The Next Housing Catastrophe Waiting to Strike

I hate to be the rain on Wall Street's parade this past Monday, but I'd say the market is getting a little ahead of itself in the celebration department. I agree that equities have been severely oversold and a wealth of value-oriented plays have been presented in the past few weeks of trading. However, I think investors are forgetting about a major piece of this housing crisis puzzle that could prolong the recovery of our economy.

Just when you thought things couldn't get worse...
After watching a 158-year-old bank go under, the government bailout of the likes of American International Group (NYSE: AIG  ) , Fannie Mae, and Freddie Mac (NYSE: FRE  ) , and a $700 billion plan implemented to help save the financial markets, it seems hard to fathom we could be on the cusp of further bad news. Unfortunately, I've got some more bad news.

It seems that the majority of investors, economists, and governmental leaders are overlooking a very important right hand side of this mortgage rate reset graph. The subprime loan reset period (represented by the green bars) may be nearing the end, but the lightly-shaded yellow bars represent $500 billion worth of option-ARM loans expected to reset from mid 2009 through 2012. 

In other words, the subprime mess was the earthquake and the next wave of option-ARM resets will be the aftershock no one saw coming.

So what's an option-ARM?
Everyone was entitled a home during the housing boom, right? No one could be turned away if they wanted to become a "homeowner." Alas, shady lending practices of our savvy mortgage brokers didn't stop at subprime lending. Borrowers who wanted to purchase a home but couldn't even afford the already low teaser rates of conventional ARM loans needed a way to finance their dream piece of real estate. The option-ARM fulfilled that need perfectly. It offered borrowers the chance to pay a minimum payment on the balance, which in many cases didn't add up to the full amount of the interest owed, let alone any portion of the mortgage balance.

When borrowers pay the minimum payment on their mortgage balance, the difference between the minimum payment and the full obligation is tacked on to the total mortgage balance. And while option-ARM loans aren't actually set to reset for five years following the origination of the loan, the structure of the loan only allows borrowers to drown in a specified amount of negative equity – to the tune of 110% to 125% of the original balance – until a surprise reset rate is triggered. To make a long story short, option-ARM borrowers will face significantly higher monthly payment increases in comparison to their conventional counterparts because the mortgage balance is now greater than the initial loan.

Similar, yet so very different
Lower interest rates may have helped ease the pain inflicted on subprime borrowers with their adjusted reset rates, but option-ARM borrowers are in for a much bigger surprise because their mortgage rates don't just reset, they recast. This means that borrowers will have to start making full payments on the loan according to a 30-year-amortized schedule. In effect, Fitch Ratings expects the average monthly payment to jump 63%. Given that many borrowers are already defaulting on marginal increases in the minimum payments due, it seems likely the recasting will be catastrophic to most of these borrowers.  

Of course, borrowers simply had the option to pay this minimum payment, along with three other possible payment options, two of which followed traditional 15 and 30 year amortization schedules. But like the tempting minimum payment option that flashes before you on your MasterCard (NYSE: MA  ) and Visa (NYSE: V  ) statement, borrowers were starstruck by the glamorous homes they could purchase well beyond their means under the teaser rates. Thus, it's pretty easy to assume the majority of home buyers weren't able to afford much more than the minimum payment option.

My thoughts may be based on speculation, but I recently ran across some stats that back up my conclusion. Credit Suisse recently suggested that roughly 13% of option-ARMs that were issued in 2006 were at least 60 days delinquent by the time they were 18 months old. According to Countrywide – not surprisingly a major player in this game – 72% of borrowers were making less than full interest payments and 83% received loans with little or no documentation. And 45% of Wachovia's (NYSE: WB  ) lending portfolio, worth $122 billion, consists of option-ARM loans, in which the average California borrower (where 60% of these loans were written) owes 109% of the value of the home.

To which I say: good luck, Bank of America (NYSE: BAC  ) and Wells Fargo (NYSE: WFC  ) shareholders.

Don't say we didn't warn you
According to Huxley Somerville, a director at Fitch Ratings, $29 billion of these loans will reset by the end of 2009 and another $67 billion in 2010. The drastic increases anticipated on each loan are expected to cause delinquencies to more than double.

Greenspan is bluffing when he suggests that the housing market crisis will bottom in early 2009 because the consequences we will face from these lending practices are inevitable. It may seem inane to introduce anymore fear into our already disturbed market, but the option-ARM loan market can only fly under the radar for so long.

For more on this turbulent economy:

Kristin Graham does not own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (55)

Comments from our Foolish Readers

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  • Report this Comment On October 15, 2008, at 5:38 PM, RayBrown3 wrote:

    Good report.

  • Report this Comment On October 15, 2008, at 6:03 PM, rarunach wrote:

    What's surprising is that nobody talks about option ARMs now! No wonder banks are hoarding cash and continue to swallow whatever capital that comes their way. Forget about lending for the next 3 years.

  • Report this Comment On October 15, 2008, at 7:31 PM, EAGDDS wrote:

    Great article. You are a very astute analyst and I think that your information should caution anyone thinking that this recession will be a V instead of a U or an L is sadly mistaken. This tsunami will provide plenty of secondary waves, so we should be very wary. I like the way you write.

  • Report this Comment On October 15, 2008, at 11:44 PM, InveSkeptic wrote:

    The housing bubble blogs have been pointing out the looming Alt-A and Option ARM resets since 2006. It's good to see the Fool now noticing. Hopefully you guys don't go recommending another housing builder in the lead up to it this time ;-)

    The unfortunate part is that our government will not notice until it's way too, and then overreact in all the wrong ways. History will repeat itself.

  • Report this Comment On October 16, 2008, at 9:27 AM, SteveTheInvestor wrote:

    Ah, some negativity. I love it. It's good to see some slap-in-the-face reality. It contrasts nicely with the seemingly constant need to buy stocks "on sale" as has been advocated over the last year (as the market continued down the sewer). And let us not forget about the likely increase in defaults on other debt instruments, like the credit cards that consumers are so fond of.

    Yes, there are a few stocks that might be worth buying/holding as long as they aren't strongly tied to the economy. Outside of that, my opinion is that most stocks are hazardous. If we get any bear market rallies, I'm selling off the pathetic recommended stocks that I own. Yeah, it will be a big loss but it will likely get bigger so I might as well just bite the bullet and dump them.

    And finally, just to join the chorus.... that our government even allowed option ARM's to be issued is astounding. What an absolute invitation to a disaster.

  • Report this Comment On October 16, 2008, at 1:24 PM, ParisFe wrote:

    Well,great article! Someone out there speaks my mind! Most people in finance are just unwilling to realize that the golden ERA of securitizing everything and constant creation of new paper out of garbage then reselling it in a nice sugar-coated wrap to anyone dumb enough to buy it, IS OVER.They all are frantically praying for the misterious "bottom"...just as if they are waiting for a Messiah of some sort...no one wants to admit that they are in a deep DENIAL...about everything....so hopefully, the new waves of resets and other developments will sober those guys up...they seem to be too drunk these day to realize whats really going on...stress kills, you know:)

  • Report this Comment On October 16, 2008, at 2:03 PM, sabinamv wrote:

    I didn't hear anyone complaining when they loosened the lending standards. As a real estate agent I refused to do deals with people who couldn't afford the house they really wanted. I figure I lost many deals but I stayed true to the guidelines by which I bought my house - 20% down and no more than 30% of your paycheck going towards the mortgage. I am doing just fine in these times. I see that all who bought multiple properties including realtors are being foreclosed on every single day. I cannot feel sorry for them - I could see this coming 4 years ago.

  • Report this Comment On October 16, 2008, at 2:25 PM, nelsmo wrote:

    Why does VISA take a hit when there is talk of card delinquencies? VISA is not an issuer of credit cards. The get paid on the transaction activitiy. since card volume will continue to go up, their revenues are not connected to delinquencies

    consumers are using cards as a transaction mechanism, not only as a credit vehicle.

  • Report this Comment On October 18, 2008, at 6:18 PM, DrBob66 wrote:

    "shady lending practices of our savvy mortgage brokers"

    You got that right. When I was thinking about buying a home in 2005, both Wells Fargo and Prudential (the two firms that my company had assigned for relocation benefits) were relentless in their attempts to push me into an ARM (and to increase the amount that I intended to borrow, of course). Whenever I asked what the payments on a 30-year fixed rate mortgage (like the kind I had on my previous home) would be, they basically dodged the question. For whatever reason (my guess: higher commissions), they did NOT want me to get a fixed rate mortgage. This was the same story for each of the four brokers that I spoke with. At the end of the day, I smelled something fishy going on, and decided to rent. And now that I see what's going on with all these resets (and the havoc that they've caused), I would never trust these guys. I think it's an outrage that the Federal govt is now giving taxpayer funds to the very same deceptive lenders who created the mess to begin with. I just hope that they'll use OUR money to fix things...but they'll probably just do something stupid and self-serving with it.

  • Report this Comment On October 18, 2008, at 6:27 PM, leejohnson22 wrote:

    If a serious investors wants more details than this surface article try:

    www.seekingalpha.com/article/73552-the- impending-mortgage-crisis. Actually, the fools have it wrong: its the Alt-A loans(liar loans) that will have a higher rate of default and each state is hit differently--see article.

  • Report this Comment On October 20, 2008, at 1:05 PM, gomdp wrote:

    You know what will happen.Govt will come in and force the banks to freeze the rates and/or monthly payments; govt will be able to do this easily now because it has stakes / equity in the banks. Not suggesting that govt stepping in like this is a good thing; all that this will do is keep the house prices propped up artificially in the hope that wages will catch up to absorb the higher rates/payments at a future date. But with so much money being pumped into the system, huge inflation and falling dollar will eat into the buying power, so measly wage increases, if any, will never be able to catch up with the higher (recast) mortgage rates/payments. Rather than propping up the house prices, all that govt should do is to guarantee all the deposits and encourage savings, debt reduction and job creation.

  • Report this Comment On October 20, 2008, at 5:51 PM, Keifer70 wrote:

    Maybe the author should actually read the articles posted on this site about this exact topic. The FDIC is completely aware of this problem and will handle it the same way they handled the bad ARM loans at Indy Mac.

    The director of the FDIC lobbied successfully to have the ability to restructured bad ARM loans as part of the banking bailout.

    This is more just doom and gloom from someone that probably has her hand in the short players till.

  • Report this Comment On October 21, 2008, at 6:23 PM, mapmakerdude wrote:

    Housing won't peter out until 2011-12. There is way to much inventory out there now and there are NO buyers. There were never any buyers to begin with. When you have speculators buying 5 to 10 houses in one year, it inflates what the true market looks like. Also adding millions of people who should of never been even able to walk into a bank recieved loans. People with prime loan on a 30 year fixed are having difficulties paying there mortgages because the cost of everything else has gone up. Good luck!

  • Report this Comment On October 21, 2008, at 8:49 PM, hannah97 wrote:

    Great report. The hits just keep on coming. I was suprised by the content as I thought the report would focus on another fraud pushed on the unsophisticated consumer. That is the reverse mortgage! The hype has all the hallmarks of a lousy deal, especially when touted by an out of work "actor" promising loans that you never have to pay back. When the banks start taking these houses after the old folks have passed on to the great ATM in the sky, they will find themselves loaded down with houses in disrepair and in desperate need of updating. Then, wonders of wonders, the solid real estate investments they hold will not be worth boo. When will America learn, you can not borrow your way to prosperity.

  • Report this Comment On October 22, 2008, at 9:14 AM, MITCHAGAIN wrote:

    FINALLY, someone that can see the forest, not just the trees! Great report.

    When I started getting calls from mortgage companies 3-4 years ago touting "borrow more, pay less, invest the rest" I KNEW the end was near! I got the last of those phone calls when I sold out of the Phoenix housing bubble 18 months ago (missing the peak by about 9 months). I took the money and ran! Now I have a home that is paid for with NO mortgage. But for those that bought into the option ARMs before 2008, be very aware that the "mortgage crisis" is still coming and its going to be very ugly!

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