We've been reading a lot lately about how subprime mortgages have submarined the economy. Lenders and banks have been taken to the woodshed for irresponsibly giving money to home buyers with poor credit just so they could bundle up the mortgages and resell them as toxic residential-mortgage bonds. But, while there's no denying the subprime problem, on closer look it's clear that even prime borrowers were taking on more debt than they could afford.
How bad is it? In Arizona, between the third quarters of 2006 and 2007, there was a 902% rise in foreclosures started against homeowners who had prime adjustable-rate mortgages, known as ARMs, according to the Mortgage Bankers Assn. ARMs, whether prime or subprime, are the real culprit in the housing crisis because they've allowed too many people to buy homes with almost no money down, with the hope that they could flip the properties or have rates drop before the loans reset.
The rise in prime ARM foreclosure starts isn't isolated to a few states. Nationally, foreclosure starts related to prime ARMs jumped 253% in the third quarter of 2007 when compared to a year earlier.
"The fact is the pain of the changing real estate markets is affecting more than just subprime borrowers," says Keith Gumbinger, vice-president of HSH Associates, a New Jersey-based financial information publisher. "It's more important to think of it as perhaps an ARM problem and a rate reset problem, not just a subprime problem."
Rising Foreclosure Starts
Arizona, Florida, Nevada, and California, which all had the greatest rise in prime ARM foreclosure starts in the third quarter of 2007, also have a heavy concentration of investor-owned properties. Many investors, who bought homes they hoped to resell quickly using no-interest loans and other mortgages with low teaser rates, got hurt when the housing bubble popped. Some investors are simply walking away from homes that are now worth less than what they owe to the bank (BusinessWeek, 1/3/08).
Maryland and Virginia, which also are among the states that have seen the greatest increase in prime ARM foreclosure starts, might have been hurt by an oversupply of new construction, which borrowers typically financed with variable-rate mortgages. Maryland prime ARM foreclosure starts increased 229% during the 12 months ending in the third quarter, 2007. Virginia, which like Maryland includes high-priced Washington, D.C., suburbs, had a 369% year-over-year increase.
Oregon, Massachusetts, and New Jersey also saw huge jumps in such foreclosure starts, in part because buyers with good credit in those states used ARMs to pay for homes that might otherwise have been out of their reach. Of course, nobody would be complaining about ARMs if home prices were still rising.
"There was so much competition for mortgages over the last couple years that the definition of prime became less and less stringent," says Addison Wiggin, publisher of Baltimore-based Agora Financial, which publishes investment advice for individuals. "Even in the prime market, you had people taking on larger loans than they historically were able to handle."
Refinancing and Option ARMs
Borrowers with good credit are in a healthier position than subprime borrowers because lenders see them as less risky candidates for refinancing and are willing to put them into fixed loans. But not all prime borrowers can qualify for refinancing, particularly if they owe more on a mortgage than the house is worth or if they've lost their job and can't meet salary or other underwriting requirements. Refinance applications from borrowers have surged in recent weeks, according to the Mortgage Bankers Assn., which doesn't break out prime and subprime applications.
Two aggressive Federal Reserve rate cuts in January are good news for borrowers with ARMs, especially those with resets coming this year. Although ARMs are not directly tied to the federal funds rate, borrowers could see their interest rates reset lower than they otherwise would have without the cuts.
One type of mortgage that was popular with prime borrowers during the boom was the so-called option ARM, which allows homeowners to choose each month from a variety of payments, including a minimum payment that doesn't even cover interest on the loan. As a result, with unpaid interest accumulating and house prices falling, some homeowners have seen the equity in their homes disappear and even head into negative territory. Lenders such as Calabasas (Calif.)-based Countrywide Financial (CFC), Seattle-based Washington Mutual (WM), and Charlotte (N.C.)-based Wachovia (WB) all have significant exposure to option ARMs.
Jay Brinkmann, the Mortgage Bankers Assn.'s vice-president for research, says the slumping home prices simply uncovered problems that borrowers could sidestep in the days of home buyer bidding wars and double-digit annual price increases. "Before, if somebody had a divorce or the main wage earner was injured and couldn't work, or some other issue, you would not have seen it because they would have sold their house and satisfied their mortgage," Brinkmann says. "Now if there's still the same level of job loss, more of those people end up in foreclosure because they can't sell."
Brinkmann says there are several scenarios in which a prime borrower with a record of on-time bill payments could now be facing foreclosure. A family that expected to move in a few years, for example, might have taken on an ARM expecting that when the time came to move, they'd easily be able to unload the home for a profit. Other borrowers might have taken on a large loan expecting their own finances to improve by the time the loans adjusted and their monthly payments ballooned.
"The magnitude of the [prime ARM foreclosure start rate] increase is somewhat large because we had a lot of activity in the last few years," says Robert Kleinhenz, deputy chief economist with the California Association of Realtors. "We thought the prime side of the market would be a steadying influence and what we had to focus on is the subprime market. That's not exactly true as the events are unfolding."
See the BusinessWeek.com slide show to learn which 20 states had the most foreclosures as a result of prime ARMs.