Mortgage Resets: One Shoe Dropping

Atrios is concerned that there will be a second wave of foreclosures when the next wave of option ARMs reset:

Option ARM rates are going to be recasting soon and in increasing numbers. That’s the magic moment when people can no longer make minimum payments, when they can longer make interest-only or neg-amortization payments.

Ryan Avent points out that most of the defaults associated with resetting mortgages happen before the reset occurs:

He notes that if you chart 2/28 and 3/27 mortgage defaults over time, you don’t see the kink at the 24 or 36 month mark you’d expect if the reset was doing most of the work in generating foreclosures. What they found was that defaults were happening surprisingly quickly — basically, underwriting standards were so terrible that borrowers couldn’t even afford the initial payment.

As the bust has proceeded, by contrast, defaults have mainly resulted from the combination of negative equity and some kind of income shock — job loss, death or illness, divorce, and similar.

And Megan McArdle concurs and offers follow-up:

The problem is not principally people who can’t pay their mortgages because their interest rates have reset–people will cut back on a lot of other things to keep their house, and if you can’t afford a 1% rate increase even with drastic lifestyle cuts, you probably have too much house. Rather, the main problem is people who have an income shock.

The initial point about resets is absolutely correct. The people I’ve talked to at the Boston Fed and elsewhere who have dealt with this data have all been completely surprised by how much the resets don’t matter. But I want to expand on it, because the point is slightly different – these loans were designed never to be paid off and to be not active at the time of the reset.

For subprime mortgages, Megan is overstating that the rate resets were minimal. Check out these rates (click to enlarge):

(For this entry, I am using data and graphs from the excellent – Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures, a Fed working paper. full paper here, pdf slides here. Last version is May 2008, so it is looking at the height of the subprime market, 2004-2007.)

Rates go from about 8% to above 11% after the two year mark. In general, the numbers I’ve heard say that mortgage payments increased about a third after a reset. This is fine if the first, cheaper, payments is much less than what you can afford to pay per month. However most buyers could barely afford the 8% rate (which was high compared to prime mortgages). So the model was to refinance. All the time. Every two years, refinance. Get close to the jump, maybe a payment or two into it, and then refinance. The banks knew this, so their strategy was to get their cut from the prepayment penalties they could legally charge (I need to go back and actually write out that model for banning prepayments), while always making refinancing available until the credit crunch came.

Instead of being a business based around collecting interest off loans, it became a business based off collecting high fees off loans. It became, though the Boston Fed is loathe to use this analogy, a credit card company business model.

Let’s look at some empirical evidence (click to enlarge):

This chart is hard to read, but take a minute to grasp it. This is from December 2007. The lines under Still Active reflect how many of the subprime loans are no longer active (in 12/07) percent wise, by time from origination. So for subprime loans originated in 2004, 81.6% were no longer in existence by month 30. They either defaulted or refinanced. Roughly ~18% of these mortgages defaulted by month 24 across all years. The rest were refinanced. If their FICO got high enough during that time period, they refinanced into a prime loan. For most, they refinanced into another subprime loan, another spin around the wheel. The evidence leads us to believe that if they couldn’t refinance, they would have been in a very risky situation.

We ended up in a situation where a product, a mortgage, that should be designed to survive a 360 month time horizon, were gone 80% of the time within 30 months. 10% of the mortgages don’t even make it 6 months! Given that it takes a few months to end the contract, that’s one out of ten not being able to make more than two payments. I can’t get a $60/month cable package if the cable company doesn’t think I own $120. Where were the underwriting standards!?!?

(If you can read heartbreak in math, look at the additional jump in months 25-30, where it goes from ~67% to ~81%. That’s some poor struggling household opening their mortgage bill and seeing their amount due jump up a third. They forgot, and their friendly neighborhood shadow bank sure as hell wasn’t going to remind them. The bank then makes sure they can squeeze some juice out of the jumped mortgage rate before sending them back to month 1 on the chart with a refi. Also note the last line in 2005 and 2006 – note how they drop off. That reflects, in December 2007 when this chart was compiled, people calling in for a refi and the bank responding “Sorry, there’s no more money.”)

So when Ryan points out that there isn’t much to worry about since most of it has been decided by the date of the reset, that’s true, but that’s true conditional on functioning mortgage markets. It’s especially true conditional on people saying “we can refinance that crappy mortgage that is falling apart into a brand new crappy mortgage that resets the clock.”

As for the loans Atrios is alluding to, I am not in the doomsday camp on them, but I think there is real worry that they are going to put the resets into play in a way we haven’t see before in the data. I don’t know the specifics on where the markets stand, but if there isn’t a wave of mortgage liquidity that can handle the jumps in refinances in months 19-24 and 25-30 you see above, we are in uncharted territory in crap mortgage land. Hold onto your hats.

Comments

[Leftfield:]

I can't emphasize enough the hit US creditworthiness and the general perception of decent hardworking people has taken from the ways our leaders have handled all this. From falling into this mess in the first place (I refinanced in 05; I can't emphasize enough how pushy and irresponsible the selling and products were) to grabbing trillions for banks without accountability and the DC pork plan. Our present market rallies are accompanied by more seeds of destruction: Rising interest rates, falling dollar and the certainty of other falling shoes, and appear an attempt to restart the bubbly, don't worry be happy economy while actually adding to the problems.

May 08 06:59 AM

[Living4Divi...:]

Rortybomb - Thank your for the article

QUESTION: You showed data from 2007. You show that in the past when mortgage rates reset, rates go up.

I am curious about what happening is TODAY. Is quantitative / qualitative easing making the rest rates lower ? Is it to correct to assume that in today's super low interest rate environment that mortgage rate resets are barely increasing payments?

May 08 07:19 AM

[Delojozafado:]

Well, this weeks Treasury auctions are the miller that tells the tale! 71 billion floated out in a week. The 30 year basically down sharply BEFORE Thursday's auction and then collapsing in the Auction. The bid ratio was a paltry 2.1. The Ten year was then of course beaten down as well to a 3.35 yield in sympathy. The Treasury is going to be floating out over a $135 billion in 30 year notes alone this year. After yesterday the only hope for the Treasury bonds is that we get a substantial correction in the stock market over the Summer months. That would not save the "Q" polluted 20 & 30 year bonds but would at least bring the ten year and lesser maturities back up in price as investors flee to their relative safety.
The Game is over with the "Q" easing. Look at the price action in international (NOT international US based) oils like BP,STO,RDS/B and the ETF ENY (Canada) since the Fed meeting in March. Look at the price action in oil itself. UT ..OHH we are heading for +$60 with in a week? The price of Nat gas has vaulted through $4 as well making a huge percentage move in just days. Silver backed off some after smashing through $14, but the gold, silver and platinum are moving ahead again this morning. If gold breaks out of the $865- $920 trading range to the upside then the US Treasury,Fed and Long Term bond holders in general are going to have the hurtin' put on them.
What all this MEANS??? Is that the sub 5% /30 year mortgage rate is about to become a missed window of opportunity for the would-be buyers awaiting lower housing prices. The lower prices are coming no doubt but will the actual cost of ownership be going down? Not likely as taxes, utilities, and insurance as well as mortgage loads increase against the known expectation for inflation in what is now perceived by most to be in the mid term NOT long term out look.
There is still some disinflation afoot as evidenced by the telecom action this week as well as the sanguine attitude towards this weeks unemployment numbers as a derivative somehow being a positive. All of this is going to ultimately weigh on wages and pension benefits to those employed in the public sector. More disinflation pressure I suppose. In all the euphoria over the Stress tests underwriting the major banks no one seems to pay any attention to the Treasury's & fed's stipulation that the expectation going forward is for an additional 700 Billion in write downs still on their way for these banks. Sure they will now be expected to survive it but at what cost? Anyone like the TMV,TBT, or SRS?

May 08 08:07 AM

[EXCBS:]

Supply/ Demand = price - www.treas.gov/offices/...
When I was at school the long bond reflected long run rational expectations of inflation. After the pause in issuance..is the supply at the long end large enough to really tell the story?

May 08 10:54 AM

[mac123449:]

An interesting and a more realistic view

Andy T at Bigpicture.com

Not to get too weird with statistics and numbers…cause they can make up any story you want….

But using round numbers:

Let’s say a country has 100 million workers…..then the country goes into recession/depression and businesses start firing .5% of the workforce every week…the weekly firings would look like this:

1st week: ( 500, 000 )
2nd week: ( 497, 500 )
3rd week: ( 495, 500 )
4th week: (492, 537)

etc….

You see how the 2nd derivative is getting better? We’re losing less and less jobs each week. That’s great, right? But, there’s the effect of dwindling numbers….there are less and less people to fire each week. If the country is slashing a certain percentage of the workforce on a routine basis, then by definition, the second derivative MUST get better at some point.

May 08 10:56 AM

[Lee Smith1:]

Please be more careful in using the terms "recast" and "reset".

The latter term refers to a change in interest rates, and may have a smaller impact on default rates. The former refers to the interest-only or negatively amortizing loan becoming a fully amortizing loan, and can have a significant impact on default rates.

May 08 11:09 AM

[levin70:]

One of the things that really irk me about the recast debate is that people continue to use really old data. Most of the information out there is from 2006 or at best, first quarter 2007 about what option arm/alt recasts are coming down the pipe-line. Does anyone have more recent info?

Saying that there is a wave of recasts coming, but only having data from 3 years ago leaves a bad taste in my mouth.

Regards

May 08 12:12 PM

[tunaman4u2:]

Mortgage reset losses will be assumed by the government printing press or put on the government balance sheet.

Very clear now... as a market bear myself its hard to be right and assume the government will do right by its people but thats not the case. The government absorbs these losses, not the banks

May 08 12:46 PM

[Larry House:]

Cetin, do you have a mortgage? Do you pay bills? Is your spending rate negative? You sound like you live on another planet!

Leftfield, you are right on all counts.

May 08 01:12 PM

[mrmillergd:]

Another related aspect that is rarely discussed is that overleveraging is beginning to hit the upper middle class too. Foreclosures and short sales in the more posh areas of my local area seem to be accelerating. These groups were as much on the edge as any other - income shocks are forcing them to sell of assets too.

May 08 01:39 PM

[altaman:]

Let me bottomline it for you - anybody that has to sell or refinance their home or commercial real estate over the next 2 years is going to be facing a combination of lower asset values (negative am or not) and higher interest rates (check the trend). Does that sound hopeful?

I can only thank God that our sober govenment officials are carefully marshalling their resources to handle the next crisis. ;)

May 08 01:55 PM

[HardwoodFlo...:]

I have been dead wrong on this. I cannot believe there are so many resest to happen. What has been going on who has been setting up these resets? It's crazy. Obviously the people that are in these ARMs can't get a qualified FHA loan- because otherwisse you would refi. That is troubling.

May 08 02:21 PM

[Ransome:]

I believe you are right, this was a credit card model, because the banks get the fees, not the investors. The securitizers asked the CC department for a pivotal measure of credit-worthiness and it was not the ability to pay, it was the credit score. Regardless that the borrower was already paying the minimum on a $20k debt at 30%, a most un-creditworthy person for a long term loan.

A former bartender could look up the credit score, hand over $500,000, and staple the paperwork together destined for a AAA rated security. The good old days.

May 08 02:57 PM

[HardwoodFlo...:]

Ransome- and the guy on the otherside fo the bar was the appraiser "buddy" who would justify it.

May 08 03:00 PM

[Jasper M:]

levin70 makes a good point.
I have eprsonally Not found any newer data re ARM resets than the Credit Suisse 2007 numbers.
However, I think these are still useful, with a few intelligent adjustments.
First, the "agency" fraction can be subtracted out, as those are essentially government controlled operations, and will bend to the will of the Administration re delaying foreclosures.
Second, there are plenty of stats on the lack of effectiveness of various efforts to keep distressed borrowers in their (actually the banks') houses. Also remember that most of those efforts were aimed at the "SubPrime" tranche - the Alt-A tranche has, I believe, barely been addressed.
So I think the rest of the data set is likely 90% the same.
Though I would love to see a newer data set. I loves me some graphs!
And remember that most of the

May 08 03:45 PM

[steve graves:]

That's an excellent point...


On May 08 10:56 AM mac123449 wrote:

> An interesting and a more realistic view
>
> Andy T at Bigpicture.com
>
> Not to get too weird with statistics and numbers…cause they can make
> up any story you want….
>
> But using round numbers:
>
> Let’s say a country has 100 million workers…..then the country goes
> into recession/depression and businesses start firing .5% of the
> workforce every week…the weekly firings would look like this:
>
> 1st week: ( 500, 000 )
> 2nd week: ( 497, 500 )
> 3rd week: ( 495, 500 )
> 4th week: (492, 537)
>
> etc….
>
> You see how the 2nd derivative is getting better? We’re losing less
> and less jobs each week. That’s great, right? But, there’s the effect
> of dwindling numbers….there are less and less people to fire each
> week. If the country is slashing a certain percentage of the workforce
> on a routine basis, then by definition, the second derivative MUST
> get better at some point.

May 09 10:38 AM

[mikesa69:]

re: "Also note the last line in 2005 and 2006 – note how they drop off. That reflects, in December 2007 when this chart was compiled, people calling in for a refi and the bank responding “Sorry, there’s no more money.”"

Not sure if you're referring to the blanks in the chart for these lines, but if so those would be indicative of the fact that the longer time periods had not yet occurred as of Dec. 2007, not that there were no loans to be had. If you meant something else then I'm afraid I didn't get your point. Overall a great article, though, and thanks for the insight.

May 09 02:52 PM

[hpcooperjon:]

And the barfly sitting next to the appraiser was looking for her next big score.


On May 08 03:00 PM HardwoodFlooring wrote:

> Ransome- and the guy on the otherside fo the bar was the appraiser
> "buddy" who would justify it.

May 09 04:54 PM

[valinho:]

you are right on the rate issue, however the underlying asset is now in some cases 60% off in value.


On May 08 07:19 AM Living4Dividends wrote:

> Rortybomb - Thank your for the article
>
> QUESTION: You showed data from 2007. You show that in the past when
> mortgage rates reset, rates go up.
>
> I am curious about what happening is TODAY. Is quantitative / qualitative
> easing making the rest rates lower ? Is it to correct to assume that
> in today's super low interest rate environment that mortgage rate
> resets are barely increasing payments?
>

May 10 05:01 PM

[Hillsfar:]

If you've got some time, I suggest watching a series of 5 short videos on abandoned houses, abandoned model homes, etc. in Southern California:
www.youtube.com/view_p...

May 11 03:32 AM