by Dan Krell © 2009
www.DanKrell.com
The Next Foreclosure Crisis
As the real estate market appears to be stabilizing, another wave of foreclosures poised and to interfere with a recovery. No, the expected wave of foreclosures is not a forgotten portfolio of subprime loans; rather the expected defaults are expected to come from Alt-A mortgages, the bulk of which are to come from resetting option arms.
The Federal Reserve (federalreserve.gov) describes the option arm (also known as a payment option mortgage) as an adjustable rate mortgage with several monthly payment options. The typical payment options include the traditional principal and interest payment, the interest only payment, and the minimum payment. The traditional principal and interest payment is the payment that you would typically make to have an amount applied to the principal amount of the mortgage to pay down your mortgage as amortized. The interest only option only pays the interest for the month without applying anything to the principal, which does not pay down your mortgage. The minimum payment option is typically less than the interest option and applies the month’s unpaid interest to the principal. Not only does the minimum payment not pay down your mortgage, but using the minimum payment over a short period of time will shortly have you owing more than the value of the home (which is called negative amortization) due to the increasing principal.
When the option arm mortgage was first conceived, it was initially used by sophisticated and affluent home owners mostly to assist with cash flow. However, the option arm became increasingly attractive to home buyers who wanted to purchase the maximum home they could qualify for during the market buildup earlier this decade. The option arm allowed the home buyer to be qualified at the very low initial interest rate (do you remember those 1% teaser interest rates?). The interest rate initially resets (or recasts) to market rates after three to six months, and again in three or five years.
When the interest resets, the payments increase. If you used the minimum payment option, then the monthly payment increases significantly due to the increased principal amortized at the new interest rate. Because of the potential for negative amortization, the lender can adjust the mortgage before the recast period if the principal amount grows beyond a predetermined number (usually 110% to 125% of the original principal loan).
Some financial experts have called the expected foreclosure crisis (which will peak in 2010 and carry through 2012) a tsunami as compared to the recent foreclosure wave. Fortunately, due to low interest rates, option arm defaults have remained relatively low after the recast. However, as interest rates begin to rise, we will see the foreclosure wave swell. Prashant Gopal reported in Business Week (Good News: Option ARM Resets Delayed; April 16, 2009) that the problem will increase beginning in spring of 2010 and peak in 2011. Gopal stated that (according to Barclays) there is a 4% to 5% default rate for option arms originated in 2006-2007.
The increased default potential is sure to overwhelm the already over burdened system. Home buyers looking for bargains will likely have another large pool of foreclosures in the next two years. Home sellers will have increased competition for home buyers. If you have an option arm, weigh your options now – before it’s too late.
This column is not intended to provide nor should it be relied upon for legal and financial advice. This article was originally published in the Montgomery County Sentinel the week of June 22, 2009. Copyright © 2009 Dan Krell.