A Crisis in Adjustable Rate Mortgages

I just wonder if the mortgage crisis along with other problems in the US economy such as the cost of Iraq and Afghanistan and the balance of trade issue will not eventually lead to a depression. I watched in amazement as the stock market reached new highs but perhaps the downward plunge has begun now.


NY Times, August 1, 2007
Economic Scene
Keep Your Eyes on Adjustable-Rate Mortgages
By DAVID LEONHARDT

Two years ago, when the housing market was roaring along, I called a
mortgage broker on the West Coast and asked for some help. I told him
that I wanted to interview some recent home buyers who had taken out an

adjustable-rate mortgage — one of the big drivers of the boom — and
he
was nice enough to pass along a short list of names.

One of the buyers was a business consultant in her 40s. She told me
about her charming new house and the fact that she expected it to be a
good investment, even if it had cost a bit more than she wanted to
spend. Then I asked about her adjustable-rate mortgage.

“I don’t have an adjustable rate,” she said.

Confused, I called the broker again to see what was going on. A little
while later, I got a sheepish e-mail message from him explaining that
her loan did, in fact, have an adjustable rate. She just hadn’t
realized it.

Now, I think this was an honest misunderstanding in which the broker
believed that he had explained the terms of the loans more clearly than

he had. And the mortgage ended up being a good one for the buyer
anyway:
she recently decided to move to a new area and sold the house before
her
rate jumped.

But the fact that this confusion could have occurred neatly captures
the
ridiculous state of the home buying business in 2005 and 2006. The
fallout is going to last a long time. House prices will need years to
work off their irrational values, more people are going to lose their
homes and Wall Street can probably look forward to some more nasty
surprises.

In fact, the mortgage meltdown has arrived at something of a turning
point. So far, most of the loans gone bad were among the worst of the
worst. Some were based on outright fraud, either by the lender or the
borrower. In many cases, buyers were never going to be able to make
their monthly payments and were instead banking on a rapid appreciation

in home values.

But the pool of people falling behind on their house payments is
starting to widen beyond this initial group, and adjustable-rate
mortgages are the main reason. Starting in the spring of 2005, these
mortgages began to get a lot more popular, largely because regular
mortgages no longer allowed many buyers to afford the house they
wanted.

They turned instead to a mortgage that had an artificially low interest

rate for an initial period, before resetting to a higher rate. When the

higher rate kicks in, the monthly mortgage bill typically jumps by
hundreds of dollars. The initial period often lasted two years, and two

plus 2005 equals right about now.

The peak month for the resetting of mortgages will come this October,
according to Credit Suisse, when more than $50 billion in mortgages
will
switch to a new rate for the first time. The level will remain above
$30
billion a month through September 2008. In all, the interest rates on
about $1 trillion worth of mortgages, or 12 percent of the nation’s
total, will reset for the first time this year or next. A couple of
years ago, by comparison, only a marginal amount of mortgage debt — a

few billion dollars — was resetting each month.

So all the carnage in the mortgage market thus far has come even before

the bulk of mortgages have reset. “The worst is not over in the
subprime
mortgage market,” analysts at JPMorgan recently wrote to the firm’s

clients. “The reason for our pessimism is that loans originated in
late
2005 and all of 2006, the period that saw peak origination volumes and
sharply decreased underwriting quality, are only now starting to reset
in large numbers.”

It isn’t hard to figure out what will happen when buyers who were
already stretching to afford a house are faced with suddenly higher
payments. Many will manage. They will cut back on other spending, or
they will refinance their mortgage and get a new one they can afford.
Others, like the buyer I interviewed two years ago, probably planned
all
along on selling their homes after a few years. For them, the
artificially low initial rate was a no-lose proposition.

But there are also likely to be a shocking number of people who lose
their homes. From 1994 to 2005, some 3.2 million households were able
to
buy homes thanks to subprime mortgages or other such loans, according
to
an analysis by Moody’s Economy.com. About 1.7 million of them will
probably lose their homes to foreclosure when all is said and done.
More
than half of the homeownership gains from subprime mortgages will be
erased.

The flood of those homes onto the market will further depress house
prices. So will the newfound conservatism of mortgage lenders, which
will make it harder for tomorrow’s buyers to get a mortgage. (Thank
goodness.) The S.& P./Case-Shiller index of home prices covering 10
major cities has fallen about 3 percent since its peak last summer. Two

or three years from now, JPMorgan predicts, the index will have fallen
15 to 20 percent. Adjusting for inflation, the decline will be worse.

The big unknown is whether the housing bust will cause a recession or a

bear market. Most people who have looked closely at the mortgage market

argue that the answer is no and that the damage will be contained.
Subprime loans still make up a distinct minority of the mortgage
market.
Over all, only 3.4 percent of mortgage holders are currently behind on
their payments. And as Victoria Averbukh, a former mortgage analyst at
Deutsche Bank now teaching at Cornell, points out, “The housing
market
is still a limited portion of the U.S. economy.” Consumer spending
has
slowed recently, but is still fairly strong. Corporate balance sheets
and the job market seem fine.

Rationally, the argument for optimism is pretty compelling: the
economy’s strengths do look big enough to overcome its weaknesses.
Yet
even many of the optimists confess to an uncomfortable amount of
uncertainty. There has never been a real estate bubble like the one of
the last decade. So it’s impossible to know what the bust will bring,

especially when there are still so many mortgages that are about to get

a lot more expensive.

E-mail: Leonhardt@nytimes.com