Defuse This Time Bomb

Source : The Business Times, February 3, 2009

Lethal loan resets will worsen US housing market crisis

WHEN talking about the US home market, mentioning 'the other shoe to drop' was quaint about a year ago. Now we are referring only to bombs. The latest ordnance is the option adjustable-rate mortgage (ARM), one of the many sucker loans marketed during the housing boom. Option ARMs basically gave borrowers four ways to pay back, most of them involving low initial outlays that would reset at much higher monthly amounts at a future date.

Of the US$200 billion of these loans outstanding, almost US$30 billion is due to reset this year and US$67 billion in 2010, according to Fitch Ratings, a New York-based ratings company.

The resets inflict more trauma on the US housing market. The average option ARM monthly payment will soar 63 per cent - or US$1,052. Although there was a slight increase in home sales in November, prices fell 18 per cent from a year earlier, according to the S&P/Case-Shiller Index.

The pain continues. Since most option ARM borrowers will be unable to refinance because of lowered credit ratings or lack of home equity, many of those resets will result in more foreclosures and further depress home prices. Ultimately, the option ARM resets might plunge 8 million more households into foreclosure. That's in addition to the 2.3 million facing home loss last year, says Eric Rothmann, an analyst for Zacks Investment Research in Chicago.

Saw it coming

Like much of the housing train wreck, regulators saw the option ARM carnage coming.

Towards the peak of the housing boom, these loose lending vehicles became ever more popular as home prices soared. Accounting for only 12 per cent of total mortgage volume in 2004, option ARMs represented four out of 10 new loans three years later, according to LoanPerformance.com, a real-estate data service with headquarters in San Francisco.

Consistent with the worst of the bubble-inflated loan practices, these ARMs required little income documentation. You even had the option of starting out with a low monthly payment that morphed into a negative amortisation loan. That means you could owe more principal than you originally borrowed, even though the home value dropped.

What happened to the top issuers of these loans? Again, little surprise. Washington Mutual Inc, which filed for bankruptcy last September, no longer exists and Countrywide Financial Corp was bought by Bank of America Corp last year. Countrywide's toxic mortgages continue to bedevil Bank of America, which is still choking on its acquisition.

The shock-and-awe days of the housing crisis are far from over because of these loans and their cousins: sub-prime, 'Alt-A' and some prime mortgages. While President Barack Obama's administration struggles to fix the banking industry, it will be difficult to directly remove these loans - and related securities - from balance sheets without triggering billions in writedowns.

The option ARM barrage will exacerbate the housing decline in the worst-hit areas.

Homes that can't be refinanced probably won't be sold immediately. Assuming no government aid comes along to help these homeowners, the houses will go into foreclosure and be resold at much lower prices. That fuels what economists call a 'feedback loop' of ever-lower values.

Houses that are resold are discounted at least 30 per cent from the original selling prices, according to US researchers John Campbell, Stefano Giglio and Parag Pathak, who studied 1.8 million transactions in Massachusetts over the past 20 years.

Once foreclosures begin to ravage an area, the social consequences take their toll. Forced sales are bad news for everyone, except the lawyers and brokers involved.

Schools and other public services receive less from property taxes because of lower assessed valuations. People become homeless. Neighbours in proximity to a foreclosure also take a hit on their property value.

'We find that foreclosures predict lower prices for houses located within a quarter of a mile, and particularly within a 10th of a mile,' the researchers said.

It is difficult to summon sympathy for those borrowers who really shouldn't have obtained these loans in the first place or didn't think through the worst-case scenario. And the brokers, lenders and Wall Street mavens who sold and repackaged these loans deserve nothing but contempt.

Yet these mortgages are an unavoidable disease that needs to be treated. Either the government finds some way to allow qualified ARM borrowers to refinance at today's low rates, or it modifies the loans.

Recent proposals by the Federal Reserve and Federal Deposit Insurance Corp to start loan modifications for those in foreclosure are a step in the right direction. Allowing homeowners to rent their homes is another option.

Convert to loans

Perhaps Fannie Mae or Freddie Mac could buy a stake in the lower-cost, newly modified loans - similar to a call option - that would give taxpayers a piece of the upside in home equity appreciation. When the market turns around, they could be resold.

Why not convert the ARMs into 30-year, fixed-rate loans? 'This mortgage could be a viable option to give everyone some breathing room to stem the current onslaught and create the right resolutions,' Zacks' Mr Rothmann said.

If you are facing a reset, talk to your lender now. Ask some questions: Does your credit rating merit a refinancing? If it's hurting, what can you do to improve it? Do you have enough equity (at least 20 per cent is desirable) to get better terms? You have some negotiating room. The lender, mortgage-security holders and you all lose in a foreclosure.

The worst solution is to throw more unaccounted-for cash at the banks, hoping they will fix the situation. They won't.

No matter which approach is adopted, the foreclosure fusillade needs to stop. Otherwise home equity, mortgages and security writedowns will keep the financial system under siege. -- Bloomberg