Los Angeles Sweet Digs

August 6, 2008

A Giant Wave is Coming

34735626 A Giant Wave is Coming

No, not a cool August swell on the great Pacific. Unfortunately, this wave is the expected surge in home defaults, this time from people with decent credit.

This New York Times story notes that most subprime borrowers’ mortgage loans have already reset from their low teaser rates to their higher, unaffordable rates, which led to the first wave of foreclosures. Now, however, the loans of lower-risk borrowers are about to reset, which experts say will produce a second wave.

Prime and alt-A borrowers typically had a five- or seven-year grace period before payments toward principal were required. By contrast, subprime loans had a two-to-three-year introductory period. That difference partly explains the lag in delinquencies between the two types of loans, said David Watts, an analyst with CreditSights. “More delinquencies look like they are on the horizon because so few of them have reset,” Mr. Watts said about alt-A mortgages.

California is predicted to be hit particularly hard:

The wave of foreclosures is still rising in states like California, where many homeowners turned to creative mortgages during the boom. From April to June, mortgage companies filed 121,000 notices of default in California, up nearly 7 percent from the first quarter and more than twice as many as in the second quarter of 2007, according to DataQuick, a real estate data firm based in La Jolla, Calif. The firm said the median age of the loans increased to 26 months from 16 months a year earlier.

The story singles out Downey Financial, parent company of Downey Savings & Loan, as a company whose alt-A and prime loans are causing it trouble. The company reported that more than 11% of its loans were delinquent as of the end of June.

The bank’s troubles stem from its $6.2 billion portfolio of so-called option adjustable-rate mortgages, which allow borrowers to pay less than the interest owed on their mortgage in the early years. The unpaid interest is added to the principal due on the loan, so over time borrowers can owe more than the initial loan amount. Eventually, when loans grow by 10 percent or 15 percent, the borrowers are required to start paying both the interest and principal due.

Many borrowers who got these loans during the boom had good credit scores, but many of them owe more than their homes are worth. Analysts believe that many will not be able to or want to make higher payments.

“The wave on the prime side has lagged the wave on the subprime side,” said Rod Dubitsky, head of asset-backed research at Credit Suisse. “The reset of option ARM loans is a big event that will drive the timing of delinquencies.”

This predicted increase in defaults is one reason many analysts say the market has not yet hit bottom. In California, outlying areas, like the High Desert and Inland Empire, have already seen prices decline markedly; that’s probably because many of the homeowners were subprime borrowers, able to buy only with the help of extremely liberal financing and whose loans reset quite quickly. The closer-in, more desirable areas are home to people (in general) with more income and better credit. When those owners start defaulting, the market will be closer to a bottom.

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Posted by Cindy Allen on August 6, 2008 8:23 AM | del.icio.us | Digg

  • Jorge
    Ron,
    To tell you the truth I've been trying to find out what the minimum payments are for a while, I think the 1-2% interest rates are teaser rates on regular ARMs, I think they were only for the first 1 or 2 years too, but I'm not sure, I can't be certain. I'm just using 80% since that is what I've heard somewhere, 70-80%. But it could certainly be different. 2% seems excessive, at that rate even I could "afford" to buy a $1MM house. Just leave the house when the payment resets, or recasts.
  • ron
    Dillon,
    The alt-a folks don't have much more resources than the subprime folks. The difference between the two is the credit score. Period. The incomes and job histories were pure fiction for both groups. It may be that people with higher credit scores tend to have higher incomes but they also tend to buy more expensive homes.

    The real difference is the structure of the loans. A 2/28 ARM has one variable, the interest rate on reset (many people will actually get a better rate when it starts to float). The Option ARM crowd is in a totally different boat (as Jorge points out) while the 2/28 subprime guy has been paying principal for two years, the Option ARM guy has not only not been paying principal, he has been adding to it and this for 5-7 years. Now, he has to pay all of his interest, plus principal, and has to do it over 23-25 years instead of thirty. And unlike the 2/28 guy, the Option ARM reset is likely to a higher rate. The payments can easily double between the minimum and the recast payments. These people are toast.

    But the question of whether they can afford it isn't really relevant. People only paid those prices because they thought that future prices would be even higher. Now that future prices are likely to be lower rather than higher, people are pricing in the future losses just as they were pricing future gains into the prices that they were willing to pay yesteryear. Classic bubble.

    Jorge,
    I am missing something in your post. I am a novice when it comes to mortgage finance, but the advertisements for Option ARM's that I saw had minimum payments calculated at 1-2% interest while the interest was accruing at something like 6-7%.

    Is this a different kind of loan that I am thinking about? Thanks.
  • Jorge
    I meant to say a $700,000 house.
  • Jorge
    To say a little more would be an understatement. Let's say prime borrower bought a house for $100,000 using a 20/80 Option ARM same bank on both so as to make your scenario make sense. 20% 2nd IO ARM at 8%, 5yr reset, 80% Option ARM at 6% (minimum payment = 80% interest accumulated), 5 year reset, recast 125%. Payment = .08*.2*700000*1/12 + (.8*.06*.8*700000*1/12) = $3173/month

    Let's say property values kept since purchase, so house is valued at 700k, at recast/reset in 5yrs the borrower will owe 840k, and have to pay $4196.85 on the first the Option ARM at 6% if interest rates don't rise, and $1027.27 on the second. Total $5,224.12/month.

    With bailout loan being fixed it is set by long term interest rates, probably 6.5% nowadays, balance $630,000, rate 6.5% 30yr fixed = $3982.03/month,
    certainly that is a large jump in payment, over $800/month MORE, over 20% jump certainly to expect that most people can handle that jump is naive at best. Certainly easier than the $2k/month jump but still. Assuming their neighborhood didn't decline they would want to move to a cheaper neighborhood most likely, rather than shell out an extra $800/month, even if it is mostly principal payments at that point, many won't be able to afford it.
  • Jose
    I disagree in terms that those who purchased must have like the property therefore they should stay in it. Most of those purchased under subprime or option arms did so well above their means and at double or triple what the property was really worth. They purchased because the money was practically given to them at 120% financing so anything was relatively lucrative due to ignorance. I also disagree with the statement that the bancs will take the hit. We the people will take the hit when the feds bail the bancs just like they did in the 90’s with the savings and loans. By the way some are buying and letting the upside down property foreclose, but most of them are short selling the property to a relative without disclosing that fact. Keep in mind that a lot of the properties currently in foreclosure were purchased by undocumented foreigners.
  • Dillon, great post as per usual. You make an excellent point that these buyers will have more resources and options. We'll have to see how it all plays out.
  • Dillon
    In general, I agree that more defaults are coming, and prices will be lower.

    However, here's a scenario to consider: A prime borrower, compared to a subprime borrower, generally has more resources and is better informed. He has also has benefit of having "learned" the lesson of what happened to subprime. If I am a prime borrower with one of these Option ARM mortgage that will reset in another two years, what might I do?

    One, I might try to get myself bailed out with the mortgage rescue bill that was just passed. My lender will take a hit, but not me. I have the good credit for a new fixed 30-year loan on my current home at a much lower valuation. I may have to pay a little more every month, but as a prime borrower, it's probably an amount I can absorb. I may have to share any gains should I be able to sell in the future for a profit, but it's a much better alternative than foreclosure.

    Another option is one that has been talked about many times before -- buying another home at much lower prices while my credit is good, and let the first home go into foreclosure.

    Will most of these borrowers take option 1 or option 2? Option 1 will avoid the foreclosures, and therefore limit supply and further price drops. But the banks will have to take a hit on the loans. Option 2 may actually add demand to the market, though the supply of homes will stay relatively the same. For every home bought, another will show up as a foreclosure. The banks will still take a hit.

    So the way I see it, the banks will lose either way. But the prime borrowers can save their credit if they can qualify for the bailout. I think most people would like to stay in their current home. After all, they must have liked it well enough to have bought it in the first place.

    So while I agree more foreclosures are coming from the prime borrowers, I doubt it will be as big of a wave as from subprime. These prime borrowers have more "options" on their Option ARMs.
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