Monday, June 04, 2007

Totally Screwed - An Adjustable Mortgage Pre-Mortem

Allow me to describe the plight of one of my wife's co-workers.

Two years ago, at the euphoric peak of the market, he bought a house for 500k.

Unfortunately he utilized an adjustable mortgage.

Today, his lender is charging him 7.75% while 30-year fixed rates are around 6.25% or 6.375%.

Remember, not only is he paying over a point more than market rates, he's still not locked in. So his rate could conceivably go to the moon (10%, 12%, 15%,...) as the mortgage market gyrates.

Recently he tried to switch to a fixed rate mortgage. The bank's assessors came and said his house "had structural issues" and they valued the house at 420k. That was a half-hearted ruse - really, the market had just deflated some.

Do you see the problem?

He owes probably 480k on the property; and no bank will loan him 480k to pay off his debt and facilitate a new mortgage; no bank will loan anyone 480k on a house that's only worth 420k.


He's stuck with the adjustable that could explode. At 7.75% he's paying over $4,000 per month. And that's just right now. The 30-year bond is still only yielding 5.05% - still not far from an historic low. Every tick up in long term Treasury rates will increase his payments, almost dollar for dollar. (I actually believe that at this point, housing will depreciate by MORE than corresponding increases in the cost of capital. Financial assets get over-sold with the same fury that they get over-bought.)

Even if he was fortunate enough to secure a 30-year fixed rate loan at 6.375%, his payments would still be around $3,000 per month ($2,994 to be precise). But alas, as I already pointed out, no bank will lend him the funds needed to refinance. You can't even say this guy is "stuck between a rock and a hard place" - there's really no dilemma, he's totally screwed.

In order for him to get a fixed rate, he'd have to write a check for $60,000 just for the privilege of locking in today's fixed rates. In other words, he just got hit with a $60,000 tab. Even if he musters up the dough, he's still going to have zero equity in his house and a 420k mortgage on it. Effectively, he'll have paid $560,000 for a house that's worth $140,000 less, just two years later. As I illustrated in a recent post, he'll still have all sorts of housing market risk even after sending 60k to the lender AND after locking in a fixed rate.

Most likely, this guy won't lock in at today's rates BECAUSE people like him, who put little money down and opt for the enticing low payments of variable mortgages, just don't have that kind of money lying around. He'll try to ride out his $4,000+ mortgage payments and hope that rates come in. Of course they won't; they are going much, much higher.

Even if he's not going to bite the bullet and ward off the disaster of higher rates, I'd like you to consider that scenario. Say rates tick up 2 full percentage points. His payments will rise to over $5,000 per month AND the value of his house will drop precipitously. In fact, a house worth 420k at today's rates will only be worth 341k with the 30-year yield two points higher, at say 8.375%. So instead of having to dig up a lump sum of $60,000 JUST FOR THE PRIVILEGE OF LOCKING IN A FIXED RATE AT THE SUBSTANTIALLY HIGHER RATE OF 8.00% or 8.25%, this idiot will now have to muster up $119,000!!!

Again, that's because no bank will loan him more than 341k on a house valued at that price. In fact, it's likely that mortgage lenders will be so ravaged at that point that they'll be wholly averse to lending 100% of market value. In other words, they might be so beat up by defaults that they are only willing to lend, say $320,000 or less on a house presently valued at 341k. That's not merely conjecture but an empirical fact. Just ask anyone who tried to take out a mortgage in the early 1990s. For example, my brother-in-law tried to pay 230k for his first house back then BUT the banks wouldn't loan him the money. They valued his target house at closer to 200k. So, even though he was willing to pay a higher price for his home, he, fortunately, had to tell the seller that no bank would write a loan for that price on that house. The seller, grappling with the market/banking realities of a real estate bust, had to sell at a price much lower than the buyer wanted to pay because any other prospective buyer would be similarly stymied in the mortgage approval process.

This co-worker of my wife's is effectively bankrupt. He might not realize it, but that's the truth. Real Estate Morons have long bleated that a stock price may go to zero but property values will never evaporate. That's a canard. Home equity can actually go below zero and render you insolvent. In fact, even if you own 10% of your house, a mere 4% decline in its market value will effectively wipe out your equity because any sale of the home would require a 6% real estate commission.

In California cities, over 40% of mortgages written in 2005 were of the variable or adjustable variety.

So this isn't just a tale of one guy in Boston; it the unfortunate case for swaths of people all across the country.

Prediction - In the next 3 months, after another disappointing "spring selling season", Alt-A defaults will be filling the headlines and roiling the stock market.

(Alt-A loans are the first notch above "sub-prime" mortgages in terms of bond ratings.)

Note that real estate would be in trouble EVEN WITHOUT all this embedded negative leverage from variable mortgages.

Don't forget, this guy stuck in adjustable hell can't even move. If he were to sell his house, it wouldn't pay off his debt, and he'd still owe 60k plus a $20,000+ real estate commission. He better pray to God that he doesn't lose his job or have to move to find a new one.

Recently I read (on an even more apocalyptic housing bubble blog) the point that for all the fear of Bin Laden, terrorism, or "climate change", no entity or person has more control over your entire life than your mortgage lender.

Ain't that the truth.

Rent as long as you possibly can.


Anonymous said...

This is an interesting article. Many ’sub prime’ people with bad credit ratings are looking for mortgage finance. One problem is that they are being exploited and misled by disreputable firms and then let down when it comes to the crunch of getting the mortgage. And the issues you raise are relevant to people all over the world who are in this situation. When I’m talking to people in the UK who are looking for a mortgage I usually recommend a company I know from personal experience, called Interesting Mortgages. They have special schemes for all kinds of people, whatever their circumstances. They’re very helpful and reliable and have a good reputation:

Anonymous said...

Interesting read. Adjustable mortgage rates are a huge risk. I think even the most careful analysis cannot predict market conditions in the near future. More bad credit loans and mortgage rates information here.

Anonymous said...

Adjustable mortgage is always not desirable..u can have some of the mortgage refinancing issues at