More comments on the mortgage and adjusting ARM data

Here we go again. Some more analysis of that great 33 page data set that I started talking about yesterday titled “Mortgage Payment Reset - The Rumor and the Reality“. Let's get right to it...after all it is a Friday!

The author starts off trying to minimize the affect of ARMs adjusting and mortgage payments increasing. There are a few things I want to point out though as we move along.

"By definition, fixed-rate loans do not face payment resets, while adjustable rate
loans do. A small increase in a monthly mortgage payment – say from
$1,500 to $1,600 – is unpleasant, but is usually not enough to ruin a
family’s finances and force them to let go of their home."

I honestly can't think of a realistic way that the mortgage payments would jump from $1500 to $1600. To get mortgage payments in this range you are probably looking at a 280-320k loan. To get $100 separation between the payments, you are talking about a 50 basis point adjustment in rate. I guess it COULD happen, but rates are way more than 50 basis points higher in the past 2-3 years. Heck, even a 1 year ARM is going to have rates over 50 basis points. You are probably looking more along the lines of a 1-1.5% change. Most subprime loans have a 1.5% cap on each adjustment. The author goes on to discuss a 'large increase' in payment.

"A large increase – from $1,500 to $3,000 – may be too great for a household to handle.
Try as they may, a family facing that sort of increase could be forced into
default if they have no equity and are thus unable to sell or refinance.
It is important to note that a household facing a doubling of mortgage
payments will be in difficulty, whether that increase is applied in a single
month or in a series of incremental steps spread over two years."

Mortgage payments doubling is going to hurt whether it takes place over 1 month, 6 months, or 24 months. This next part made me shake my head in disbelief:

"Additionally, an interest-only feature makes little difference, since the first few years of a
mortgage loan are almost entirely devoted to interest in any case; including
or omitting principal payments doesn’t change the monthly terms much
for the first few years of a mortgage."

Are you kidding me??? If the interest only feature made little difference, then 82% of the purchase loans in California last year would not have been interest only or option-ARM mortgages. Sure, on an 60k loan, the I/O payment is not going to save much. But look at the numbers for a $550k 'median' priced California home. At 6% on a fixed rate, you are looking at a payment of $3,297.53. If you get an interest only (I/O) payment at 6%, the payment is $2750.00 a month. That is a monthly savings of $547.53. I don't know about you, but I think 550 bucks a month makes a difference. Not to mention that the interest only loan would probably have a lower rate than a fixed rate loan to begin with. I know that you only pay about 1% of principal per year in the first few years of a 30yr fixed mortgage, so it only stands to reason that the larger the loan amount, the more that interest only is going to help. The author is correct about that point, but he is not applying it to the large loan amounts that are necessary and commonplace in the 'bubble areas'.

"The primary driver of reset sensitivity
is the magnitude of the interest rate change. An initial interest rate of 5
percent that adjusts to a market rate of 6.3 percent will lead to higher
monthly payments, but the increase will not be catastrophic. On the other
hand, a loan with an initial interest rate of 1 percent that resets to a market
rate of 6.3 percent will experience a substantial increase in payments, all
the more so if negative amortization has increased the total principal
amount subject to interest. That type of loan will experience reset payment
sensitivity. An option-payment loan with a minimum payment below that
of a 1 percent loan will face even greater reset sensitivity."

Nothing to argue with there, some pretty solid information. In the next part, you will see where this guy is using 'old school' ratios. I say 'old school' in the sense that it is not the standard I see most companies using. I think it is a good rule to abide by, but it is by no means the norm in high cost areas of this country.

"From Table 10, we see that an adjustable loan of $300,000 that resets from
5.0 percent to 6.5 percent has a monthly payment increase from $1,610 to
$1,896, a rise of $286, to about 18 percent higher than it was before. If the
borrowing household was devoting 30 percent of their income to mortgage
payment, the increase is 18 percent of 30 percent, or 5.4 percent of their
income. This level of strain upon family finances is definitely unpleasant, and
might require cutbacks in personal spending or other lifestyle adjustments.
But normally this level of pain would not be enough to force default. To
look at an example from another part of the economy, the late summer
and early fall of 2005 saw a dramatic increase in gasoline prices, in many
places to above $3.00 per gallon. This price rise led to changes of choice
and to lifestyle adjustments. The sales of large sport utility vehicles (SUVs)
declined. But the national economy did not enter into a tailspin. Yes, there
was pain; but life went on, and life still goes on."

Is this guy funny or what!?!? First off, if you look at the statistics, very few people can get a $300k mortgage and only spend 30% of their income on the payment. Take the $1610 mortgage payment...remember this is just the mortgage, no taxes or insurance included. If you take that amount and divide by .30, you need a monthly income of $5,366.67 or $64,400 a year. Remember, I'm not adding in $350-400 for taxes and insurance that most companies would take into account for housing debt ratios. If I did, the required annual income would be $80k a year, not $64k. Yes, I know that many single people and couples can 'afford' this type of payment...but if you look at the median income in California, it falls at about 53k. The government stats have the nationwide median income at about $45k. My point is that many people qualifying for these 300k loans are spending more than 30% of their income. An 18% jump in payment IS going to hurt. Keep this in mind: I can do fulldoc (W2's and paystubs) to a 55% debt to income ratio. The author is talking about 30% just on mortgage, I'm talking about total debt payments. That probably puts the DTI the author is targeting in the 30-35% range, not the 55% range that many subprime loans are being done at. Keep in mind, this doesn't include the 'stated income' deals that couldn't even fall into the 55% DTI category. I think it is completely comical to take increases in fuel costs, and compare it to mortgages adjusting. For the most part, individuals have more control over fuel usage than mortgage costs. Individuals can change they car they drive, drive less, take public transportation, carpool, etc. I know some people are driving a lot, but it takes a lot of driving for the extra 70-80 cents a gallon of gas to break people financially (as compared to a mortgage adjusting).

"Perhaps surprisingly, reset adjustments to sub-prime loans may not be as serious as
one might think. An adjustment on a $300,000 loan from 8.0 percent to 9.0 percent
(linked to a national prime rate or other index rate) leads to an increase in payments
from $2,201 to $2,414, about 9.6 percent higher than before. If a family had been
paying 30 percent of their income in mortgage payments, this increase would be 30
percent times 9.6 percent = 2.88 percent of their monthly income. Even a family
with stretched finances paying 40 percent of their monthly income on their mortgage
would experience an increase of 40 percent times 9.6 percent = 3.84 percent of
their monthly income. Such an increase is less in percentage terms than the earlier
example of the reset of a near-market-level adjustable loan. While painful, this
increase would probably not lead to an immediate default. Furthermore, if the
situation worsened and a default did occur, many lenders would be protected from
loss exposure by having used more conservative loan-to-value-ratio guidelines."

I really don't think this guy has a handle on the subprime mortgage market. One of the BIG misconceptions is that subprime is all high rates. Sorry to inform you, but for a long time there, I had 'subprime' rates in the 5's with a few blocks in the 4's. Not too long ago, I could to a stated 100% loan for a borrower with a 620 FICO, and the rates would have been in the 6's on the 1st and 10's on the 2nd. Yes, there were some areas where borrowers could get into the 8's and 9's, but you would REALLY have to try to get rates that high! With all of the competition, there were times when subprime rates were better than A-paper rates on certain programs! I won't go into it again, but for subprime loans, the author is using debt ratios that are too low. I used to do lots of loans for "a-paper" borrowers on the subprime side BECAUSE subprime would take the higher debt to income ratios (DTI), and the rates were about the same. I don't know where he got the idea that lenders were using 'more conservative' guidelines with subprime borrowers as far at DTI is concerned.

"With this in mind, consider what happens when a 1 percent payment schedule is
reset to a market level of 6 percent. It matters little whether payments are calculated
on an interest-only basis or not; and it matters little whether the reset happens all at
once or in a series of increments. It is the broad magnitude of the reset increase,
brought about by interest rate differentials, that is important. From Table 10, the
monthly payments reset from $965 to $1,799, or 86 percent higher than before. A
family paying 30 percent of their income on mortgage payments would experience
this as 30 percent times 86 percent = 25.8 percent of their total income, which is
likely to be an unendurable strain. They would have to devote 30 percent + 25.8
percent = 55.8 percent of their income to mortgage payments alone. If, in addition,
the household has no equity in their home and therefore cannot sell or refinance, a
default may loom in the future."

No argument from me there. I don't think most borrowers have a handle on the type of loan that they have. This article from Yahoo supports that fact. 52 percent of the homeowners said they didn't know much about the mortgage options that were available when they bought their homes. Gotta love it when half the people are pretty clueless to what will probably amount to the 2nd largest expenditure of their life (house), with taxes being the first. That should really tell you something right there. Half the people don't know much about their mortgage options when buying a home. Even the article admits this is a vague question, but it doesn't really surprise me with what I have seen the past 2 years in the market. Lots of borrowers know the 'payment' and that is about it. That means that 1 of your next door neighbors is probably clueless to the surprise coming in the mail when their mortgage adjusts. (this paragraph had corrections made after an inaccuracy on my part was pointed out in the comments)

"The difficulty of payment reset can be worse than what I have described. If the
original loan was 30 years with an introductory period of 2 years, the mortgage
would reset into a 28-year schedule rather than one of 30 years, resulting in higher
payments. Moreover, this does not consider the impact of negative amortization. A
loan with a true rate of 5 percent and minimum or introductory payments at 1
percent will add the remaining 4 percent to the balance of the loan, increasing the
amount owed by 4 percent per year, or 8 percent in two years. Thus, the newly reset
payments will be 8 percent higher because of this increase in principal – and it will
be less likely, after this increase, that the property will still have equity to make a sale
or refinance possible."

I'm glad that he covered the fact that when a 2 year interest only ARM adjusts, the loan is amortized over the next 28 years, not 30 like most people 'think'. I did the math for this exact scenario in this post. Check it out and see some realistic examples of what happens when 2, 3, 5, 7, and 10 year ARMs adjust.

Well, I hope I was able to shed some light on 'another' viewpoint here. I think the author did a good job overall. I believe he is looking at things on a 'national' scale instead of a 'bubble area' scale. I don't think there is much of a 'nationwide' housing bubble...but I definitely think there are several areas that have become so disconnected from the fundamentals, that a correction is inevitable. I also agree that the crazy lending practices are probably more commonplace in the skyrocketing areas than the 'normal' areas where real estate isn't booming.

Have a great weekend everybody...and I look forward to the comments and feedback!!
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I am going to keep making my posts over here, but most of the comments are happening at the new site. Go to...
www.housingbubblecasualty.com
or
www.anotherf@ckedborrower.com
...if you would like to see more comments and activity. Don't forgot to check out the activity in the FORUMS!

SoCalMtgGuy