NEW YORK (Reuters) - Stumbling home prices and already heavy monthly payments are a bigger problem for borrowers with adjustable-rate mortgages than the looming rise in the cost of their loans, and it could blunt attempts to ease the strain on homeowners.
With hundreds of billions of dollars of adjustable-rate mortgages, or ARMs, having reset so far in 2007 and almost a trillion dollars expected to adjust to a higher interest rate by the end of 2008, many analysts have pointed to this as the main driver of surging defaults.
But the worst-performing mortgages were made in 2006 and have not yet reset and will not until at least mid-2008.
The larger problem stems from the lax lending standards in 2006, which allowed many borrowers, particularly subprime and “Alt-A” mortgage candidates, to take on too much debt. Many now hold loans with monthly payments they cannot afford.
“While subprime ARM resets get a lot of headlines, that is really not what is causing the huge rise in delinquencies and defaults,” said Nicholas Strand, manager within the mortgage strategy group at Barclays Capital in New York.
“People have missed the boat on what is the underlying factor driving delinquencies in the present environment because ARM resets cannot explain the delinquencies that we have seen thus far,” he said. “If you look at loan level data, it is really the very highly leveraged borrowers whose default rates have increased over the past year.”
Many Washington policy initiatives have been aimed at helping subprime and Alt-A borrowers tackle the “payment shock” when their ARM resets to a higher rate.
Legislative efforts to soften the increase of resets may prove fruitless as many borrowers cannot even meet the payments on below-market teaser rates, let alone higher rates that reflect the risk posed by their credit history.
Falling home prices pose a much bigger risk to the U.S. housing market than resets on adjustable-rate mortgages, said Strand.
Loans made in 2005 were helped by rising home prices, but now, values across most of the U.S. are either flat or declining.
If the house is worth more than the mortgage loan, most people do not default as they have other alternatives such as selling a house or tapping into the equity of their home. A drop in home prices removes these options and drives up the incentive to default.
The Mortgage Bankers Association early last month said second-quarter mortgage delinquencies rose to 5.12 percent from 4.84 percent in the first quarter, the highest level since the second quarter of 2002. Delinquencies on subprime mortgages rose to 14.82 percent from 13.77 percent, the highest since the second quarter of 2002 as well.
The subprime mortgage market, which caters to borrowers with poor credit histories, has been at the eye of the U.S. housing market’s storm this year.
“Alt-A” loans often went to borrowers who could not provide full documentation of income or assets to lenders. Many lenders accepted information at face value, allowing borrowers to exaggerate and get larger loans.
There is approximately $9.5 trillion outstanding in first lien single-family mortgage debt and of that amount, 17 percent are adjustable-rate mortgages that are subprime and Alt-A, according to Bank of America Securities.
A large number of Alt-A ARMs outstanding are either option ARMs or have a fixed rate of five or more years, which indicates that these loans may not reset for a number of years, the company said in recent research.
The option ARM mortgage offers a low payment that does not even cover interest costs, leaving borrowers each month deeper in debt.
“Interest only loans and option ARMs are another problem,” said Mike Larson, a real estate analyst at investment firm Weiss Research in Jupiter, Florida.
“Over time, more borrowers who have been paying only interest will hit the date where they have to start paying back principal too,” Larson said, leading to another batch of delinquencies and foreclosures.
Eric Belsky, executive director at Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts, noted that speculative investors are a primary reason for the surge in defaults.
Speculators are easily inclined to default on mortgages because the property is often not their primary residence, said Belsky, who expects home prices to continue to drop next year.
“They are walking away from a poor investment,” Belsky said. “All homeowners are hoping that prices go up, but they do not rely on them to be able to get to the point that they can sell a house, but speculators do.”
Many of the weakest borrowers have also taken on more debt in recent years. About 15 percent of Alt-A ARM loans made in 2003 were to borrowers who also had second mortgages, and that percentage balloons to more than 40 percent in 2005 and 2006, according to Barclays Capital.
A drop in home prices pushes up defaults and forces more leveraged borrowers into foreclosure. This, in turn, puts extra supply to the housing market and pushes down home prices at the margin and the cycle starts again ultimately.
This should make the next several quarters very interesting for the U.S. housing market and not just because of the ARMs resetting in the same period of time, the company said in recent research.
Additional Reporting by Patrick Rucker