Mortgage Resets: One shoe dropping

Atrios is concerned that there will be a second wave of foreclosures when the next wave of option ARMs reset:

Option ARM rates are going to be recasting soon and in increasing numbers. That’s the magic moment when people can no longer make minimum payments, when they can longer make interest-only or neg-amortization payments.

Ryan Avent points out that most of the defaults associated with resetting mortgages happen before the reset occurs:

He notes that if you chart 2/28 and 3/27 mortgage defaults over time, you don’t see the kink at the 24 or 36 month mark you’d expect if the reset was doing most of the work in generating foreclosures. What they found was that defaults were happening surprisingly quickly — basically, underwriting standards were so terrible that borrowers couldn’t even afford the initial payment.

As the bust has proceeded, by contrast, defaults have mainly resulted from the combination of negative equity and some kind of income shock — job loss, death or illness, divorce, and similar.

And Megan Mcardle concurs and offers follow-up:

The problem is not principally people who can’t pay their mortgages because their interest rates have reset–people will cut back on a lot of other things to keep their house, and if you can’t afford a 1% rate increase even with drastic lifestyle cuts, you probably have too much house.  Rather, the main problem is people who have an income shock.

The initial point about resets is absolutely correct. The people I’ve talked to at the Boston Fed and elsewhere who have dealt with this data have all been completely surprised by how much the resets don’t matter. But I want to expand on it, because the point is slightly different – these loans were designed never to be paid off and to be not active at the time of the reset.

For subprime mortgages, Megan is overstating that the rate reset were minimal. Check out these rates:

(For this entry, I am using data and graphs from the excellent – Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures, a Fed working paper. full paper here, pdf slides here. Last version is May 2008, so it is looking at the height of the subprime market, 2004-2007.)

Rates go from about 8% to above 11% after the two year mark. In general, the numbers I’ve heard say that mortgage payments increased about a third after a reset. This is fine if the first, cheaper, payments is much less than what you can afford to pay per month. However most buyers could barely afford the 8% rate (which was high compared to prime mortgages). So the model was to refinance. All the time. Every two years, refinance. Get close to the jump, maybe a payment or two into it, and then refinance. The banks knew this, so their strategy was to get their cut from the prepayment penalties they could legally charge (I need to go back and actually write out that model for banning prepayments), while always making refinancing available until the credit crunch came.

Instead of being a business based around collecting interest off loans, it became a business based off collecting high fees off loans. It became, though the Boston Fed is loathe to use this analogy, a credit card company business model.

Let’s look at some empirical evidence:

This chart is hard to read, but take a minute to grasp it. This is from December 2007. The lines under Still Active reflect how many of the subprime loans are no longer active (in 12/07) percent wise, by time from origination. So for subprime loans originated in 2004, 81.6% were no longer in existence by month 30. They either defaulted or refinanced. Roughly ~18% of these mortgages defaulted by month 24 across all years. The rest were refinanced. If their FICO got high enough during that time period, they refinanced into a prime loan. For most, they refinanced into another subprime loan, another spin around the wheel. The evidence leads us to believe that if they couldn’t refinance, they would have been in a very risky situation.

We ended up in a situation where a product, a mortgage, that should be designed to survive a 360 month time horizon, were gone 80% of the time within 30 months. 10% of the mortgages don’t even make it 6 months! Given that it takes a few months to end the contract, that’s one out of ten not being able to make more than two payments. I can’t get a $60/month cable package if the cable company doesn’t think I own $120. Where were the underwriting standards!?!?

(If you can read heartbreak in math, look at the additional jump in months 25-30, where it goes from ~67% to ~81%. That’s some poor struggling household opening their mortgage bill and seeing their amount due jump up a third. They forgot, and their friendly neighborhood shadow bank sure as hell wasn’t going to remind them. The bank then makes sure they can squeeze some juice out of the jumped mortgage rate before sending them back to month 1 on the chart with a refi. Also note the last line in 2005 and 2006 – note how they drop off. That reflects, in December 2007 when this chart was compiled, people calling in for a refi and the bank responding “Sorry, there’s no more money.”)

So when Ryan points out that there isn’t much to worry about since most of it is has been decided by the date of the reset, that’s true, but that’s true conditional on functioning mortgage markets. It’s especially true conditional on people saying “we can refinance that crappy mortgage that is falling apart into a brand new crappy mortgage that resets the clock.”

As for the loans Atrios is alluding to, I am not in the doomsday camp on them, but I think there is real worry that they are going to put the resets into play in a way we haven’t see before in the data. I don’t know the specifics on where the markets stand, but if there isn’t a wave of mortgage liquidity that can handle the jumps in refinances in months 19-24 and 25-30 you see above, we are in uncharted territory in crap mortgage land. Hold onto your hats.

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6 Responses to Mortgage Resets: One shoe dropping

  1. Steve Sailer says:

    Subprime loans were always a terrible idea, but the real problem was the huge increase in subprime lending following George W. Bush’s October 15, 2002 White House Conference on Increasing Minority Homeownership, where degrading credit standards was rationalized as being necessary to help minorities get their fair share of the American Dream.

    This was a highly bipartisan effort. For example, on March 29, 2007, Barack Obama’s chief economics adviser during the campaign, Austan Goolsbee, wrote in the NY Times:

    ‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded

    “The traditional causes of foreclosure, even before there was subprime lending, were job loss, divorce and major medical expenses. And the national foreclosure data seem to suggest that these issues remain paramount. The latest numbers show that foreclosures have been concentrated not in places where real estate bubbles have supposedly been popping, but rather in places whose economies have stagnated — the hurricane-torn communities on the Gulf of Mexico and the industrial Midwest states like Ohio, Michigan and Indiana, where the domestic auto industry has suffered. These do not automatically point to subprime lending as the leading cause of foreclosure problems.

    “Also, the historical evidence suggests that cracking down on new mortgages may hit exactly the wrong people. As Professor Rosen explains, “The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated against, the people without a lot of money in the bank to use for a down payment.” It has allowed them access to mortgages whereas lenders would have once just turned them away.

    “The Center for Responsible Lending estimated that in 2005, a majority of home loans to African-Americans and 40 percent of home loans to Hispanics were subprime loans. The existence and spread of subprime lending helps explain the drastic growth of homeownership for these same groups. Since 1995, for example, the number of African-American households has risen by about 20 percent, but the number of African-American homeowners has risen almost twice that rate, by about 35 percent. For Hispanics, the number of households is up about 45 percent and the number of homeowning households is up by almost 70 percent.

    “And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.

    “When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.

    “For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage. ”

  2. racerx says:

    The subprime data is an eye opening illustration at how poor underwriting (really it’s more like loan processing since risk or ability to repay was never assessed) was during this period. The fact that so many loans went bad so quickly is a very telling indicator of fraud and speculation. If a loan goes bad in 6mo you were probably conned.

    Should mortgages be designed with the intent to survive a 360 month time horizon? If someone underwrote mortgages with that mindset very few borrowers would qualify.

  3. Aki_Izayoi says:

    Yes, it is all because of those Hispanics and blacks with their low IQs. Keep telling us Steve.

  4. Pingback: Will Dearman Lifestream » Daily Digest for May 8th, 2009

  5. orbital says:


    you’re missing one critical component — there’s a difference between a reset and a recast. the reset is obvious — on a 3-year ARM it comes in the third year.

    but a recast is automatic–it’s a function of the LTV of the loan. since these loans have negative amortization, there’s a limit to how much the borrower can go underwater (usually something like 110% or 115% of total property value). once you hit that threshold, the ARM recasts immediately, and you end up with payments 50-100% higher.

    this is why it can be a big surprise to many homeowners — they thought they had five years, when in reality they only had two. this wasn’t considered a timebomb at the time because the assumption was that the neg am would never get to 110%–they could always reassess the value of the property to keep the ratio consistently under the maximum amortization limit. that hasn’t worked out so well.

  6. Ron Stone says:

    I think these resets are a ticking time bomb. What worries me is all the mortgage ARMs out there where people planned on either selling a home or refinancing. As to selling a home, I don’t need to elaborate on the problems with that. On people planning on refinancing, stuff can and has happened. The result in many, many cases is job loss, business slow down, etc. And that could easily mean many of those people intending on refinancing can no longer qualify so they are stuck with an ARM that could easily become unaffordable.

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