Editor’s note: Steven Krystofiak offers an insider’s take on what’s been unfolding in the subprime mortgage industry. Read Krystofiak’s previous articles, “What is a subprime loan? It depends on whom you ask“; “High-risk loans enable buyers to obtain, not afford, homes“; “Why home-ownership shortcuts will lead to longer recovery“; and “Sales pitch all smoke and mirrors.”)
Trillions of dollars of short-term fixed mortgages that will reset in 2007 and 2008 are just the primer and the beginning for a real estate downturn that will take real estate prices into an extreme dive beginning in late 2008. And the recovery will not come until Iraq is a family vacation destination.
The culprit for the extreme dive will be negatively amortized loans. The hardest-hit area will be California. Let me explain.
In 2007 and 2008, more than $1 trillion worth of loans across the United States will adjust from their teaser “affordable” interest rates. This means that hundreds of thousands of households will be hit with increased payment shocks on their mortgages. In some cases, the payment shock can be an increase of more than 40 percent.
These resetting loans and resulting payment shocks for many borrowers will cause a massive explosion of foreclosures compared to the very tame foreclosure numbers we have seen during the run-up of prices in the recent past. In the future, we’ll look back at the past economic boom years and refer to them as the real estate renaissance. But unfortunately, there was no enlightenment in this particular renaissance.
Many industry insiders believe the teaser-rate adjustment period will mark the end of an era in which people always believed that home prices only move upwards.
I’d like to focus attention into the future, beyond the summer of 2008. In this future scenario, I would like to keep one large unknown variable the same, that being home prices. Even though I feel home prices will drop in the coming 18 months in large part due to the trillions of dollars of loans resetting to higher unaffordable monthly payments, I don’t want to scare you with a doomsday forecast. Rather, I will portray a conservative outlook in order to highlight how much trouble we will be in at the end of 2008 even if the optimistic scenario of flattened home prices continues (as opposed to falling home prices).
Since all real estate markets differ across the United States, I would like to keep the real estate figures the same with one local market: the San Francisco Bay Area.
Flashback: It’s 2003 and less than 1 percent of all home loans taken out were negatively amortized. Zoom forward to 2005 and we will see in the San Francisco Bay Area that percentage increased to almost 30 percent of all loans originated. That number grew even more in 2006 to 39 percent of all originations.
The problem we will have in 2008 will be because of the high percentage of loans originated back in 2005 that allowed homeowners to make small minimum payments, which causes the balance of the loans to increase. The problem is that many of these loans only allow the homeowner to make the minimum payments to 110 percent or 115 percent of their original loan balance. This means that if someone took out a $500,000 loan they could make the minimum loan payments until their balance grew to $550,000.
With balances compounding and growing faster than $1,200 a month (in some cases growing faster than $1,800 a month), there are people whose loan balance could increase by $50,000 in as short as 2.4 years or in other cases a little over three years. This is how we will build up to dire situations in 2008 when many of the loans that were originated in 2005 will start to reset. Homeowners could face mortgage payments that spike as much as 300 percent after these loans reset. Yes, payments can more than triple!
If you currently have a negatively amortized loan — also known as an option-ARM or pick-a-pay loan — there is a good chance you have a prepayment penalty attached to it. The penalties vary within different banks and different states. But in the scenario above for the $500,000 loan, the penalty could be in the range of $15,000 to more than $20,000. This penalty could make refinancing illogical or in some cases, not possible.
If home prices do stay the same since their peak in the summer of 2005, homeowners will have a hard time selling or refinancing since they have less equity in their homes. Come 2008, this will be compounded by the fact that if the person does refinance into a cheap interest-only loan, the payments will be calculated with a much higher loan balance. (Borrowers with negatively amortizing loans are making very small payments, so they’d need to refinance into an interest-only loan to end up with the next-cheapest type of loan.)
Modest declines in home prices in 2007 will make it even more difficult to refinance or sell homes with negatively amortized loans. This, along with further resets in adjustable-rate mortgages, will make the foreclosure wave of 2007 look miniscule compared to 2008.
Steven Krystofiak is a mortgage broker based in California. He is president of the Mortgage Broker Association for Responsible Lending, an advocacy group.
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