My View On Today's Economic Issues - Part II

A minimum payment of $1,666.26 on a $500,000 mortgage does not even cover the interest. Every month the interest is capitalized into the amount of the loan. With this loan borrowers would be deferring over $850 in interest every month, which is capitalized to the amount of the loan. If at any point, as defined in the fine print, the balance of the loan became more than a certain amount the loan would automatically reset. Even worse, most option ARM loans have a condition in the fine print known as an early payoff penalty. If a borrower chooses to refinance before the early payoff term expires they face fees in the range of $10-20k, on top of additional broker and bank fees for the refinance.

With mortgage brokers heavily commissioned on these loans, they made a lot of money marketing and selling option ARMs. Borrowers already locked into a 5.25% fixed were lured into a 5/1 option ARM with a teaser rate of 1%, but the teaser rate only lasts so long. The rate always resets during the first repayment period to a higher adjustable rate.

Many borrowers who refinanced into these loans found themselves paying an adjustable rate higher than their original loan, which they refinanced out of, only a year earlier. Unable to afford to pay all the fees to refinance again, they either squeeze their budgets or foreclose before the first term even expires.

The second time bomb in these loans depended on an upward swinging market to keep a borrowers head above water. In a market decline, as we have seen over the past 36 months, the loan balance is growing while home values are dropping. In 2005 we saw the first wave of option ARMs reset. Millions of homeowners realized they could no longer afford to live in the home they had been paying on for the past few years. They put their homes up for sale at record rates. The lucky ones got out early and even cashed out at the top of the market. Those that couldn’t sell started to foreclose, at record rates.

According to Fitch Ratings, up to 45% of option ARM borrowers whom originated their loans from 2004-2007 are expected to default. The worst is yet to come. Business Week magazine estimates the sum of these loans resetting during the next one to four years to be as much as $500 billion. If these loans default at the rate estimated by Fitch Ratings, we will see another $225 billion in defaults from these products alone. Piling another $225 billion of defaulted properties and write downs into the market, on top of existing unsold inventory and foreclosures from non option ARM products, will be catastrophic.

Prime loans are the next wave of defaults to hit the market. According to a NY Times article the prime loan market accounts for approximately $12 trillion in assets. The latest figures put the increasing default rate for prime loans at 2.7 percent, or $324 billion. Sum the Option ARM, Alt-A, and prime defaults together and we are likely to see an additional $600 billion in mortgage defaults in the next two to three years.