America’s got a broken ARM

by Don Kuehn

Even if you're not a "news junkie," it would be hard not to have heard about the real estate crisis that's been hammering the economy for the past year or so, roiling the stock markets and threatening an estimated 2.2 million families with home loan foreclosure.
But just in case you have spent your time preparing lessons or working a second job and haven't heard about subprime mortgages and America's broken ARM, here is a brief summary of what has happened and why you should care.

If you watch much cable television, you probably know that there are countless programs that focus on decorating and preparing houses for resale. Whether they're selling the family home or buying and repairing a house to "flip" for a profit, it looks easy to make money and receive multiple offers over the asking price when they do it in a half-hour TV program.

You can predict when the economy is building a "bubble" when there are so many television shows on similar topics. But all bubbles have one thing in common—they burst.
Remember the "dot com" bubble? Back in the 1990s, it seemed like any fool could make money investing in tech stocks. When it burst, we got the recession that began in 2000. In order to soften the effects of recession, the Federal Reserve began an unprecedented series of cuts in interest rates. That, in turn, led to more and more people taking advantage of low rates to become homeowners for the first time or to refinance existing mortgages, some taking equity out of their home to finance consumer spending.

When the real estate markets were clipping along and setting records in almost every region, it seemed like everyone could share in the great American dream of home ownership. It seemed that way because lenders were qualifying marginal homebuyers for loans far greater than they would be able to repay.

If you are lending money to someone, it seems fundamental that you expect to be paid back. But that clearly wasn't the case with real estate while the bubble was growing.
One of the truths uncovered during the unraveling of this crisis (and it is a crisis for all of us) is that lenders were more than happy to loan money to people they knew had no chance of making their payments at the time the loan was made, much less after it adjusted to a higher interest rate. In some cases, loan officers were encouraged to falsify data on applications to make it appear that borrowers were better qualified than they actually were.

The goal of predatory lenders was to close the loan, package it with other mortgages (collateralize it), and sell them to investors and institutions specializing in real estate.
These are called "subprime" loans. They are made to borrowers who would have difficulty getting a mortgage loan at regular (prime) rates. These borrowers' credit scores are too low, they don't earn enough money, they can't make a normal down payment—but they want to share in the bounty of the real estate market. So they pay higher interest rates and additional fees. With all kinds of hybrid loans, adjustable rates, interest-only and other come-ons to lure borrowers into the market, hundreds of thousands of people became homeowners for the first time.

"I do believe lenders that were doing these subprimes knew they were getting these borrowers into loans they couldn't get out of," said James Nutter Jr., president of James B. Nutter & Co., a real estate company in Kansas City, Mo. "They would make six to seven times what we (nonsubprime lenders) would make on a conventional loan."

Generally, subprime mortgages are for borrowers with FICO credit scores under 620. Credit scores range from about 300 to about 850, with most consumers landing in the 600s and 700s. Anyone who is habitually late in paying bills, and especially someone who falls behind on debts by 30, 60 or 90 days or more, will suffer from a plummeting credit score. If it falls below 620, that consumer is in subprime territory, according to Bankrate.com.

The principal tool in the subprime market is the ARM, an acronym for adjustable rate mortgage. Many readers are familiar with ARMs. They have been a mainstay of the mortgage industry for years and can be attractive, especially during times when interest rates have been high but are expected to begin dropping or for people who don't plan to stay in a house for more than a few years.

The initial interest rate on an ARM is lower, but the rate is only guaranteed for a fixed time-say, one or two years. After that, the loan adjusts according to a preset benchmark, and can adjust again and again after set periods elapse.

Bankrate.com points out that a subprime loan also is more likely to have a prepayment penalty, a balloon payment, or both. A prepayment penalty is a fee assessed against the borrower for paying off the loan early-either because the borrower sells the house or refinances the high-rate loan. A mortgage with a balloon payment requires the borrower to pay off the entire outstanding amount in a lump sum after a certain period has passed, often five years. If the borrower can't pay the entire amount when the balloon payment is due, the loan has to be refinanced or the house sold (often in a depressed market).

The Center for Responsible Lending (responsiblelending.org) estimates that one in five subprime loans will end in default. The highest rates of defaults will be in Arizona, California, Nevada and greater Washington, D.C. Twenty-four states are projected to see declines of more than $1 billion in home values.

That might affect you and your job. As property values decrease and foreclosures grow, tax collections will go down. That translates into less money for schools, law enforcement and other public services.

In the "good old days," a person facing a short-term problem making a mortgage payment could go down to the local bank and have a heart-to-heart with the loan officer. Today the system is far less personal. There's no longer a person in the local branch that has direct contact with your loan. For many borrowers, the only way out of a pinch is to default. For the institution that bought the loan, it means foreclosure. For the neighbors, it means the property values in the neighborhood suffer, affecting all borrowers, not just those with subprime loans.

Studies have shown that a foreclosure lowered the price of other single-family homes an average of 9 percent, with downward pressure on prices extending to nearby homes that sold within two years after a foreclosure. Based on that calculation, 44.5 million neighboring homes will experience a decline in value because someone in their neighborhood couldn't make the payments on their subprime loan.

And thousands more families will lose their homes even though they don't even have a mortgage loan and have never missed a payment on their rent. They are renters who are living in homes purchased with subprime mortgage money and then rented to unsuspecting tenants.

Lenders typically evict tenants who reside in foreclosed properties because banks don't want to be landlords. They are in business to make mortgages.

Some experts expect the high levels of foreclosures will continue well into 2008. In early 2008, $300 billion's worth of subprime loans with adjustable rates will reset. Until those loans work their way out of the system there will be continued default and foreclosure activity.

The rash of foreclosures following the collapse of the housing bubble has caused several major subprime lenders to shut down or file for bankruptcy. At a Web site called The Mortgage Lender, ml-implode.com, the "implode-o-meter" says 189 major U.S. lenders have "imploded"—i.e., gone bankrupt or been acquired by other companies—since late 2006.
So, you don't have a subprime loan. Maybe you don't have a mortgage loan of any kind. Does all of this mean anything to you?

In a word, yes. Interest rates have gone up; the stock market has gone down. Retailers like Home Depot and Wal-Mart are seeing reduced revenues. Homebuilders and companies that furnish homes, from carpeting to lighting to cabinets, will see less business and be forced to lay off workers. As the effects trickle through the economy, almost every sector will feel the pinch. When the housing industry catches a cold, the entire economy sneezes.

On the other hand, this crisis is creating a buyer's market for those who are poised to act. Builders are offering incentives and upgrades, and in severe cases are cutting prices on—even auctioning—new homes. We may soon see a time when finance companies sell more houses (from foreclosures) than realtors do.

People trying to sell their home, however, either out of necessity or to move to a larger home, are faced with a longer than normal time on the market, and smaller and smaller profits from the sale of their property. Desperate sellers take drastic moves to lure buyers.

Can you make lemonade out of this lemon of a housing market? You can if you have been saving for a down payment and are now in position to buy. Deals are out there if you can qualify for a normal (prime) mortgage and don't get suckered into something other than a fixed rate loan at a reasonable rate.

If you have an adjustable rate mortgage (ARM) and are worried about rates rising, this is a good time to investigate a refinance into a fixed-rate loan. There could be fees involved and you might pay a little more each month. But if you wait until the loan resets, you could find yourself, like millions of borrowers, unable to make the new, higher payments and faced with a default or a foreclosure by a lender you have never met.

Don Kuehn is a retired AFT senior national representative. For specific advice relative to your personal situation, consult competent legal, tax or financial counsel. Comments and questions can be sent to dkuehn60@yahoo.com.