Negative Amortization and Interest Only: The Next Mortgage Bomb?

When it comes to problem mortgages, most people’s attention has been on pending ARM resets, with a certain Credit Suisse chart depicting an ARM reset schedule over the next eighteen months getting a lot of attention on this site and others. However, contained within that same Credit Suisse research report are two other charts that are no less disturbing that haven’t received anywhere near as much attention:

The first depicts the % of total mortgage originations that were either Interest Only or Negative Amortization:

It’s already an accepted fact that people who bought homes with zero money down and are now in a negative equity situation are quite likely to go into foreclosure, however, how about people who never paid down a lick of principle over the time they owned the home and/or are now dealing negative amortization to the tune of 10-20%? It’s quite possible that there are home owners out there who on top of 20% worth of negative amortization from their mortgage loan, are dealing with depreciation in the area of 10, 20, even 30%. Even if you can afford to make the payments, facing down the barrel of owning 30-50% more on your home than it’s worth is a horrific situation for a home owner to be in. Considering how many new home owners are in this situation, what will this do to new home buyer psychology long-term? Americans aren’t used to hearing (and have a hard time dealing with) financial horror stories from home ownership.

Finally, let’s look at the types of mortgages (alt-a, prime, subprime, et al) that were originated as negative amortization or interest only:

The thing that jumps out at me is the fact that for three years straight, nearly 60% of negative amortization and interest only mortgages were in the alt-a space, where it’s now pretty much accepted that the borrowers often lied about their potential income. The implication here is pretty clear: borrowers lied about their income to borrow more money, than took the loan with a minimum payment to make-up for the fact that it was more mortgage than they could afford and at some point, these loans will recast as fixed rate mortgages with the full payment, once the maximum negative amortization amount is reached.

At the moment, the market is fairly aware of ARM reset data and the implications as far as loan defaults and foreclosures, however, who is keeping an eye on all of the negative amortization loans that are scheduled to reset? If you consider the impact of negative amortization + housing price depreciation, it’s quite likely that resetting negative amortization loans will have higher foreclosure rates than ARMs.

Finally, in case anyone asks: “Why didn’t anyone see this coming?” The answer is pretty simple: these trends aren’t new, they’ve been developing for a couple of years now, Wall St. and the lenders saw it coming, they just chose to pretend it didn’t exist and hope that “somehow” the profits would keep rolling in. It kind of makes you wish you could rank hedge fund managers, lenders, money managers, financial executives, et al, by their propensity to wear rose colored glasses and ignore pink Elephants.

Sources:

Credit Suisse Research Report: “Mortgage Liquidity du Jour: Underestimated No More” – March 12, 2007

Disclosure: As of the writing of this article the Author doesn’t own a position in any of the companies mentioned in this article.

Comments

[Retiredinsobe:]

The following are some applicable excerpts from Downey Financial (DSL)'s recent 10-Q:

$8.9 billion or 76% of our residential one-to-four unit loans held for investment were subject to negative amortization at June 30, 2007, of which $377 million or 4.2% represented the amount of negative amortization included in the loan balance subject to negative amortization. The amount of negative amortization increased by $20 million during the current quarter, as borrowers took advantage of the flexibility of this product. During the current quarter, approximately 29% of our loan interest income represented negative amortization, down from 31% in the first quarter of 2007 but up from 26% in the year-ago second quarter. At origination, these loans had a weighted average loan-to-value ratio of 73%. In addition, $2.3 billion or 19% of our residential one-to-four unit loans held for investment represented loans requiring interest only payments over the initial terms of the loans, generally the first three to five years.
. . .
89% of our real estate loans were concentrated and secured by properties located in California, principally in Los Angeles, San Diego, Orange, Santa Clara and Riverside counties.

2007 Sep 08 07:50 AM

[Sr. Pessimist:]

I really got left behind in life. That's bad. I never got enough social rehearsal to court women. I don't have a woman. I don't have children. I got my nose bloodied in my very early career so I don't own a home. Hey- I don't own a home. Things aren't so bad. Not only that, I didn't used to own a home, either!

2007 Sep 08 12:11 PM

[Sam:]

You are making it very simplistic. Does it not take about approx 10years for NegAm to catch with the value of the house including appreciation? if there is any that is?
so the time frame for 2006 negam loans would be 2016 when who knows what will be the price of Real Estate????

2007 Sep 09 11:26 AM

[Markham Lee:]

I'm not quite sure what you mean here....

However, the fact remains that the customer is only digging themselves into a hole and creating more debt for themselves, with a property that is (at the moment) only losing value.

-M

2007 Sep 10 07:57 PM