lenders fell into the ARM trap – buyers by not fully understanding the requirements of their loans, and lenders by not completing sufficient risk assessments on potential buyers.  Lenders must ensure their borrower can pay both the current mortgage and the future mortgage payment on ARMs.

There are several key items that must be understood by borrowers purchasing homes with ARMs [3] 

• Some ARMs have lower interest rates at the beginning of the loan – hence the name 2/28 or 3/27.  For the first two years in a 2/28 ARM your rates are lower, or for the first three years in a 3/27 ARM.
• Some ARMs have a ‘balloon payment’ – You may have a 30-year loan and for the first 10 years your payment remains the same, but at the end of 10 years a ‘balloon’ or full payment of the balance outstanding is due.  Your option is to refinance and if you’re unable to refinance then you must sell.
• Some ARMs have increased interest due to reduced documentation.  Full documentation loans require you to supply proof of income, assets and liabilities to the lender and generally have lower interest rates.
• Some ARMs carry a large prepayment penalty if you sell your house or refinance within the first few years of the loan.
• Some ARMs do not incorporate taxes and insurance into their payments and the buyer must come up with a lump sum payment to cover these expenses.

The following sample chart indicates the difference in payment requirements on a $200,000.00 loan at a fixed 30-year rate of 7.5% compared to a $200,000.00 “2/28” ARM at 7% for 2 years then adjusting to a variable maximum rate of 10% - in year 3, an 11.5% maximum rate year 4, and a 13.0% variable maximum rate in years 5-30. The sample indicates no rate change in years 3 & 4 and a 2% rate increase in year 5.  The sample includes $200.00 per month for taxes and insurance. [3]

Click following link to view chart http://www.articlesandanswers.com/ARMCHART.htm

While the fixed mortgage rate remains constant at $1,598.00 per month, the ARM mortgage increases $839.00 per month, from $1,531.00 in years 1 and 2, to $2,370.00 in year 5.

Wall Street Journal online has an excellent interactive map indicating the areas of the country that have been hit by the worst subprime delinquencies.

Some newspapers lumped families who have been caught in the subprime mortgage crisis with speculators who purchased houses for flipping purposes.  Somehow I just don’t have the same amount of sympathy for the speculators as I do for the families that are going to lose their homes.

If all those subprime mortgages were still held by the banks that granted them, they wouldn’t have become the problem we have today.  

But, they were rolled up, sliced and diced to serve as securities for further issuance of debt.  When it all starts to unravel, we have the credit crunch that Bernanke is trying to alleviate with the cut in the discount rate.

This wasn’t the rate cut everyone was looking for, but there will be a cut in the Fed fund rate in the very near future.  In the meantime, the cut in the discount rate – the discount rate window – will help, but I’m not sure it will be enough.

Sources: [1] John C Dugan, OCC, April 2007 [2] WSJ Online – Subprime Mortgages [3] Federal Reserve