Forget exploding ARMs -- watch for imploding prices

The target for the federal funds overnight rate, which stood at 5.25 percent in September, has been slashed six times, to 2.25 percent. Although many ARM loans are indexed to another short-term rate, the London Interbank Offered Rate, or LIBOR, that has come down as well (although perhaps not as much as we'd been led to believe -- see MarketWatch).

While reduced payment shock for ARM borrowers is good news -- 1.72 million owner-occupied homes with such loans are projected to see resets this year and next -- it's probably too soon to pop the cork on the Champagne. According to the latest economic letter from the Federal Reserve Bank of San Francisco, it's likely ARM loans have higher delinquency rates than fixed-rate loans not because of the payment shock associated with interest rate resets, but because the people who took them out had higher risk characteristics.

Furthermore, differences in house price changes account for most regional variations in delinquency rates, regardless of whether borrowers are prime or subprime -- or whether loans carry fixed or adjustable rates -- the letter, adapted from a speech by San Francisco Fed CEO Janet Yellen, concludes.

"To the extent that the subprime meltdown is tied to declining house prices rather than interest rate resets, other borrowers, including prime borrowers, also could be affected," Yellen said. "Indeed, while default rates for the latter loans are lower than for subprime loans, delinquency rates among all categories are highly correlated with house price declines across regions of the country."

The bottom line? The reduced payment-shock on ARM loans is not going to save markets that saw massive price runups during the housing boom from further price declines.

"Looking ahead, it seems likely that the period of house price declines will not be over very soon, since some models of the fundamental value of houses suggest that prices are still too high, and futures markets for house prices indicate further declines this year," Yellen says.

Analysts at Standard & Poor's, who were projecting peak-to-trough price declines of 11 percent as recently as November, now project home prices will fall 20 percent from peak 2006 levels. Thats a big problem for several major private mortgage insurers, who Standard & Poor's says must demonstrate to Fannie Mae and Freddie Mac that they can continue to write new business (see story).

One of those insurers, PMI Mortgage Insurance Co., predicts that while downward pressure on national house prices should start to ebb in the second half of 2008, it's likely prices will continue to decline well into 2009, as inventories remain large.

PMI projects that the Standard & Poor's/Case-Shiller index will fall by around 20 percent from its peak in mid-2006, and that a government price index that measures data from conforming mortgages will drop by around 8 percent from its peak in mid-2007.

The flip side of Yellen's analysis is that markets that weren't subject to lots of speculation are in better shape to weather the storm. PMI's latest risk index shows a reduced risk of price declines in markets that didn't see steep run-ups in prices during the housing boom.

In 32 of the 50 largest U.S. markets tracked by PMI, the chance that housing prices will fall in the next two years actually declined in the latest risk index -- a remarkable turnaround from the previous quarter, when PMI said the risk of price declines increased in 39 of the 50 largest markets (see story).

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