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Did Anyone Hear that Warning?

Any economic recovery depends on the housing market.  That is the hard reality.  Right now the housing market remains seriously weak - home sales weak and foreclosures remain extremely high.  But is this reality being ignored by the stock market and others who are talking up the economy.  A warning about option adjustable rate mortgages (ARM) was reported this morning but may be overlooked in the rush for anything positive.  These warning are becoming more frequent.  Here is one from last week.  Is anyone listening?

What are option adjustable rate mortgages (ARM)?  The riskiest mortgage product ever created.  Option ARMs allowed many people to buy homes who could not afford owning a home with more conventional mortgages.  It provided the promise of very low monthly payments - at least initially.  Generally, with an option ARM a borrower is allowed the option to choose among three monthly payment options: 1) interest only; 2) some calculated minimum payment; or 3) interest only that is tied to a index plus a margin rate and adjusts accordingly (still less than full interest rate).  This loans involve something called negative amortization.  Negative amortization is when a monthly payment does not cover the full interest owed and does not cover or reduce any principal.  The amount owed is added to the principal balance so in the end your principal balance is actually increasing instead of decreasing like in most conventional mortgages.  Here is a very simple example:

Borrower A signs for a mortgage of $200,000 at 7% interest but Borrower A exercises his option for an even lower payment instead of paying full interest - say $1000.  But his full monthly interest costs were $1166.67.  The difference - $166.67 is added to his principal balance and $200,000 becomes $200,166.67.

Imagine this happening every month - 12 months a year for 5 years.  But there is a big catch.  At the end of 5 years these favorable very low mortgage payments reset to a more typical payment schedule with a monthly payment now based on the original interest (in the case of the above example 7%) and some reduction in principal (which is higher because of negative amortization).  The result is a much higher monthly payment which most people can’t afford.  Here is a more real world example:

Shirley Breitmaier’s mortgage payment started out at $98 when she refinanced her three-bedroom home in Galt, California, in 2007. The 73-year-old widow may see it jump to $3,500 a month in two years

Shirley Breitmaier took out a $315,000 option ARM to refinance a previous loan on her house.

Her payments started at 3/8 of 1 percent, or less than $100 a month, according to Cameron Pannabecker, the owner of Cal-Pro Mortgage and the Mortgage Modification Center in Stockton, California, who is working with Breitmaier. The loan allowed her to forgo higher payments by adding the unpaid balance to the principal. She’ll be required to start paying principal and interest to amortize the debt when the loan reaches 145 percent of the original amount borrowed.

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So, what were mortgage lenders and borrowers thinking?  Well, that real estate prices would always go up and people could refinance out this Option ARM before it resets in 5 years.  Both assumptions have been proven terribly wrong. 

Now we get another warning about those Option ARM but is anyone listening:

About 1 million option ARMs are estimated to reset higher in the next four years, according to real estate data firm First American CoreLogic of Santa Ana, California. About three quarters of those loans will adjust next year and in 2011, with the peak coming in August 2011 when about 54,000 loans recast, the data show.

Option ARM borrowers hit with unaffordable monthly payments are another threat to the housing recovery and the economy, said Susan Wachter, a professor of real estate finance at the University of Pennsylvania’s Wharton School in Philadelphia. Owners who surrender properties to the bank rather than make higher payments for homes that have plummeted in value will further depress real estate prices and add to the inventory of properties on the market, she said.

This will be a big problem for the housing market and the economy - particularly in California where 58% of these Option ARMs may reside.  This is also a big problem for certain financial conglomerates: Bank of America, JP Morgan Chase and Wells Fargo.  These financial conglomerates each acquired other financial institutions that specialized in Option ARMs: Countrywide Financial, Washington Mutual and Wachovia. 

We are not out of the woods yet.