By Dirk van Dijk
So you think we are out of the foreclosure woods? Don't bet on it. Take a look at the chart below, created by Credit Suisse (a larger version is available here). It shows the date of first reset or recast of various classes of adjustable-rate mortgages (ARMs). A reset refers to a change in the interest rate, a recast refers to a change in the payment.
For most "plain vanilla" ARMs they are the same thing, but for Option ARMs the payment can change without a change in the interest rate. Option ARMs (the yellow part of the bars) allow the borrower to pay less than the amount of interest on the loan early in the mortgage life, with the difference being added to the principal of the mortgage. Even in a flat housing price environment, this would cause the loan-to-value (LTV) ratio to rise over time. In a falling home price environment, with both the loan growing and the value falling, it happens much more quickly.
The vast majority of the homeowners with these "pick a payment" mortgages pay only the minimum payment. When it exceeds a set level, or at a set date in the future (whichever comes first), the mortgage holder has to start paying the fully amortizing payment of the now much larger mortgage. This can cause huge jumps in the monthly payment, with increases of over 50% not uncommon.
These are the ultimate in "exploding mortgages." The number of these recasts is relatively small right now -- at about $1 billion per month -- but that number is set to grow dramatically over the next few years, exceeding $8 billion per month in the fall of 2011. If the equity in your house is gone and your monthly mortgage payment suddenly jumps from $2000 per month to over $3000 per month, what do you think is going to happen? How about if one or both of the people in the household has been laid off?
This is going to be a huge problem, particularly for Wells Fargo (WFC). The biggest writer of these abominations of housing finance vehicles was Golden West, which was bought by Wachovia, which was then absorbed into WFC. Unlike sub-prime mortgages, these were for the most part targeted at more upscale homeowners. The next wave of foreclosures will be in gated communities, not on the "wrong side of the tracks."
The chart shows that the sub-prime problem is largely behind us (dark grey part of the bars), as most of those teaser rates have now expired. As long as people have some equity in their houses or are less than 5% underwater, it is possible for them to refinance their mortgages as long as rates stay low. The refi of up to 105% is part of the Obama housing relief plan. If people are further underwater than that they are out of luck (and increasingly out of a place to stay).
Refi's have helped many people and have cushioned the impact somewhat. However, their most significant effect has probably not been in preventing foreclosures, but in raising the disposable income of those who would have probably been able to stay in their homes in any case. This has worked like a tax cut and has helped to maintain consumer spending. But in any case, that pig has mostly worked its way through the python.
Instead, the Option ARMs and the Alt-A loans are going to be the big problem. Alt-A loans (green) were offered to people with good credit ratings, but were often jumbo loans, or were low-or-no-documentation loans (aka "liar loans").
The next wave of foreclosures is going to have much higher average loan balances, so each foreclosure is going to hurt the banks more. So far, more upscale communities have avoided the full impact of the housing crisis. Over the next year, they will be the central part of the story.
Foreclosures being dumped onto the market have caused the low end of the housing market to suffer much larger percentage declines in values than upscale areas have seen. Currently, there has also been much more activity in the existing home market at the low end of the market, with about half of all sales being "distressed sales" (either short sales or recent foreclosures).
The high end of the market still remains frozen, particularly for properties that need mortgages above the local conforming limits (max $730,000 nationwide, but varies by local area). This has caused the median transaction value to decline more sharply than if the relative activity between high end and low end homes had stayed constant. As foreclosures move more upscale, we may well see an increase in median existing home sale price. I'm sure this will be spun as good news of a housing bottom. Don't believe it -- it just means that the cancer is spreading.
This wave of foreclosures is over and above the current uptick that is happening due to the expiration of foreclosure moratoria at Fannie Mae (FNM) and Freddie Mac (FRE) and because mechanisms put in place by several states to slow down the foreclosure process have run their course. The vicious cycle continues -- lower home prices put more homeowners under water, which leads to more people walking away or being foreclosed on, which in turn further lowers home prices.
The reduction in wealth associated with this spiral causes people to need to save more, and reduces the amount they will spend. This leads to lower demand and higher unemployment. Higher unemployment then leads to more people being unable to afford their mortgages, leading to more foreclosures.
The housing crisis is not over, not by a long shot. Based on the recast and reset schedule shown below, it could last all the way until 2012.