Housing Market Rebound by 2010? Not Likely

Over the past three years, the US economy has been ravaged by the 3 million or so foreclosures that took place during the period. Many of these foreclosures were caused by the resetting of ARMs (adjustable rate mortgages), which led to higher interest payments borrowers could no longer afford. In early March, the Mortgage Bankers Association released the results from its latest National Delinquency Survey and found, “a shift away from delinquencies tied to the structure and underwriting quality of loans to mortgage delinquencies caused by job and income losses.” The MBA cited the decline of the 30-day delinquency rate for subprime ARMs to the lowest level since the first quarter of 2007 as the proof behind the pudding. Since the origination of subprime ARMs was largely halted in 2007 and the typical hybrid ARM has only 2-3 years of fixed interest rate payments, many of these toxic mortgages have already been cleansed from the system. However, the MBA fails to acknowledge the impact of option ARMs, which typically recast after 5 or 10 years, and the impending damage yet to be felt by the US housing market.

In the earlier part of the decade, as lenders became frantic to take advantage of the highly lucrative subprime mortgage market, ARMs grew popular with both lenders and homeowners and even spread to the prime loan market. Most ARM loans took two forms, hybrid and option.

The hybrid ARM, usually referred to as just an ARM, offers a fixed initial interest rate for a period of two or three years then the mortgage resets to floating rate, which is derived from an index rate (e.g. 1 year CMT or LIBOR) plus a margin added by the lender, for the remaining duration of the loan. For example, a 2-28 hybrid ARM has a fixed rate for two years then a floating rate, which fluctuates on a scheduled basis depending on the reset date, for the remaining 28. Another commonly employed structure is the 3/1, which has a fixed rate for the first three years then a floating rate that adjusts annually thereafter. The fixed rate was often referred to as a “teaser rate” because it was so low (1-2%) to entice homeowners and allow them a few years to build equity in the home.

The option ARM, also called a “pick-a-payment", allows homeowners multiple choices in terms of the amount in mortgage payments they will make each month. Typically, the homeowner can choose to make the minimum payment, an interest only payment, a 15 year fully amortizing payment, or a 30 year fully amortizing payment. In most cases, the minimum payment was lower than the monthly fixed interest payments. When this occurred, the unpaid difference was added to the outstanding principal. This is known as negative amortization. Option ARMs usually have a neg-am cap, which causes the interest payment to recast regardless of the established fixed rate terms and locks in the borrower to a higher rate if the value of the outstanding principal breeches a previously established amount. A recast differs from a reset in that a recast sets the borrower back on track to amortize the loan in full by the maturity date, whereas, a reset adjusts the interest payment to reflect the current index rate plus margin. If the homeowner chooses to make to make the minimum payments for the first few years of the loan, the loan will automatically recast after either 5 or 10 years, depending on the original terms, at a much higher rate.

Over the past three years, we’ve seen the antagonistic effects the resetting of hybrid ARMs and the recasting of neg-am capped out option ARMs have had on the US housing market and the economy in general. As 3 million US homes have gone into foreclosure, borrowers with ARMs have been disproportionally represented. According to MBA’s yearend 2008 data, subprime AND prime ARM loans continue to dominate delinquencies. In the second quarter of 2008, the delinquency rate for prime and subprime ARMs were 1.82% and 6.63%, respectively. In comparison, the delinquency rate for regular prime and subprime loans were 0.34% and 2.07%. Take particular note of the very comparable delinquency rates of prime ARMs and regular subprime loans. This comparison perfectly illustrates the absurdity of the mortgage origination market during this period - the fact that some mortgages were structured so poorly to create an environment in which prime borrowers were defaulting on their loans at nearly the same rate as their subprime counterparts.

The hope for stabilization in the housing market within the next year, as some market forecasters predict, looks to be a view held by those wearing rose colored glasses. From 2004 to 2007, there was $750 billion option ARMs originated, according to Insider Mortgage Finance. Comparatively, there were roughly $1.9 trillion mortgages originated for each subprime and jumbo category. Goldman predicts that more than half of all outstanding option ARMs will eventually default. With over $375 billion worth of option ARMs headed for delinquency within the next few years, it appears we are just entering the second wave of foreclosures in the housing market.

Below you will find a chart illustrating the monthly reset/recast rates for mortgages from 2007 on.

click to enlarge

Under most circumstances, the fact that 30-year mortgage rates are currently hovering just above the all time low of 4.78% would allow homeowners to refinance. However, the incredible decline in home prices over the past two years has drastically reduced homeowner equity to levels rendering refinancing in many cases useless. It is estimated that over 55% of borrows with option ARMs owe more money than their homes are worth. Making matters even worse, only 17% of option ARMs originated in 2004-2007 required full documentation from the borrower. This means an unknown number of borrowers may have taken out additional loans or misrepresented their income, which could heap additional pressure on already stretched homeowners. Essentially, we know there is going to be a high rate of default but the incomplete data set only allows for rough predictions. As the next wave approaches, we really won’t know its true size until it hits.

The second wave of foreclosures could not come at a worse time. As the economy worked through the resetting of hybrid ARMs from 2007-2009, borrowers faced much more advantageous conditions in terms of unemployment rates and home values. Unemployment remained below 6.1% until October 2008 when it spiked above 8% over the next 4 months. Additionally, during the same period, the average US home value declined from $225,000 to just above $175,000. These numbers are expected to continue to worsen over the next year. Goldman predicted at the start of 2009 that unemployment will rise to 10% in 2010 and housing prices in 20 major US cities to further decline 20-25% from current levels by the third quarter 2010. Not to mention, some economists estimate the number of US workers currently unemployed and underemployed (meaning workers involuntarily working part-time) to be around 15.6%.

Over the past few months the Obama administration rolled out its plan to help struggling homeowners. The plan has provisions for both primary and secondary mortgages. For primary mortgages, the plan calls for interest rate modification and principal deferment. It goes even further for secondary mortgages, calling for interest rate modification and possibly even loan forgiveness. These programs may keep struggling homeowners afloat in the near term, but as Mark Zandi, chief economist at Moody’s Economy.com, noted “…in many ways, we are kicking the can down the road.” By lowering rates or deferring payments, we may be creating a legion of “zombie homeowners” that are anchored down by high levels of negative equity in their homes. The plan, while lessening the immediate economic impact by preventing some of the millions of foreclosures expected to take place over the next few years, fails to address the real issue at hand, which is the negative equity many borrower’s have in their homes.

The second wave of foreclosures, starting this year, is estimated to reach 3.5 million, according to a recent Credit Suisse report. These foreclosures will only contribute to the current vicious cycle as the foreclosed homes hit an already oversupplied market at fire sale prices, thus continuing to decrease home value. Borrowers struggling to keep up with their payments will have to deal with increasing unemployment, falling home prices and government policies that may do little more than delay the pain. The next wave will certainly touch all mortgage types and borrower classes but it will be the final remnants of the lending craze, the option ARMs, which lead the surge.

This article was written by Andrew Florio, analyst at JBH Capital.

Comments

[gordon:]

A recent survey revealed 37% of homeowners expect to put their home back on the market "when the market improves". Add this shadow inventory to the stealth inventory of bank-owned,(sitting on empty non-performing mortgages during the "stress tests") it's easily another million units, maybe 1.5 mil, doubling existing inventory.

May 17 12:25 PM

[nyoneway:]

What does it really mean "when market improves", does mean the owners intend to sell at the first sign of recovery? If so, this is the same logic as selling your portfolio early in a bull market.


On May 17 12:25 PM gordon wrote:

> A recent survey revealed 37% of homeowners expect to put their home
> back on the market "when the market improves". Add this shadow inventory
> to the stealth inventory of bank-owned,(sitting on empty non-performing
> mortgages during the "stress tests") it's easily another million
> units, maybe 1.5 mil, doubling existing inventory.

May 17 06:49 PM

[76423:]

for: nyoneway

One doesn't sell one's portfolio early in a bull market. One sells one's portfolio after the bull market has collapsed and a 'new' bull market has supposedly materialized.. It's all psychological. If a stock (or a house) drops 50%, many people feel they've come out a little bit better if they can now get 51% for their asset. A portfolio is supposed to be liquid and evolving anyway, not something stuck in mud just because prices are going higher or lower. How many Citigroup, or BofA folks (etc)., wished they had sold when the 'market improved' after the initial collapse?

May 17 08:29 PM

[Clarence th...:]

We can stare at this Rate Reset graph all night long and imagine all of those borrowers washing out when their number is up. A more prescient analysis must consider a fight-or-flight tipping point. (where's that Gladwell guy when we need him?) A Capitulation Factor (CF). That middle of the night realization that your kids are going to be sacking groceries just to pay for Junior College, because you were too proud to take the hit and get it over with.

Remember when a divorce was a black mark on your record? You stuck it out - for better or worse - because you didn't want to be "that" guy. Now you're just another middle aged guy with a physical trainer. What happened? Critical Mass. A posture of acceptance of divorce in polite society.

The much anticipated (don't say bottom, don't say bottom...) reduction of the angle of declination in this market will be preceded by the realization - en (critical) mass - that it just ain't the end of the world / people will forget / I'm not the only one.

May 17 10:19 PM

[Jimmy K:]

good points Clarence... I saw my neighbor yesterday (living in $500+k home at peak) bagging groceries yesterday at my grocery store... no one is immune.

May 18 08:56 AM