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Impact of Mortgage Resets Likely to Be Worse Than Reported

New evidence suggests the first round of ARM resets will not peak in 2008 as reported. There are billions in optional adjustable rate resets and Alt-A resets scheduled to occur over the next 4 years. It is these resets, not the subprime resets, that we should be most worried about.

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Peak Resets Will NOT Be Next Year

ARM Loan	Peak	First Reset in Billions (at Peak)
Option Adjustable Rate	2011	$39
Subprime	2008	$36
Alt-A	2011	$20
Prime	2010	$22
Agency	2011	$10

Source: Global Financial Stability Report by the IMF (International Monetary Fund), based on data from Credit Suisse, via IaconoResearch.

Although it has been reported time and time again that ARM resets will peak in 2008, the reality is that the real peak will not occur until 2011.

As you can see from the chart above, when optional adjustable rate mortgage resets are taken into account the story changes. Optional adjustable rate resets will begin in earnest next year, but will not reach their peak until 2011. The same is true of Alt-A loans and agency ARMs.

It is also important to note that the chart above (like most others) only illustrates first resets. The majority of ARMs are tied to a LIBOR index, which means many homeowners will likely be hit with a second, third, and fourth reset if rates continue to rise. The resets could persist for some time depending on what rates do. Note that unlike central bank policy interest rates such as the Fed Funds Rate, LIBOR is set in the open market, making it more sensitive to real inflation and financial turbulence conditions.

As if that was not bad enough, an additional wave of option ARM payment shock is likely to occur before the 2011 peak, as borrowers reach the negative amortization ceilings on their loans (typically 110-125% of principal). At that moment, the pay option ends, and both the principal, interest on the principle, and deferred (higher) interest from the pay option must be paid back. It is impossible to represent this in a chart such as the above, since the exact date of this occuring depends on how much the individual borrower paid over time. However, given that the vast majority of pay option borrowers have made only minimum payments, the neg-am ceiling is a very real hazard for the entire period through 2011.

The Impact

According to Fannie Mae, 76 percent of the borrowers who had subprime ARM resets in 2006 were unable to pay off their mortgage by selling or refinancing. Half of the borrowers who did not pay off their loan ended up delinquent or in foreclosure. With more resets expected in the coming years and banks reluctant to lend money (and many lenders simply gone), the delinquency ratio is likely to increase.

Another compounding issue is the continued ignorance of borrowers. A study commissioned by the AFL-CIO shows that only 20 percent of ARM mortgage holders understand the factors that determine their rate adjustment. Of those surveyed, 73 percent have no idea how much their payment will increase, and 18 percent do not even know how what their current interest rate is.

How will these borrowers get it together in time to save their homes from foreclosure? There is no telling how far down the pipe housing will be by the time the real peak occurs in 2011. Selling may not be an option. Too many people took out ARMs in 2005 and 2006; they do not have an equity cushion. Worse yet, a lot of them are underwater.

According to an analysis by Comstock Partners, 70 percent of the borrowers who obtained a pay-option ARM last year owe more on their home now than when they took out a loan. Comstock also estimates that more than 15 percent of 2005 homebuyers (all loans) owe at least 10 percent more than their homes are worth.

The bottom line is that many of ARM holders will not be able to sell, refinance, or keep up with payments, leaving them with only one option: foreclosure (failing some form of mass-amnesty).

It is difficult to predict how big the foreclosure surge will be because we are in an unprecedented situation. The only thing that can be said with confidence is that one trend is likely to continue: the impact on housing, lending, and the economy in general will probably be much worse than the gloomiest of headlines to date.