“The first wave of Americans to default on their home mortgages appears to be cresting,” writes Vikas Bajaj in this morning’s New York Times, “but a second, far larger one is quickly building.”
Homeowners with good credit are falling behind on their payments in growing numbers, even as the problems with mortgages made to people with weak, or subprime, credit are showing their first, tentative signs of leveling off after two years of spiraling defaults.
The percentage of mortgages in arrears in the category of loans one rung above subprime, so-called alternative-A mortgages, quadrupled to 12 percent in April from a year earlier. Delinquencies among prime loans, which account for most of the $12 trillion market, doubled to 2.7 percent in that time.
What’s especially interesting is how closely the scenario outlined in the Times article matches up with this chart, published last year by the International Monetary fund using data from Credit Suisse, showing the value of mortgage rate resets due to happen each month between 2007 and 2015. (A reset is when the repayment terms of a loan change—invariably by increasing—according to a schedule determined by the loan contract.)
Earlier this decade, as the ballooning housing market pushed the affordability index past the point where the average first-time homebuyer could afford a typical home in many areas, the real-estate industry kept the boom going by offering “teaser-rate” mortgages. These loans had artificially low annual percentage rates that were only good for the first few years of the contract, after which they would reset to a much higher APRs that the buyers in many cases would not be able to afford. As long as housing prices kept going up, the story went, buyers would be able to use the increased equity in their homes to refinance into more affordable loans. Then housing prices stopped going up.
As the IMF graph shows, the problem began a couple of years ago with a huge wave of resets in the subprime market, giving rise to talk about the so-called “subprime crisis.” It has been the failure of these loans that has been responsible for much of the turmoil in the housing market over the past couple of years. By early 2009, however, most of the subprime resets will be over and done with. Then, beginning in early 2010 and continuing for a couple of years, there will be another big wave of resets, this time in alt-A and option ARMs.
As this scarily prophetic Business Week article from nearly two years ago puts it, option adjustable rate mortgages — the so-called “pick-a-payment” mortgages — “might be the riskiest and most complicated home loan product ever created.” Option ARMs offer several payment choices each month, typically differing by thousands of dollars. The least expensive option doesn’t even cover the full amount of the interest due on the loan, so the leftover interest gets added to the principle (a situation called negative amortization). Option ARMs sold like hotcakes during the boom, accounting for 9 percent of the volume of all mortgages sold in the US in 2006, and significantly more in boom states like California and Florida.
According to Standard & Poor’s, more than 75 percent of option ARM holders were making only the minimum monthly payment in 2007.
Those attractive payment options come to an end when the mortgage resets. Faced with a monthly payment that’s nearly double what they’ve been making, a debt that’s tens of thousands of dollars bigger than it was when they took it out, and a home that may be worth less than their outstanding debt by a wide margin, many homeowners will be forced to default or to seek protection in bankruptcy court.
Option ARMs, it can’t be pointed out often enough, are prime loans, not subprime. As today’s Times article notes, prime and alt-A loans make up a much bigger percentage of most banks’ mortgage portfolios than subprime loans do, raising the specter of a new wave of defaults that may dwarf the troubles we’ve already seen:
“Subprime was the tip of the iceberg,” said Thomas H. Atteberry, president of First Pacific Advisors, a investment firm in Los Angeles that trades mortgage securities. “Prime will be far bigger in its impact.”