Economic Issues - Part III

Current Conditions

Current market conditions can be described by a fairly simple demonstration of supply and demand. Supply (the number of homes on the market) conditions are being influenced by the increasing amount of foreclosures and defaults, new construction, natural home sales (not attributed to default), and a slowing purchasing rate.

Demand factors (the number of buyers consuming the supply) include low interest rates, home price depreciation, a borrower’s ability to obtain a loan, unemployment rates, income levels, and perception of market conditions.

Low interest rates typically increase demand. The Fed has been consistently dropping its target rate since September 2007. Although rates are low and money is cheap, this is having very little effect on demand due to liquidity problems. Banks are simply unwilling to take on risk by lending out cash. Banks are utilizing all the liquidity they can get their hands on to cover losses from poor lending decisions in the past. This increases the gap between the target fed funds rate and the actual lending rates. As banks are forced to raise their lending standards the pool of qualified buyers significantly decreases, further decreasing demand. The same problem exists with decline in home prices. Other macroeconomic factors such as unemployment and perception further decrease the pool of potential borrowers.

Foreclosures from sub-prime and option ARM borrowers are flooding the housing market with new inventory every day. Just a small amount of new home construction contributes to building inventories, currently at a seasonally adjusted rate of just 625,000. This indicator is at its lowest level since the US Census Bureau started tracking it in 1959. Inventories are building as demand continues to plummet.

The problem continues to grow. The current situation is bad. Adding in the potential $600 billion, or more, defaults yet to come has the potential to throw our economy into the worst depression it has ever seen.

Buyers and sellers are failing to come together in a way that makes the home purchasing transaction possible. Sellers can’t afford to take the loss of making up the difference between a realistic selling price and the value of their home, so they walk away and let the bank take care of it. Potential buyers can’t qualify for a loan because banks are simply unwilling to take more than a small risk in lending. Although the prospect for a resolution seems minute, there is a solution.

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.

My View on Today's Econimic Issues - Part I

The Problem

In 1981 the mortgage industry created a new product called the Option ARM. The option ARM is a unique product, which introduced a new product to an industry that had been fairly uniform for half a century. The concept behind the option ARM is buyers generally have two periods of repayment. The first is anywhere between one to ten years with very low payments. The second period consists of the remaining balance of a 30 year total term with higher payments.

During the first period of repayment homeowners have the option to pay one of four amounts. The first option, or minimum payment, represents a negative amortization amount. A recent study by Fitch Ratings reported up to 80% of all option ARM borrowers make only the minimum payment. A negative amortization payment capitalizes the unpaid interest into the balance of the loan, which increases the loan balance every month.

The second payment option represents an interest only option. Homeowners selecting to pay this amount retain the same balance on their loan through the entire first period. No principal is ever paid down with this option.

The last two payment amounts represent a more conventional option. The third payment option represents a 30 year fully amortized payment. The fourth payment option represents a 15 year fully amortized payment.

At the end of the first repayment period the mortgage resets to a conventional type loan with the balance amortized over the remainder of the loan term. Due to severly relaxed lending standards borrowers were not required to show they were qualified for the loan during the second repayment period.

Many borrowers who qualified for option ARM’s from 2001 to 2005 cannot afford, and would not be qualified for, a fully amortized payment on a loan of the same amount over a 20-25 year term. Eighty percent of these loans reset to a rate higher than market, on a balance larger than the original, with a shorter term. All these factors can significantly drive up a borrower’s monthly payment. Homeowners often find themselves in financial trouble when these loans reset.

Until about 2001 the Option ARM was reserved for well qualified buyers. The events surrounding 9/11 dealt a blow to the economy and the US was headed for another recession. Looking for a way to create new business mortgage brokers and banks marketed this loan as an affordable option for the masses. During a time with very little regulation in the industry, these loans were easy to come by. No proof of income was required. Brokers advertised teaser rates as low as 1%. Many people were sucked in by this to good to be true marketing message.

Both potential homeowners and existing homeowners saw this as a dream come true. Brokers advertised a $500,000 loan with monthly payments of only $1,666.26. This would save a homeowner in the ballpark of $14,000 a year in mortgage payments. What brokers didn’t do was educate the consumer and read them the fine print.

Is It The Right Time To Buy?

I've been looking around at houses lately. I'm a first time buyer in the Real Estate world but have been around it for a long time. There are many deals out there right now. The one thing that scares me is the trend. Home prices have been dropping for a while now. How much longer will this continue? I know I can get a great deal, but if I wait 12 months, will I get a much better deal? Or is this about where the market will be until recovery?

What I've concluded is that if I get a good deal today, it's going to be a good deal next year as well. We all know the market will turn around at some point, and the important thing is to be comfortable with the deal I get, no matter how much farther down the market goes.