Are ‘Option ARMs' a Dangerous Step Backward?

November 28, 2005

Calling option ARMs "an outrage," a veteran banking industry analyst questions how long investors will stand behind the rash of real estate lending.

"How fast will investors in financial company stocks and in mortgage-backed bonds rush to sell if they begin to sense that a wave of loan defaults is inevitable?" asks the Los Angeles Times. Wall Street is beginning to wonder how many people really can't afford what they bought in recent years on incredibly cheap credit.

Lenders have eagerly offered 1% mortgage loans, 0% car loans, home-equity loans for more than what property is worth—all of this creating a cushy financial reality for U.S. consumers. Behind many of these lenders stands a global army of investors who've supplied them with capital at rock-bottom rates.

"In the midst of any wild party, however, some people do things they later regret," observes the Times. Money handlers on Wall Street are focusing on the home mortgage and equity line-of-credit markets, where debt has swelled from $4.8 trillion at the end of 2000 to nearly $8 trillion now. And behind every borrower there's a lender.

Richard Bove, a veteran banking industry analyst at the firm of Punk, Ziegel & Co. in New York, last week sent clients a research report with a chilling title: This Powder Keg Is Going to Blow.

In it, Bove summarized the many ways fee-hungry lenders have fallen over themselves competing to write mortgages for almost anyone who applies. He claims that we're reliving the 1920's boom years when interest-only loans were standard.

When the Great Depression arrived in the 1930s, and incomes and asset values dived, home repossessions soared. People couldn't afford their loans and they couldn't sell their homes for more than they paid.

Bove believes the lending industry has taken a dangerous step backward with option ARMs. "The consumer simply doesn't understand what this loan is in terms of the risks it poses—not the least of which is how the loan principal amount can rise, instead of shrinking as it would under a full-payment loan," he says.

Adjustable-rate loans in general accounted for about half of all mortgages written last year, and the bigger the loan, the more likely it was to be an ARM. Given sky-high home prices, the only way many buyers could get into their dream homes was via a teaser-rate ARM.

Also, an increasing number of homebuyers have been "piggybacking." These buyers need two loans rather than one to complete their purchase—a first mortgage typically for 80% of the home's value, and a home equity loan to finance the rest. Despite high loan to value, many of these loans lack private mortgage insurance.

At present, mortgage delinquency rates are low. And historically, most people make their house payment, no matter what. Even so, many economists believe delinquencies will rise as more people face the first upward payment adjustments on their ARM loans next year. Any slowdown in home prices would compound the problem.

Wall Street is beginning to focus on how large the potential danger zone is—the people who have drastically overreached with mortgage debt and who may well end up in trouble in 2006 or 2007.

"For financial markets, just the scent of an upturn in delinquencies could be enough to fuel heavy selling of securities tied to housing's fortunes—builders, lenders, and mortgage insurers," says the Times. Financial services stocks make up the biggest single chunk of market value in the blue-chip Standard & Poor's 500 index, at nearly 20% (technology is second at 15%.)

The biggest threat of upheaval is in the mortgage-backed securities market itself.

That market—worth nearly $4 trillion—has provided much of the capital for the housing boom, with loans packaged and sold to investors worldwide via mortgage-backed bonds. The bond owners get the loan interest and principal passed through to them.

But the increasing complexity of the securities also raises the risk that some investors will feel they can't be sure exactly what they're holding, particularly in the case of bonds backed by the new wave of adjustable-rate mortgage loans. If investors begin to worry that they won't be repaid, their rush for the exits could be thunderous.

Of course, it's entirely possible that a continuing healthy economy, and relatively tame long-term interest rates, will provide a soft landing for the housing market.

The question is whether it will require a full-blown financial crisis to get the lending industry—and those who supply it with capital—to start telling the truth to people whose homeownership ambitions far exceed their means, according to the Times.

This article was prepared by the staff at the Point for Credit Union Research and Advice and is published online at http://thepoint.cuna.org/. Reprinted with permission.

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