Negative Amortization and Interest Only: The Next Mortgage Bomb?

by: Markham Lee

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.