Knowing your risk

This article regarding Adjustable Rate Mortages (ARM's) highlights the problem of individuals being extremely financially leveraged in the real estate market without fully understanding their level of financial risk. This could lead to drastic changes in the overall housing market (see links below about a possible housing bubble) .


The full article (link) with my comments below:

Clock is running down on 'cheap' mortgages Now comes the hard part for holders of certain loans.

You know those cheap mortgages that everybody's been getting to speculate on housing? Where somebody at the other end of a toll-free phone will lend you $200,000 and your payment will only be $678 per month?Lenders who started making those teaser-rate loans a few years ago are getting ready to charge real-world payments on them.Starting in 2006 and accelerating into 2007, as much as $2.5 trillion worth of the fancy mortgages called "hybrids" are coming to the end of the free-lunch part of the deal.And while prices in Southwest Florida are hovering at twice those of three years ago, the house party seems to have ended in July. Since then, as mortgage rates continue their upward creep, inventories are stacking up, while the rate of closings is slowing down.The best-case scenario for the future, the one from the real estate agents, is that prices will level out to single-digit appreciation rates.Assuming that scenario, some would-be investors -- those who took out highly leveraged loans with extremely low payment options -- could soon find themselves owing more on a house than it is worth. Comment: Meaning will they be able to afford the higher monthly payment? If not, what will they do? Refinance (if available and most likely leading to a higher monthly payment if they refi - will they be able to afford the payment) Sell the place to get out of the bad situation they have placed themselves in - possibly leading to more places on the market (factor in that the exotic loans will most likely go away) meaning more supply then demand ("inventories are stacking up") - leading to falling housing prices. Also the speed or some might say liquidity of the market is slowing - not a good sign for any bubble type investment.
That's called being "upside down" in a loan.Many more will simply find that their monthly bill has instantly risen by roughly the amount of a car loan. The reason is that after their initial one-, two- or five-year interest, their loans are now scheduled to "reset" at more realistic rates, and will continue to do so, usually for the life of the loan.Economists are still trying to put numbers on this reset factor, particularly when it comes to the riskiest home loans, referred to as "sub-prime.""We don't have enough data to know how big a problem this will be," said David Berson, chief economist at Fannie Mae, the nation's largest mortgage packager.For now, though, the lending party is still going strong."The mortgage business has been banging for the last five, six years," said Marta Grande, managing broker at Sarasota's Commonwealth Mortgage. "It has just gone crazy."Personally, Grande likes what a borrower can do with an adjustable-rate mortgage, or "ARM.""I've owned six homes, and every one of them has been an ARM. But I tell people today to get a fixed because I think rates are going to go up."The ticking clockSarasota's John Barron is typical of the new crop of homeowner-investors. He and his wife, Lauren Wood, are sitting on big profits at their two 2004 purchases in the up-and-coming Gillespie Park neighborhood, close to downtown Sarasota.But the couple made their big moves using ARMs that are about to be reset. If they don't act soon, their monthly bills will rise by hundreds of dollars per month.They used two separate three-year, interest-only, adjustable-rate mortgages from SunTrust Bank to buy the homes within the past two years.And there's more, Barron said."Besides the two ARMs, we also took out a home equity line on the Seventh Street house to put down a deposit on the Fifth Street house. There was no cash that we had in our pockets to put down on the Fifth Street house. All we had was our shining credit record. And the faith that the banks have in this real estate market that allows you to borrow 100 percent."If they don't sell, with interest rates rising, the couple will have to refinance the loans. Comment: At the end of the article, this issue of refinancing comes up - what if they are unable to secure a new loan? and besides that the loan if at 30 yr fixed is going to have a significantly higher monthly payment, again will they be able to afford it?
Barron and Wood have a lot of company, says Paul Kasriel, chief economist at Chicago-based Northern Trust.With possibly $2.5 trillion in household debt that is going to be repriced higher "the household debt-service ratio is bound to climb to new highs," Kasriel wrote last month.Even before the reset gets under way, households were devoting a record 13.75 percent of their after-tax income to servicing debt, including mortgage debt.And the screaming housing boom of the last three years?"There will be an end to it. I think it is going to be related to further increases in interest rates," Kasriel said during an interview. Comments: possibly, the Fed is raising short term rates to try and slow the superheating housing and credit markets (getting rid of cheap credit) that they themselves fostered as a last pitch effort to save the house (financial/economic system) now by making money/credit super cheap (lowered Fed fund rate to around 1%) only to burn it hotter and faster latter, but in essense the system (financial etc) is close to breaking and some would argue that the Fed has lost control or can do very little to influence the situation. Personally, I think home loan interest rates will go up and exaccerbate the somewhat hidden flaws in the housing market and other markets (ie the risk associated with ARMs coming due). Long term bonds, short term bonds, gold and other financial instruments are all giving different signals as to what is happening. A lot of confusion in terms of how the system worked in the past because it doesn't seem to be working the same now. That gets into a different topic, but really it all connects.
"Asset bubbles are characterized by cheap credit. Usually what bursts a bubble is higher cost of credit, because that is what inflates the bubble, is cheap credit."Risky but not riskiestIn the Sarasota-Bradenton-Venice region, prices for existing single-family homes have risen at one of the fastest clips in the nation during the past three years.Prices in Sarasota-Bradenton-Venice have risen 93 percent, a rate roughly triple the national average and well ahead of the 79 percent growth rate for the top 20 metro areas in the nation.But the feverish activity seems to have dried up.In July, only 1,626 existing single-family homes were available for sale in the Sarasota market, and Realtors were closing sales at the rate of 156 per week. Dividing that sales rate into the number of listings, it was a 10.4-week supply of homes.By mid-December, though, the picture had changed dramatically. Sales had slowed to a rate of 100 per week while listings rose more than 170 percent. Comment: Showing atleast in this area that the housing market is in the process of turning over - much like Boston and other West Coast hot markets (ultimately forms into a buyers market, but when to get in? If it is for investment purposes, not when it is stagnant or on its way down but at the bottom - long time/way to go if the market has really turned in my opinion).Even so, National Association of Realtors researchers are cheery about the future of Southwest Florida property because of several factors: a strong job market, the continuing influx of wealthy retirees and, in their view, the acceptable degree to which the market is leveraged in loans. Comment: May be a great job market down there, but I think I know what other areas of the country are feeling or the country as a whole is feeling - jobs leaving the country (think GM, Ford and the outsourcing of jobs overseas) and general wages falling in relation to inflation - people are loosing purchasing power (they make near the same amount, yet prices for stuff - food, gas, housing, education, medical care, etc - are going up)
NAR measures mortgage risk as "mortgage servicing cost relative to the median income."For Sarasota-Bradenton-Venice, that ratio stands at 24 percent, higher than the 16 percent national average but well below the 30 percent for the top 20 metropolitan areas.The NAR concludes that the Sarasota loan level "implies no widespread financial overstretching to purchase a home in the region." But the organization admits that "there is no good data on ARMs or interest-only loans for the local market" and grants that "there have been some reporting in the media of a higher use of these loans in recent years compared to the past." Comment: So NAR say earlier that the market isn't excessively leveraged, but now they say there is "no good data on ARMs",etc which is one very big portion and good way to see if the market is leveraged. Laughable. Refer further down in the article. Way more ARMs conpared to fixed rate, etc.
The house specialtyLocal mortgage brokers are perfectly willing to add to the preponderance of evidence about high-leverage mortgages.At Sarasota's Integrity Mortgage Group, ARMs have far and away taken over as the most popular.Five years ago, there was only an occasional one-year or five-year ARM."Out of 200 loans you'd do 10 adjustables," Integrity President Jason Thurber said. "In the last year, I've probably done five fixed-rate loans, 30- or 15-year, out of 150 loans. So all the rest are some kind of hybrid." Comment: People are exposed to the risk of higher payments that will eventually arrive with their ARM, if they do not have a good understanding and plan ahead ("I will refi" to me is not a plan, but wishful thinking. It may mean significantly higher payments anyway or the new loan may not be available). Do people realize their risk? Will there be an OH s___! moment when their monthly payment goes up and can they afford or for how long can they afford the higher payments? This in some ways could be the linch pin question. What would be your reaction to an Oh s___ moment - mine would be to sell the risk away, even at a loss. Could this influence the market if it happens in a cascading or even in a more frequent fashion? most definitely.
The big picture looks similar, says SMR Research of Hackettstown, N.J., which regularly surveys lenders who make 90 percent of America's home loans."I can say that the first half of this year, ARM share was 55 percent nationally," said SMR's George Yacik. "For the full year 2004, it was 50 percent."Surprisingly, that shift toward adjustables has happened in an environment in which fixed-rate loans are extremely attractive, Yacik said. Comment: Why?, because a lot of the people wouldn't be able to afford the payment on the fixed loan. Hence they are most likely over leveraged with the ARM they have and may not even realize it. Another reason could be that they can make the payment on a 30 yr fixed but rather have a lower payment now and shoulder the additional risk. I worked with a woman in Seattle that tried for a few years to qualify for a loan but could not and I didn't think should have become a homeowner in her current financial situation. Enter in the exotic loan and she could qualify and did buy a home. Her answer to my question of what she would do when her ARM came due - I will Refi. Maybe and hopefully she will be able (A few months later I sold my place - this was one of the reasons. I was a little early to leave the market) The info below spells out how this could spell trouble for people.
Even after a year of moderate increases, the 63/8 percent you can lock on a 30-year fixed-rate mortgage is much closer to a 50-year low than to any high.Making matters worse, it is the the sub-prime lenders issuing the most adjustable-rate mortgages. With those who participate in the survey, 80 percent of their loans were ARMs compared to 55 percent in the broader market.So when do these loans adjust?Surprisingly, there is little data that is publicly available on that subject. The best resource is a study conducted in the spring by Fannie Mae, a federally chartered corporation that buys mortgages after lenders have issued them. Fannie Mae looked at 2002-2004 loan data to determine what portion of the existing loan pool would be "adjusted," and when.Fewer than 10 percent of the conventional conforming loans will reset in 2006-2007, but nearly two-thirds of sub-prime loans will. That is because a large portion of the sub-prime loans are two-year adjustables, says Berson, the Fannie Mae chief economist.Berson offered a typical example of what the industry calls a "2-28," an ARM in which the interest rate is fixed for the first two years and then adjusts regularly for the next 28 to whatever index the loan calls for. The average yearly cap on this loan is 2.3 percentage points per year.If the consumer took out this two-year ARM in December 2003, he started out paying a typical rate of 7.7 percent, Berson said."You would be getting a letter from your lender this month telling you that next month, your rate would be going to 10 percent."Roughly speaking, a consumer's monthly bill could rise from $330 to as much as $1,425 to $1,755.If the loan started out as interest-only, the shift in payments would be even larger.Fannie Mae expects sub-prime loans to be reset en masse this year with that trend continuing into 2007.But over at the Mortgage Bankers Association, senior economist Michael Fratantoni is more interested in the five-year adjustables that were issued during the refi craze of 2002-03. That's a large crop that will sprout in 2007."The estimate is that in 2007, more than a trillion dollars worth of hybrids are going to hit their first reset date," he said.That one chunk of hybrid loans represents 12 percent of the $8.8 trillion in single-family home loans outstanding nationwide.The genesisTo find fixed-rate mortgages as cheap as the 5.83 percent average of 2003-04, you'd have to go back to the 1950s and early '60s.Starting in 2003 and accelerating into 2004, lenders in 2003 began adding enticements to make ARMs an offer that consumers would find hard to refuse. Comment: Lenders don't just give out candy. They make money when others don't understand the risk and get caught. Think of this as a larger scale version (yet not an exact version) of where a person with a lot of credit card debt finds themself. Stuck paying the >18 some odd % interest and making little or no head way paying down their debt. They are pretty much slaves to their debt or debt owners (look at the new bankruptcies laws that took effect in Oct 05 and how this affects people that make financial mistakes).
"You had lenders with large origination machines running full tilt, and they decided to keep those machines running, so they started to push more heavily," said Keith T. Gumbinger, vice president of mortgage data publisher HSH Associates.Lenders started by adding the interest-only feature to basic adjustable-rate mortgages such as the 2-28.With interest-only, the lender is telling the mortgagee not to worry about principal payments at first, but after the freebie years have ended, the borrower is stuck paying the entire principal in a compressed 28-year time frame.Other marketing features gradually found their way into the market. "No doc" loans, now quite common, mean the borrower doesn't have to provide any documentation that he has earnings, such as paycheck stubs.Lenders started covering for lack of downpayments by making "piggyback loans" where they issue a first mortgage covering 80 percent of the purchase price, and then either a second mortgage or an equity line covering the remaining 20 percent."Everybody goes away pretty happy," Gumbinger said. "With the exception that there is a property out there that is mortgaged to 100 percent of its price."Like many ARM borrowers, Barron, the Gillespie Park buyer, is not really sure how much his payment will go up when the loans are reset. The new rate is a moving target."Come year four, they adjust it based on the prime rate," he said. "It is like prime rate plus two, or, I can't remember exactly what the adjustment is. They can never raise it more than 2 percentage points. That can add up pretty fast." Comment: Good luck to this person
'Neg Am'Now, lenders are pushing an exotic mortgage that is so leveraged it makes Barron's straight adjustables look tame.Just like it sounds, the option ARM gives the borrower a set of optional payments to choose from each month, ranging from minimal to hefty."It sounds like a product that some derelict accounting firm would come up with, but it makes sense for some workers," said Mark Vitner, Wachovia Bank's senior economist.Option ARMs were designed for people who are highly compensated but receive their income in chunks, such as Realtors, but they are now "being used much more widely than it was ever intended," Vitner said.At Washington Mutual's Bee Ridge Road office in Sarasota, 25 percent of current applications are for option ARMs, says senior loan consultant Mike Bangasser.The interest rate on the bank's "one-month option ARM" changes monthly based on a moving average of one-year Treasury bills, with the only limit a lifetime cap of 9.95 percent.For customers with good credit, there is only about a half-percentage point difference between the 5.75 percent rate on an option ARM and the 6.375 percent rate on a 30-year fixed rate mortgage.So why bother with the ARM?This is the key: The minimum payment today on a $200,000 option ARM would be only $678, a little more than half the cost on a 30-year, fixed-rate loan. On that $200,000 loan, a 30-year fixed would be $1,248 per month in principal and interest. With the option ARM, there are three other payment choices: $958, $1,167 or $1,661.The $678 payment doesn't even cover all the interest, Bangasser acknowledged."Granted, your mortgage balance is going to go up under this scenario, but as long as my property is appreciating, I personally don't care too much what my mortgage balance is." Comment: Let the good times roll! Party like it is 1999! but in no way consider or factor in that housing will ever (Gasp!) go down in price.
If a borrower decided to pay $978 this month, that would cover only interest. The $1,167 would cover principal and interest, as if the loan were amortized over the usual 30 years. The high-end payment of $1,661 "is a 15-year amortization and that would choke a horse," Bangasser said.Not covering the interest on a loan is referred to in the industry as negative amortization, "neg am" for short.The loan gets bigger over time. Usually when it reaches some pre-determined top, like 115 percent the value of the underlying property, the lender forces the borrower to pay the loan's real price, or to refinance it, says Grande of Commonwealth Mortgage.In the meantime, the borrower is "paying juice on the juice," adds Thurber of Integrity Mortgage.He guesstimated that if somebody borrowed $250,000 on a typical option ARM and made minimal payments for five years they would be "going to be in the hole 15 percent to 20 percent of your original balance, meaning $285,000 to $300,000.""You don't have to have negative am," Grande said. "As long as you make that fully-indexed payment, you're fine. But most folks aren't doing that. They take the easy way out, get themselves in trouble."There is one more ingredient to add to this layer cake, and it is one that barely occurs to most borrowers today: What if someday, loans were difficult to get?"Consumers have become so accustomed to very liquid mortgage markets, where credit is available for almost any circumstance, that they are not aware this is unusual in the market," HSH's Gumbinger warned. "Somewhat tighter credit availability and somewhat higher interest rates are much more normal." Comment: Yes, liquidity is an important thing to consider. What if it starts to dry up? If times turn sour or the risks to great, lenders/banks will tighten lending standards.
"Borrowers think they can always refinance. That is not always a safe bet."

Source: Hearldtribune.com


A decent overview about the question of housing bubble:
http://www.investorsinsight.com/otb_va_print.aspx?EditionID=256

Blog that posts most current articles on Housing (Worth taking a look at the Comments to the post - The 'Shape Of The Decline In 2006') :
http://thehousingbubble2.blogspot.com/