Berkshire Hathaway
Meanwhile, Out in the 'Burbs...

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By hartmanbirge
April 3, 2006

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We've turned the corner on yet another month now... April 2006. That means a few things. Amongst other things it means that another month has passed on the clock of the benign environment on Adjustable Rate Mortgages. One thing that has always bothered me about risk scenarios and loans on the book etc. is that those who make them tend to make some horrific assumptions on the true meaning. I've seen it written in more than a few places that "good" loans to own are those where the interest rate risk is assumed by the buyer.. Analysts love to talk about these things... but in so doing, they fundamentally ignore reality for the guys wearing the football jerseys and drinking the beer in the back yard....

Let's say a hypothetical family bought a house in northern Virginia and in order to afford the payments they did a "payment option ARM" which is a popular thing these days (I know a more than a few guys who have done it this way). Let's say the house cost about $360,000 - give or take (I think that gets you a duplex in northern VA).... I have recently found out what the overhanging liability on all of this is.... If the initial rate is 6% that means the initial payment at the beginning is $1200 (piece of cake) and everyone is enjoying their summer Bar-B-Q. Nonetheless, if rates remained stable for his period of ownership the family would still be hit with scheduled amortization and his scheduled payments would begin to escalate. At year five those payments would have ticked up to $1600 per month. But at year six the payments would sort of explode - to $2500. This all assumes a benign interest rate environment of course. But...what happens if we get a 200 basis point move in rates to the upside during the first five years? Payments now come in at $3166 for year number 6 - practically double. The family is now in a race against time....

So they will probably be looking to sell. After all, the ARM deal is designed for the mobile family who tends to move right? With lower initial payments they can pocket a lot of money and then sell before the real kickers start (obviously very popular with military families just to name one mobile group)...alas...Rates have risen and values are declining just a bit... someone is probably holding a bag of debt. The family above will wait until "things turn" and so they can get their money back and cover the cost of the mortgage liability.... the clock continues to tick...unease...heating and cooling bills have escalated far above wages and salary - disposable income is decreasing... cushion is decreasing. There's one for the earnings assumptions. This is going to be interesting.

I'm not sure when we reach the point at which it all really turns nasty but I'm fairly convinced that the lag time on these FED moves is longer than it used to be - due to the initial cushion of the ARM structure...but... things turn nasty fast. And when she blows I think it's going to move fairly fast.


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