We’ve commented in recent months about how the drive of new homebuyers to acquire their first home, and existing owners to move up to larger homes, has reached almost manic proportions. Who or what started all this almost a decade ago isn’t clear, but in recent years we’ve seen that mania spread to mortgage lenders as well.
As home prices continued to escalate, particularly in the coastal markets of California and in the northeast, homebuyers saw affordability slipping away like sand sifting through their fingers. In the spring of 2005, just 18% of California households could afford a median priced home in the Golden state. In some micro-markets, such as Santa Barbara, affordability was as low as 7%.
In 2004 and through the first half of 2005, it became clear that the desire of mortgage lenders to continue issuing loans to homebuyers was as great as the desire of the buyers themselves to continue acquiring properties.
The result has been the development of so-called creative debt instruments that may in fact prove to be just as much of a hazard to the issuing lenders as to the homebuyers that sign up for them. The time has come to ask: Are these loans viable mortgages, or are they financial minefields?
The first sign of irrationality in lending appeared about eighteen months ago when lenders (including the secondary market dominated by Fannie Mae and Freddie Mac) began easing permitted payment income ratios from the traditional 28-33% to 40% and even 50%. We read Freddie Mac’s underwriting guidelines word for word late last year, and we saw the 50% number in there.
Next, we’ve seen easing of credit standards in both the “A” and sub-prime (B paper or lower) markets almost to the point that if you could breathe and had a job, you could get a mortgage. Now, were seeing real evidence of the mania having spread from homebuyers to the lenders so eager to serve them.
The next step toward the edge of the cliff seems to be the increasing use of interest only loans. People have been using these loans to buy homes they could not otherwise afford. The loans are written at below market rates, such as 4% or 4.5% and then convert in two to five years as fully amortized adjustable rate loans at the then current market rate.
Payment shock when these loans convert can be extreme, ranging from 20% to as much as 40% depending on the length of the interest only period and how much the indices for adjustable rate loans rise. Borrowers are putting their chips on the come line, hoping that their incomes will increase or that they can refinance just prior to the conversion point.
For example, a 30 year $400,000 mortgage with the interest only option at 4.5% would require a monthly payment of $1,500 for (typically) five years. If in five years, the market rate is 6% (certainly a conservative expectation) the payment on $400,000 would jump to $2,577.21. Remember that only 25 years now remain on the loan term for full amortization. A refinance into a new 30 year loan at 6% would require a payment of $2,398.20, still a hefty increase.
Another high risk loan is the new “minimum payment loan” that sports a start rate good for one to five years of 1.25% to 1.95%. These loans result in negative amortization (the loan balance increases with time, rather than decreasing as it would with a fully amortized loan). Eventually, the piper must be paid, though, and many of these homebuyers will find themselves in a bind. While payment increases in these loans is limited to 7.5% per year, the loan can be recast at the lender’s discretion when the loan balance reaches 110% of the original amount. Then what?
What does this mean to the foreclosure property investor?
First of all, these interest only and minimum payment loans will in many instances laid a trap for the homeowner that elects it. These loans were originally meant for short term ownership, such as an executive who has been transferred across the country on a temporary assignment but needs a home for business entertainment.
However, with the continued rapid escalation of home prices, many buyers are using these loans to buy permanent residences. In 2004, 47.6% of home purchases in San Diego were financed with interest only loans. In San Francisco, the number was 45.3%, and in Las Vegas, 33.7%.
When conversion time rolls around, many economists are expecting a wave of forced sales, defaults or both, despite significant equity buildup at least through 2006.
The opportunities for profitable foreclosure investment will be tremendous!
While most interest only loans will convert in five years, Scott Bice, Nevada’s Mortgage Commissioner reportedly believes many homebuyers opted for a two year interest only period. Still despite substantial equity, these homebuyers will be faced with paying for a home they really can’t afford, and investors will be able to bail them out at a discount in 2006 and beyond.
In Phoenix AZ, 38.3% of homebuyers opted for interest only loans in 2004, and price appreciation there has been almost 40% year over year. Financial writer Catherine Burroughs for the Arizona Republic, reports that if a homebuyer had chosen a 4% fully amortized adjustable mortgage at a given income level, they could have qualified for a $250,000 loan. With the interest only option, they could get a $350,000 loan, a 40% increase. You don’t have to be the proverbial rocket scientist to see what’s going to happen to that homebuyer’s payment when the loan converts to full amortization.
A similar situation is developing with the fully amortized adjustable loans. Recently, we heard from Fed Chairman Alan Greenspan who stated that the Fed would continue raising interest rates throughout the rest of 2005. We can expect the discount rate to reach 4% by year-end, and the payments on those adjustable rate mortgages and home equity lines of credit will be going up virtually in lockstep with the Fed’s short-term rate increases.
While there have been plenty of investment opportunities even with defaults at their historic baselines, when the people playing a game of financial chicken with these risky loans come face to face with reality, we’re going to have more business than we can handle. Are you ready for it?
