60 Minutes did a report this week on what many of us who are following the mortgage market mess have known for awhile - there is still a big second bubble of "exotic" mortgage loans out there that are just starting to hit the market - and are expected to default in big numbers. The adjustable rate subprime loans have for the most part reset, causing massive defaults and foreclosures, but the Alt-A loans and the Option ARM loans are just starting to reset.
Alt-A loans are loans made to people with good credit histories (so not subprime by definition), but who could not provide verification of income or assets. They are usually interest-only, adjustable rate loans. Option ARM loans are typically negative amoritzation or interest-only loans with low teaser rates that will eventually reset to higher monthly payment amounts. The following chart from Credit Suisse shows how we are currently in a trough between the end of subprime adjustable rate resets and the beginning of the Option ARM/Alt-A resets (click for a larger chart):
As you can see by the chart, the bulk of the resets are yet to come over the next three years - causing many mortgages to reset with higher interest and therefore higher monthly payments. With home prices already very depressed, the question becomes whether homeowners with these types of mortgages will stick it out and continue to pay the higher monthly amount - or give up and walk away from their homes because of how far underwater they are on their loan. As I wrote earlier this week, Arizona is particularly susceptible to the "walk away" effect because of the current consumer protection laws in place.
Credit Suisse revised their predictions earlier this month to predict that 8.1 million homes will go through foreclosure in the next four years (approximately 16% of all home mortgages). Currently about 1 in 10 home mortgages are in default or in foreclosure.
One mitigating factor recently has been the drop in interest rates used to calculated the adjustable interest for these loans. Many loans are tied to LIBOR, various U.S. treasuries or COFI (popular in California). The lowering of these rates has made the adjustments in interest rates more bearable for most buyers - as their mortgage payments haven't jumped quite as high as they would have earlier in 2008. But with negative amortization loan, deferred interest has been building up and is now added into the principal amount going forward. So interest is paid on a higher amount and still creates a fairly significant jump in most borrower's monthly payments.
What is a bit scary about the 60 Minutes report is that analysts are seeing the Alt-A and Option ARM default rates increasing even before they adjust to higher payments. One of the effects of foreclosures in the subprime market over the past year has been rapidly deteriorating home values - particularly in Arizona. Like dominoes, a foreclosure in a neighborhood can cause others to simply walk away from their homes due to their home being worth so much less than their outstanding loan. So foreclosures are starting to seep into the prime mortgage market as well in many areas. The resets in Option ARM and Alt-A loans over the next three years may exacerbate this problem and continue the downward spiral of home values and the spike in foreclosures that Arizona is currently seeing.
As I have said before, I think the solution to stop the bleeding is for banks to come up with a formula to adjust principal downward by a reasonable amount during loan modifications so homeowners feel like they won't be underwater for 10 to 15 years and it is worthwhile to stay in their home (as many people in Arizona currently will be). The obvious problem here is that it creates an incentive for homeowners who are not in trouble to try to get their principal adjusted downward. So banks will have to figure out a way to screen for people who truly need help (no easy task I admit).
Below is the full 60 Minutes report. It is worth watching and goes through many of the issues I just highlighted. Only briefly addressed in their report - and something I did not touch on in this post - is that many expect a wave of commercial real estate loan defaults in the next two years as well.
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