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The Mortgage Corner

What happened to the toxic mortgage problem? It was touted several months ago that perhaps up to $4 trillion in toxic mortgages were being held by financial institutions that could blow up and blow more holes in our financial system.

But in fact lower interest rates are lowering the risk of such a wave of defaults. First, the facts. What is a toxic mortgage? It is probably either an Option ARM, or shorter-term 5, 7, or 10-year fixed rate ARM that will go to a fully amortized ARM interest rate at the end of the fixed term. So the problem occurs when it adjusts and borrowers must begin to pay back the principal loan amount at current interest rates.

In the case of the Option ARMs (OA), borrowers had the choice of paying a minimum payment—originally as low as 1 percent—an interest only payment, or pay down principal with a 15 or 30-year amortization payment. Most, of course, chose the minimum payment, which for most OAs wouldn’t be recast to a fully amortizing payment until the fifth year (except for World Savings’ loans—see below).

Since most of these loans originated in 2005-07, they will be recast 2010 to 2012. So the question is what will interest rates be at that time? Today, if recast, the OA or fixed rate ARM borrower is in the best of worlds. Their index will probably be either the LIBOR (London Interbank Overseas Rate), or MTA (monthly treasury average), which are now at or below 1 percent, thanks to the Federal Reserve.

And since most borrowers have margins that were between 2 and 2.5 percent on a primary home, that means the real interest rate is currently hovering between 3 to 3.5 percent; much better than today’s interest rates. Actually, OA holders should be taking advantage of the record low interest rates by paying more than the minimum payment. It could be at least interest only, for instance, or even the 30-yr amortized payment. In fact, the minimum payment amount, which rises 7.5 percent annually for 4 years before the recast, may itself help to pay down any negative amortization that had accrued when interest rates were higher.

Fitch Ratings says there are just $189 billion in securitized OAs outstanding, so the number of toxic mortgages may not even be a major problem, but only if the Fed keeps interest rates low for a prolonged period of time, as they say they will do. The holders of World Savings pick-a-payment Option Arms are in an even better position, as their loans don’t recast for 10 years.

And borrowers are paying down their mortgages with a vengeance, as I have said. For Q2 2009, the Net Equity Extraction was minus $48 billion, or negative 1.8% of Disposable Personal Income (DPI). The Fed’s latest flow of funds report shows the amount of mortgage debt outstanding is declining, and this is partially because of debt cancellation per foreclosure sales (and a little from modifications), and partially due to homeowners paying down their mortgages (as opposed to borrowing more).

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Credit Suisse came out with an even more radical forecast. The Option ARM problem could be over by 2014! I.e., those loans would either be paid off or written off by then.

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What happened? Firstly, Credit Suisse is reckoning that perhaps 40 percent will have walked away from their homes and loans. And with such low interest rates, many in fact are paying down their principal even with minimum payments, since those payments keep rising until the fifth year, while the underlying interest rate, which adjusts monthly, continues falling. Therefore, the danger of reaching maximum negative principal balance (usually from 115 to 125 percent) seems to have passed for several years, at least.

This is why this is a window of opportunity for Option ARM (and fixed rate ARM) holders to keep their homes—by bringing down their principal balance so that it coincides with current housing values.

Harlan Green © 2009