[NYTr] Housing Bubble: Clock is running down on 'cheap' mortgages

[nytr at olm.blythe-systems.com]

sent by cherie (activ-l)

Herald Tribune, Florida - Jan 3, 2006
http://tinyurl.com/8aujx

Clock is running down on 'cheap' mortgages

Now comes the hard part for holders of certain loans

By Michael Pollick

You know those cheap mortgages that everybody's been getting to speculate on
housing? Where somebody at the other end of a toll-free phone will lend you
$200,000 and your payment will only be $678 per month?

Lenders who started making those teaser-rate loans a few years ago are
getting ready to charge real-world payments on them.

Starting in 2006 and accelerating into 2007, as much as $2.5 trillion worth
of the fancy mortgages called "hybrids" are coming to the end of the
free-lunch part of the deal.

And while prices in Southwest Florida are hovering at twice those of three
years ago, the house party seems to have ended in July. Since then, as
mortgage rates continue their upward creep, inventories are stacking up,
while the rate of closings is slowing down.

The best-case scenario for the future, the one from the real estate agents,
is that prices will level out to single-digit appreciation rates.

Assuming that scenario, some would-be investors -- those who took out highly
leveraged loans with extremely low payment options -- could soon find
themselves owing more on a house than it is worth.

That's called being "upside down" in a loan.

Many more will simply find that their monthly bill has instantly risen by
roughly the amount of a car loan. The reason is that after their initial
one-, two- or five-year interest, their loans are now scheduled to "reset"
at more realistic rates, and will continue to do so, usually for the life of
the loan.

Economists are still trying to put numbers on this reset factor,
particularly when it comes to the riskiest home loans, referred to as
"sub-prime."

"We don't have enough data to know how big a problem this will be," said
David Berson, chief economist at Fannie Mae, the nation's largest mortgage
packager.

For now, though, the lending party is still going strong.

"The mortgage business has been banging for the last five, six years," said
Marta Grande, managing broker at Sarasota's Commonwealth Mortgage. "It has
just gone crazy."

Personally, Grande likes what a borrower can do with an adjustable-rate
mortgage, or "ARM."

"I've owned six homes, and every one of them has been an ARM. But I tell
people today to get a fixed because I think rates are going to go up."

The ticking clock

Sarasota's John Barron is typical of the new crop of homeowner-investors. He
and his wife, Lauren Wood, are sitting on big profits at their two 2004
purchases in the up-and-coming Gillespie Park neighborhood, close to
downtown Sarasota.

But the couple made their big moves using ARMs that are about to be reset.
If they don't act soon, their monthly bills will rise by hundreds of dollars
per month.

They used two separate three-year, interest-only, adjustable-rate mortgages
from SunTrust Bank to buy the homes within the past two years.

And there's more, Barron said.

"Besides the two ARMs, we also took out a home equity line on the Seventh
Street house to put down a deposit on the Fifth Street house. There was no
cash that we had in our pockets to put down on the Fifth Street house. All
we had was our shining credit record. And the faith that the banks have in
this real estate market that allows you to borrow 100 percent."

If they don't sell, with interest rates rising, the couple will have to
refinance the loans.

Barron and Wood have a lot of company, says Paul Kasriel, chief economist at
Chicago-based Northern Trust.

With possibly $2.5 trillion in household debt that is going to be repriced
higher "the household debt-service ratio is bound to climb to new highs,"
Kasriel wrote last month.

Even before the reset gets under way, households were devoting a record
13.75 percent of their after-tax income to servicing debt, including
mortgage debt.

And the screaming housing boom of the last three years?

"There will be an end to it. I think it is going to be related to further
increases in interest rates," Kasriel said during an interview.

"Asset bubbles are characterized by cheap credit. Usually what bursts a
bubble is higher cost of credit, because that is what inflates the bubble,
is cheap credit."

Risky but not riskiest

In the Sarasota-Bradenton-Venice region, prices for existing single-family
homes have risen at one of the fastest clips in the nation during the past
three years.

Prices in Sarasota-Bradenton-Venice have risen 93 percent, a rate roughly
triple the national average and well ahead of the 79 percent growth rate for
the top 20 metro areas in the nation.

But the feverish activity seems to have dried up.

In July, only 1,626 existing single-family homes were available for sale in
the Sarasota market, and Realtors were closing sales at the rate of 156 per
week. Dividing that sales rate into the number of listings, it was a
10.4-week supply of homes.

By mid-December, though, the picture had changed dramatically. Sales had
slowed to a rate of 100 per week while listings rose more than 170 percent.

Even so, National Association of Realtors researchers are cheery about the
future of Southwest Florida property because of several factors: a strong
job market, the continuing influx of wealthy retirees and, in their view,
the acceptable degree to which the market is leveraged in loans.

NAR measures mortgage risk as "mortgage servicing cost relative to the
median income."

For Sarasota-Bradenton-Venice, that ratio stands at 24 percent, higher than
the 16 percent national average but well below the 30 percent for the top 20
metropolitan areas.

The NAR concludes that the Sarasota loan level "implies no widespread
financial overstretching to purchase a home in the region." But the
organization admits that "there is no good data on ARMs or interest-only
loans for the local market" and grants that "there have been some reporting
in the media of a higher use of these loans in recent years compared to the
past."

The house specialty

Local mortgage brokers are perfectly willing to add to the preponderance of
evidence about high-leverage mortgages.

At Sarasota's Integrity Mortgage Group, ARMs have far and away taken over as
the most popular.

Five years ago, there was only an occasional one-year or five-year ARM.

"Out of 200 loans you'd do 10 adjustables," Integrity President Jason
Thurber said. "In the last year, I've probably done five fixed-rate loans,
30- or 15-year, out of 150 loans. So all the rest are some kind of hybrid."

The big picture looks similar, says SMR Research of Hackettstown, N.J.,
which regularly surveys lenders who make 90 percent of America's home loans.

"I can say that the first half of this year, ARM share was 55 percent
nationally," said SMR's George Yacik. "For the full year 2004, it was 50
percent."

Surprisingly, that shift toward adjustables has happened in an environment
in which fixed-rate loans are extremely attractive, Yacik said.

Even after a year of moderate increases, the 63/8 percent you can lock on a
30-year fixed-rate mortgage is much closer to a 50-year low than to any
high.

Making matters worse, it is the the sub-prime lenders issuing the most
adjustable-rate mortgages. With those who participate in the survey, 80
percent of their loans were ARMs compared to 55 percent in the broader
market.

So when do these loans adjust?

Surprisingly, there is little data that is publicly available on that
subject. The best resource is a study conducted in the spring by Fannie Mae,
a federally chartered corporation that buys mortgages after lenders have
issued them. Fannie Mae looked at 2002-2004 loan data to determine what
portion of the existing loan pool would be "adjusted," and when.

Fewer than 10 percent of the conventional conforming loans will reset in
2006-2007, but nearly two-thirds of sub-prime loans will. That is because a
large portion of the sub-prime loans are two-year adjustables, says Berson,
the Fannie Mae chief economist.

Berson offered a typical example of what the industry calls a "2-28," an ARM
in which the interest rate is fixed for the first two years and then adjusts
regularly for the next 28 to whatever index the loan calls for. The average
yearly cap on this loan is 2.3 percentage points per year.

If the consumer took out this two-year ARM in December 2003, he started out
paying a typical rate of 7.7 percent, Berson said.

"You would be getting a letter from your lender this month telling you that
next month, your rate would be going to 10 percent."

Roughly speaking, a consumer's monthly bill could rise from $330 to as much
as $1,425 to $1,755.

If the loan started out as interest-only, the shift in payments would be
even larger.

Fannie Mae expects sub-prime loans to be reset en masse this year with that
trend continuing into 2007.

But over at the Mortgage Bankers Association, senior economist Michael
Fratantoni is more interested in the five-year adjustables that were issued
during the refi craze of 2002-03. That's a large crop that will sprout in
2007.

"The estimate is that in 2007, more than a trillion dollars worth of hybrids
are going to hit their first reset date," he said.

That one chunk of hybrid loans represents 12 percent of the $8.8 trillion in
single-family home loans outstanding nationwide.

The genesis

To find fixed-rate mortgages as cheap as the 5.83 percent average of
2003-04, you'd have to go back to the 1950s and early '60s.

Starting in 2003 and accelerating into 2004, lenders in 2003 began adding
enticements to make ARMs an offer that consumers would find hard to refuse.

"You had lenders with large origination machines running full tilt, and they
decided to keep those machines running, so they started to push more
heavily," said Keith T. Gumbinger, vice president of mortgage data publisher
HSH Associates.

Lenders started by adding the interest-only feature to basic adjustable-rate
mortgages such as the 2-28.

With interest-only, the lender is telling the mortgagee not to worry about
principal payments at first, but after the freebie years have ended, the
borrower is stuck paying the entire principal in a compressed 28-year time
frame.

Other marketing features gradually found their way into the market. "No doc"
loans, now quite common, mean the borrower doesn't have to provide any
documentation that he has earnings, such as paycheck stubs.

Lenders started covering for lack of downpayments by making "piggyback
loans" where they issue a first mortgage covering 80 percent of the purchase
price, and then either a second mortgage or an equity line covering the
remaining 20 percent.

"Everybody goes away pretty happy," Gumbinger said. "With the exception that
there is a property out there that is mortgaged to 100 percent of its
price."

Like many ARM borrowers, Barron, the Gillespie Park buyer, is not really
sure how much his payment will go up when the loans are reset. The new rate
is a moving target.

"Come year four, they adjust it based on the prime rate," he said. "It is
like prime rate plus two, or, I can't remember exactly what the adjustment
is. They can never raise it more than 2 percentage points. That can add up
pretty fast."

'Neg Am'

Now, lenders are pushing an exotic mortgage that is so leveraged it makes
Barron's straight adjustables look tame.

Just like it sounds, the option ARM gives the borrower a set of optional
payments to choose from each month, ranging from minimal to hefty.

"It sounds like a product that some derelict accounting firm would come up
with, but it makes sense for some workers," said Mark Vitner, Wachovia
Bank's senior economist.

Option ARMs were designed for people who are highly compensated but receive
their income in chunks, such as Realtors, but they are now "being used much
more widely than it was ever intended," Vitner said.

At Washington Mutual's Bee Ridge Road office in Sarasota, 25 percent of
current applications are for option ARMs, says senior loan consultant Mike
Bangasser.

The interest rate on the bank's "one-month option ARM" changes monthly based
on a moving average of one-year Treasury bills, with the only limit a
lifetime cap of 9.95 percent.

For customers with good credit, there is only about a half-percentage point
difference between the 5.75 percent rate on an option ARM and the 6.375
percent rate on a 30-year fixed rate mortgage.

So why bother with the ARM?

This is the key: The minimum payment today on a $200,000 option ARM would be
only $678, a little more than half the cost on a 30-year, fixed-rate loan.
On that $200,000 loan, a 30-year fixed would be $1,248 per month in
principal and interest. With the option ARM, there are three other payment
choices: $958, $1,167 or $1,661.

The $678 payment doesn't even cover all the interest, Bangasser
acknowledged.

"Granted, your mortgage balance is going to go up under this scenario, but
as long as my property is appreciating, I personally don't care too much
what my mortgage balance is."

If a borrower decided to pay $978 this month, that would cover only
interest. The $1,167 would cover principal and interest, as if the loan were
amortized over the usual 30 years. The high-end payment of $1,661 "is a
15-year amortization and that would choke a horse," Bangasser said.

Not covering the interest on a loan is referred to in the industry as
negative amortization, "neg am" for short.

The loan gets bigger over time. Usually when it reaches some pre-determined
top, like 115 percent the value of the underlying property, the lender
forces the borrower to pay the loan's real price, or to refinance it, says
Grande of Commonwealth Mortgage.

In the meantime, the borrower is "paying juice on the juice," adds Thurber
of Integrity Mortgage.

He guesstimated that if somebody borrowed $250,000 on a typical option ARM
and made minimal payments for five years they would be "going to be in the
hole 15 percent to 20 percent of your original balance, meaning
$285,000 to $300,000."

"You don't have to have negative am," Grande said. "As long as you make that
fully-indexed payment, you're fine. But most folks aren't doing that. They
take the easy way out, get themselves in trouble."

There is one more ingredient to add to this layer cake, and it is one that
barely occurs to most borrowers today: What if someday, loans were difficult
to get?

"Consumers have become so accustomed to very liquid mortgage markets, where
credit is available for almost any circumstance, that they are not aware
this is unusual in the market," HSH's Gumbinger warned. "Somewhat tighter
credit availability and somewhat higher interest rates are much more
normal."

"Borrowers think they can always refinance. That is not always a safe bet."