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Two reports out yesterday revived fears that waves of new foreclosures will come crashing down on residential real estate markets as borrowers default on exotic adjustable rate mortgages (ARMs) that will reset over the next three years.

Waves of Resets Promise a New Foreclosure Flood

Two reports out yesterday revived fears that waves of new foreclosures will come crashing down on residential real estate markets as borrowers default on exotic adjustable rate mortgages (ARMs) that will reset over the next three years.

It’s very bad news that’s sure to sell newspapers, as they used to say back when newspapers were made of paper, and both reports earned prominent stories in the Washington Post and New York Times.

The first report, by Fitch Ratings, warned that of the $189 billion securitized Option ARM loans outstanding, 88 percent have yet to recast. Of these, 94 percent of borrowers have utilized the minimum monthly payment to allow their loans to amortize negatively. ‘Having not demonstrated their ability to make payments at the full rate, option ARM borrowers are at the greatest risk of default resulting from payment shock,’ said Group Managing Director and U.S. RMBS group head Huxley Somerville.

Especially alarming is the finding that nearly half (46 percent) of all Option ARM loans studied by Fitch are delinquent 30 days or more despite the fact that only 12 percent have recast. Buyers are giving up and “strategically defaulting” before the recasts hit.

Fitch’s prediction for expected losses from Option ARMs range between 35 percent to 45 percent. Negative equity cause by falling values, especially in the four states of California, Florida, Nevada, and Arizona, which account for 75 percent of all Option ARM loans, has caused prospects for Option ARM borrowers to deteriorate. As a result, Fitch increased its forecast of Option ARM losses to 60 percent in those states from 40 percent a year ago.

Because of falling property values, Fitch is more negative about Option ARMS than it was in a highly publicized report issued a year ago. Then it predicted roughly $29 billion worth of loans would recast to higher monthly payments by the end of 2009 and an additional $67 billion would recast in 2010. Fitch predicted delinquencies on option ARMs would more than double, and option ARM defaults would likely spread the foreclosure plague into higher priced neighborhoods, because many borrowers leveraged the very low minimum monthly payment to buy more expensive homes. To make matters worse, only 17 percent of option ARMs written from 2004 to 2007 required full documentation.

The good news about Option ARMS is that they account for “only” 1.3 percent of percent of outstanding mortgages and were used by a far smaller segment of the population than subprime mortgages, according to First American CoreLogic as cited in the Washington Post, and they are highly concentrated in four states, as noted.

The second report, by First American CoreLogic for The New York Times, shows there are 2.8 million active interest-only home loans worth a combined total of $908 billion. Interest-only loans, popular during height of the boon, allow borrowers to make payments only on the loan’s interest for a set period. Then payments for the principle also kick in and monthly payments can jump by as much as 75 percent. With many homes underwater, borrowers can’t refinance.

The interest-only periods, which put off the principal payments for five, seven or 10 years, are now beginning to expire. In the next 12 months, $71 billion of interest-only loans will reset. The year after, another $100 billion will reset. After mid-2011, another $400 billion will reset, for a total of $572 billion.

Should the interest-only wave produce foreclosures at the same 35 to 45 percent loss rate that Fitch forecasts for Option ARMs, expect the interest-only wave to create $200 to $266 billion worth of foreclosures. Add to that the Option ARM losses of 35 to 45 percent of $100 billion, we could expect resets of exotic loans to create $235 to $311 billion worth of new foreclosures over the next three years. By comparison, the subprime meltdown that kicked off the housing crisis generated roughly $400 billion worth of foreclosure losses, and they are still coming in.

In spite of the seriousness of the pending resets-a situation made even more serious by the inability of either the private sector or the government to mount a loan modification program of sufficient effectiveness and size to make a dent in these forecasts the major cause of foreclosures is not toxic loans but unemployment. Prime fixed rate loans that don’t reset now account for one in three foreclosure starts, according to the Mortgage Bankers Association’s second quarter delinquency survey. A year ago they accounted for one in five, while delinquencies caused by ARM resets are declining. What’s worse, delinquencies caused by unemployment are almost impossible to modify because out-of-work borrowers have lost their source of steady income.

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