Remember how, in the scary movie, our protaganist missed the claw hammer to the back of the head only to meet up with Scary Guy while fleeing out the front door?
Such it might be with residential real estate. No, the problem isn’t with subprime mortgages. That problem is largely behind us, although the ripples are still being felt, and are likely to continue to be felt in the form of rising foreclosures, vacancies, and the like. Nope. The problem is in the other mortgage types, namely what’s known as Alt-A and Option Adjustable Rate Mortgages, or Option ARM. An Alt-A mortgage is a better quality mortgage than a subprime mortgage, but isn’t as good as a prime mortgage.
An Option ARM is a mortgage that offers borrowers a few payment options, like interest only, principal and interest, or a minimum rate. Trouble is, with an Option ARM, making a minimum payment can result in negative amortization, a situation where what’s owed is more than the mortgage amount. Compound that with a contracting real estate market and the problem worsens. Compound that with what our own intrepid Steve McElhoe (aka Big Mac) contends was done with the funds not tied up in making traditional principal and interest payments, speculate in Florida real estate, and the result is like some metaphor I can’t think of.
So long as the the borrower can make the payments, the Option ARM performs as expected. Where it becomes a problem, with respect to our storm analogy, is when the ARM resets–or, more technically, recasts–or has to be reamortized at a new rate. In effect, the entire mortgage becomes payable. At least two factors have to be considered in the recast, the interest rate on the new mortgage, and the appraised value of the property. The first one shouldn’t be too bad, although the banks are likely to demand a higher premium over the funding rate to compensate for their increased skittishness. It’s the second one that’s the problem. (You can click here to see a chart of the Case-Shiller Home Price Index to get some idea of the fall in home prices.) The $200,000 home financed with an Option ARM, that is due to reset, might now be appraised for $180,000, which is far less Draconian than the (-)27%+ decline in the Case Shiller index. That eats up half of a presumed original 20% down payment. Banks don’t want to write mortgages without the downpayment. Voila, distress.
The chart, below, shows the mortgages (in $ billions) set to recast in the next few years. The “you are here” line isn’t intended to highlight the peak in Option ARMs, but that the highest amount of them recast in the next couple of years, as do a big chunk of Alt-A mortgages.
Big Ben today said that the Fed would keep interest rates at “exceptionally low levels for an extended period.” That should anchor rates near the low end, and maybe–just maybe–real estate values will begin to creep up. In the meantime, we’re likely to see more distress in mortgages. That’ll likely be accompanied by more foreclosures, which means more homes adding to the inventory of homes available for sale, which will likely depress home prices, which . . .