http://www.myleftwing.com/showDiary.do?diaryId=6608
Ticking Econ Bomb: $600 BILLION Sub-Prime Mortgages
by: Bonddad March 10, 2006 at 05:14:37 America/Los_Angeles
Since the first quarter of 2001, the US consumer has gone on a mortgage binge, with the total amount of mortgages outstanding increasing from 4.8 trillion in the first quarter of 2001 to 8.2 trillion in the third quarter of 2005. That's a total increase of 70% and a compound annual growth rate of 7.15%. In other words, low interest rates have helped the US consumer go on a debt acquisition binge. However, not all of these mortgages were written to solid credit risks. As a result, there is a possibility of these higher risk credit risks coming home to haunt mortgage underwriters in the next 2 years.
Barron's wrote an article on this situation titled Coming Home to Roost. It appeared in the February 13 issue.
Over the next 2 years, monthly payments on an estimated $600 billion of mortgages to borrowers with checkered or no credit histories – the "sub-prime" market – may zoom as much as 50% higher, as the two-year teaser rates on hybrid adjustable rate mortgages expire and interest payments hit their fully indexed levels.
The total amount of mortgages that will adjust totals 7.31% of the total mortgage market. That's a large amount. In addition, as economist David Rosenberg recently observed, 54% of the average US consumer's budget now goes to necessities and interest payments. This is the highest total on record. This figure becomes especially disconcerting when the number vacillated between 44% and 48% for the preceding 20 years.
In the past, such resets caused little disruption. For one thing, the sub-prime market was strikingly smaller. Only $97 billion of such mortgages were originated in 1996, compared with a mammoth $628 billion last year and $540 billion in 2004, according to trade publication Inside B&C Lending. Sub-prime loans now account for more than 10% of the total US mortgage debt of 8.4 trillion.
10% -- or about 840 billion -- of the total mortgage market is sub-prime. And 71% of that market could reset, raising the mortgage costs as much as 50%. That could be a big problem.
But now the refi window may be closing for the sub-prime crowd. The Fed's hikes in short-term interest rates have pushed up fully indexed ARMs rates. At the same time, evidence is mounting that home-price appreciation is slowing or, in a few areas, reversing. And the secondary mortgage market in mortgage backed securities, which provides 90% of the liquidity in the sub-prime market, is starting to balk at the easy lending practices in this sector.
The lack of home price appreciation means selling the house may not be an option, essentially sticking the buyer with the house – and the resulting loss. In addition, sub-prime bond buyers balking usually means they are either selling these bonds or demanding higher interest rates to compensate bond purchasers for what they perceive to be increased risk in holding the securities. Either way, that translates to higher interest rates in the sub-prime market.
Compounding the possible problems is the fact that 210 billion of the total sub-prime market does not have equity they can leverage.
But Glenn Costello of Fitch' Ratings estimates that at least a quarter of all sub-prime borrowers facing resets may have precious little equity left, even with the huge surge in home prices in the past two years. Many piggy backed loans to borrow the down payment on their homes in addition to taking on a conventional mortgage. "For some borrowers, there will be no loan-to-value gap left.
In other words, these homeowners don't have an equity left to use to refinance their homes. And as mentioned above, these mortgages are now charging higher interest anyway. So even if people could get the loans, the interest rate might be prohibitive.
Here is an example of what might happen to a typical ARM's purchaser from the last 2 years.
Say they are paying a fixed teaser rate of 7% (typical of what the 2004 and 2005 cohort of sub-prime borrowers had to pay while the borrowers with good credit got fixed rates of 5%). Come reset, typical contracts call for a floating rate of 600 basis points [6%] over the six-month LIBOR (London Interbank Rate). Six-month LIBOR has risen to around 4.7%, which means that the borrower would have more than a 50% jump in mortgages interest expense to 10.7%, subject to certain temporary caps on the permissible jump in interest rates.
That's a hefty jump in interest rates. And as noted above, expenses for necessary expenses now consumer 54% of the average families budget – an all-time high. A jump of that magnitude may be enough to send a family into bankruptcy.
Finally, as economist David Rosenberg noted in the same speech mentioned above, the total amount of mortgage debt on banks books has increased from 31% in 2000 to 39% in 2005. This makes banks more susceptible to problems if the mortgage default rate increases substantially in a short period of time – say, two years.
So, let's recap. 10% of total mortgages – or about $840 billion – are sub-prime. $600 billion of these – or 71% -- will reset within the next two years. A typical reset could increase the interest rate on the mortgage by 50%. And the typical US family now pays 54% of its monthly income to necessary expenses. And real estate loans as a percentage of bank credit have increased 25% over the last 5 years.
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Colin Brace
Amsterdam