The Impact of Variable Rate Mortgages

We noted earlier in the year (here and here), that the $2 trillion in mortgage resets won’t impact the consumer as much as many fear.

The key issue will be how many people will NOT be able to refinace in advance of the coming resets.  The impact on the Real Estate market, however, is potentially significant, as detailed in a Damon Darlin column on Saturday :

"As home prices appreciated from ridiculously high to unbelievably higher, more Americans began using mortgages that allowed them to buy more house for less of a monthly payment. Next year, a large portion of those rates move up and homeowners who opted for the exotic mortgages could find their payments doubled. Talk about bloody. They need to find a way to minimize the pain.

Many will refinance their loans. But for others, whose mortgages now exceed the value of their homes or whose debt payments exceed 40 percent of their incomes, there may be no other solution than to get out of their houses. With the housing market cooling, selling it may not be easy. Some may default on their loans.

With more homes on the market, prices could begin to fall. That reduces home equity — the difference between the amount borrowed and the total value of the home — and could force people whose loans change in 2008 and 2009 to consider selling, further accelerating the drop in prices. Some of those cities with the highest proportions of interest-only loans are also at the greatest risk of falling prices."  (emphasis added).

Here’s what the data looks like:

"In 2003, of all new mortgages, 10.2 percent were interest-only, meaning the homeowner paid only the interest for the initial period of the loan. According to Loan Performance, a research firm, 26.7 percent of all loans were interest-only last year and another 15.3 percent were payment-option adjustable rate mortgages, which allow homeowners to choose how much they paid each month."

The problem is more concentrated in some regions: "In most California cities, as well as in Denver, Washington, Phoenix and Seattle, interest-only loans represented 40 percent or more of all mortgages issued in 2005."

Here’s how this plays out:

"Traditionally, interest-only loans and adjustable-rate loans were used by people who expected to live in a house only a short time, but such loans have turned into “affordability products” as housing prices rose. The interest rate on the loans, while below that of conventional 30-year fixed-rate mortgages at the beginning, resets after 3, 5, 7 or 10 years, depending on the loan. So, homeowners who took out loans in 2004 could find, for example, that their initial 4.25 percent loan climbs to 6.25 percent or 7.25 percent next year.

Someone now paying $350 a month for a $100,000 interest-only loan could be facing payments of $680 both because of the shift to the higher rate and because the borrower would have to start paying off the principal as well as the interest."

So while the majority of homeowners (and therefore, the lion’s share of consumers) are likely safe, there is still the Real Estate market to consider:   

In any speculative market, one of the key risks is forced sales.
In equities, its when the margin clerks walk around a firm, literally
hitting bids indisciminately. Its as per legal/regulatory requirements
— if you don’t have the cash in the acocunt — WHACK!

The scenario laid out above is similar — on the margins, a small number of speculative defaults lead to forced liquidations.

Since the marginal speculators helped drive prices skyward, its no
surprise that the double whack of the loss of speculative buying plus
forced selling can impact a neighborhood or even a region (I’m thinking
Miami condos and houses in las Vegas) quite strongly. The key
determinant as to the impact on a region will be the percentage of
people whose "mortgage exceeds the value of their homes, or whose debt payments exceeds 40 percent of incomes." These people may be unable to refinance, and will be ripe for  foreclosure.

Note that mortgage delinquencies and foreclosures remain low nationwide, including the areas where prices appreciated the most.


UPDATE JULY 17, 2006  1:59pm

Here is the accompanying map from NYT



Keep Eyes Fixed on Your Variable-Rate Mortgage
NYTimes, July 15, 2006

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What's been said:

Discussions found on the web:
  1. Smokefoot commented on Jul 17

    I don’t see how refinancing is going to save a person who got an interest-only loan or ARM in order to afford the payments. Getting either a fixed-interest loan or letting the ARM reset is going to cause they payments to go up, causing consumer pain.

  2. metroplexual commented on Jul 17

    From what I have read, in 2006 $600 Billion worth of ARM’s are resetting in 2007 it will be 1.3 Trillion. Since total outstanding mortgage debt is in the neighborhood of $10 Trillion, I see the resets as a significant event. Higher fuel and household energy costs and credit card minimum payments due to the new bankruptcy laws in addition to the inflationary pressures will impact every household.

    Personally, I do not see how this will not affect consumers. I feel that by yearend 2007, things will look pretty bad.

  3. Bob A commented on Jul 17

    When you are paying $5000/month in interest only to live in a house you could rent for $2500/month, and you come to the realization it is not only not going to appreciate soon, but is losing value, the option of walking away becomes very real. Many of these purchases were based primarily on the idea that appreciation would make up for the higher payments compared to renting.

  4. jucojames commented on Jul 17

    One factor that I have not seen mentioned in many places is the fact that over the last several years, many mortgage and home equity loans have been issued on a recourse basis rather than non-recourse. During prior real estate busts like the early 1990’s, loans were non-recourse, which means that the banks could take the home back but not attach to other personal assets. This is no longer the case in many circumstances. This could have a profound effect on how the liquidation occurs and its impact on consumer spending. I would guess that it is actually more bearish on consumer spending and delay the realized decline in home prices. Home owners will reduce discretionary spending to try and save their house (and other assets), which will dry up the number of transactions in the home market for a period of time until real forced selling occurs…

  5. Bob_in_MA commented on Jul 17

    “These people may be unable to refinance, and will be ripe for foreclosure.”

    Actually, it will be a small subset of those people who face foreclosure. Not many people are going to default on a loan simply because they have negative equity. There are very real costs to defaulting on a loan, both financial and psychological. But these people are certainly more vulnerable, and those among them who suffer financial stress, from loss of a job, a huge medical expense, etc., are going to have few options but to default. The investment banker who’s $5m manhattan condo is suddenly only worth $4.5m is not going to walk away from it.

    I think you’ll see the most pain in working class neighborhoods, you already can see it in these areas in places like Boston and Philadelphia. Retail jobs have been falling for several months and now construction employment seems to have peaked. The blue collar situation is increasingly diverging from that of the white collar.

  6. Bob_in_MA commented on Jul 17

    jucojames, that’s a very interesting point. I haven’t read anything about that. I just did some searching and what it sounds like is that when someone takes an 80% mortagge and than a second one for the other 20%, that smaller loan is often made a recourse loan.

    Do you have any good sources on the subject? I really couldn’t find much at all.

  7. M.Z. Forrest commented on Jul 17

    The risk of foreclosure increases as LTV increases. A bank is only willing to work with a defaulting party in so much as the loss risk is diminished by doing so. In a declining market a defaulting party with a 90%+ LTV is going to have difficulty finding a bank willing to help. It is not just the putative poor that are affecting by this. The rich man with the $500,000 condo with an LTV of 100% may be able to get the bank to writeoff some of the loan depending on market circumstances. We don’t really need to have all the ARMs foreclose to cause an impact. As Barry so well noted, leveraged assets do not fare well in declining markets.

  8. Unleveraged Californian commented on Jul 17

    The fact omitted from the article is that many of these adjustable rates loans have maximum annual payment increases of 7.5% per year. So the actual cash payment does not increase as fast. Instead the difference between the higher interest rate and the new payment is tacked on as negative amortization.

    The cruch comes when the negative amortization becomes 110% of the original loan balance. (This is a small print loan contract detail often not known.) At that time the loan becomes fully amortized at the then current interest rate. And the payment is then no longer capped by the 7.5% annual max payment increase.

    It will take 3 years from the date of origination to usually get to this point. Most borrowers are not aware of this 110% cap and it will come as a great surprise that their option loan has a new option and no others.

    And when the borrower goes to refinance not only is his original balance higher these loans often have pre-payment fees which but them further under water. not to mention that the appaissals will come in lower on re-fi’s and the market may be lower. Or their Home equity loan has to be paid off as well.

  9. RW commented on Jul 17

    Unleveraged, it sounds like that fine print clause in effect originates a new, uncapped loan at the higher rate; that could be a very nasty surprise indeed. Is that typical of interest only ARMS or is it a more widespread feature of ARMS generally these days?

  10. cm commented on Jul 17

    metroplexual: In any market, price formation happens when items are traded (whether individual trades are vonluntary or not). When only a small portion of housing stock participates in trades, the traded stock will set price levels. The problem with houses is that prices are used not just in trading, but as valuation of collateral for obtaining loans.

    Imagine that as a result of slightly falling prices, a lot of people who are in everybody’s decscription “safe and sound” when it comes to servicing cannot take out a HELOC anymore. Then consumer spending for discretionary items can hit the skids very quickly, putting pressures on attached business and labor sectors.

  11. cm commented on Jul 17

    Unleveraged: Wow, I second RW, please elaborate.

  12. Bearish commented on Jul 17

    This was a mania pure and simple. As prices rose, borrower and lender risks disappeared. And as we all know, as risks disappeared, more people entered the market to bid up prices.

    Now that we’re at nose-bleed levels and looking around. It is obvious that prices have dramatically exceeded their underlying fundamentals (yields on rental-equivalents) in many, many locations.

    Now we get to learn whether the leveraged mania works in reverse. As prices stagnate, exposing the dramatic risks taken on by borrowers and lenders, will 1) buyers bid less and 2) lenders raise standards?

    We often blame homebuyers for being ignorant of the fundamentals. But what about the capital markets? Why is mortgage paper priced at the levels at it is? Why are lending standards loose, as compared to years ago?

  13. metroplexual commented on Jul 17


    What I see happening is the opposite of the “wealth effect” when prices rachet downward.

  14. Michael C. commented on Jul 17

    Just went to the Grand Opening of a new master community here in CA. Price range was $500k-1.5M. Seemed like a good deal of interest, though it was heavily promoted. The gala event had shuttles, a few police navigating traffic, balloons, ice cream, etc. How this will translate to sales I do not know.

    However, what stuck out to me was that the upper end homes were not priced as most likely they will be gauging market conditions at the time of release. They placed heavy emphasis on the application on whether you owned or rented, so as to be contingent or non-contingent. Also, the HOA was $250 with property tax of 2%. On a $1M home, that’s over $1,900 a month for HOA & property taxes. I just can’t fathom this. While it didn’t make that much sense during the housing boom, I guess it just makes even less sense with so much home inventory currently out there.

  15. yizzung commented on Jul 17

    “Note that mortgage delinquencies and foreclosures remain low nationwide, including the areas where prices appreciated the most.”

    The reason for this is that rapid appreciation = equity. Plus, it’s still very early in this cycle. Any bank (or motivated buyer) will bail you out if you’re above water.

    I bought a house in SF two years ago and built up 25% equity by just sitting in it. (I sold it last month.) The point is, even someone who grossly overpaid 12 months ago with no down payment is already sitting on 10-15% equity. But as that appreciation curve flattens, you’ll probably see foreclosures pick up at a healty clip.

    Already in CA, forclosures in Q1 were up 28.7% over previous year Q1. Look at markets like Dallas TX and you’ll see that foreclosures are much, much higher and climbing. Very little appreciation combined in that market with shady subprime lending and overbuilding.

    Historically, the highest rapidly appreciating markets fall the fastest in a down market housing cycle. But these things play out over years, not months. In the last bust in SF real estate, REAL prices fell for about four years…

  16. The Big Picture commented on Jul 17

    Interest Only Mortgages

    Our discussion of Interest Only Mortgages this morning was incomplete without an accompanying graph. Here is the accompanying map from NYT: click for larger map Thank to the NYT for their invaluable

  17. DanF commented on Jul 17

    When twenty-five percent of the mortgages for San Bernandino/Riverside counties in California are interest-only (, we’ve got trouble. These are largely blue-collar counties with many residents typically commuting two- to three-hours to work each day. I grew up in San Bernandino; it’s not glamourous SoCal. It’s desert. It’s hot. It’s dry. It’s not without it’s charms, but many people choose to live there because they can afford to buy a house there. Well – at least they used to be able to afford a house there.

    If your commute is two to three hours, you’re paying $100 dollars a week for gas, then your mortgatge doubles. Heating bills keep increasing (it gets cold in the desert at night) and your salary has remained flat. And then gas goes up another twenty-five cents – which causes prices on all goods and services to increase.

    I don’t think we’ve seen market forces like this before. This isn’t just high prices on limited, desireable real-estate like Manhattan or SF. This is high priced housing everywhere – even in hot, brush-laden land sixty miles from your job. Even my house in Indiana has appreciated at least 30% in three years. It was barely worth what I paid for it. Believe me, there is nothing special about my house to cause it to go up that much.

    Too much creative financing has been going on and I fear it has caused mass speculation, get-rich quick excitement, and a very large bubble.

  18. Mr. Bubbles commented on Jul 17

    “Note that mortgage delinquencies and foreclosures remain low nationwide, including the areas where prices appreciated the most.”

    Not true in my area of California (which, according to multiple studies, was one of the 10 fastest appreciating areas in the nation over the past several years). Delinquencies/foreclosures are up 350 % year-over-year. The number of delinquencies/foreclosures equates to about 50% of current for-sale inventory! Median prices now flat year-over year.

    I believe my area to be a harbinger for much of the rest of the country (especially the coasts). This will NOT end well.

  19. mbarl commented on Jul 18

    My name is Steven Krystofiak, President of the Mortgage Brokers Association for Responsible Lending. I have a letter in a word document form that highlights the risks of the current loan industry unrealized by regulators and economists alike, mainly due to stated income loans.
    Email me at if you want me to send you a copy.

    ~ Steve Krystofiak
    13 main points in the letter are;
    1. Stated income loans are associated with fraud, and started to become popular in 2002.
    2. Banks originate these loans because they are profitable and then sell them to reduce their risk.
    3. Fraud is encouraged by the banks
    4. Stated income loans help no one.
    5. Exotic loans originated with stated income are now causing foreclosures or forcing homeowners to refinance into negatively amortized loans.
    6. Stated income loans are why home prices have skyrocketed. They have caused a large demand in the US housing supply.
    7. Banks have sold their loans and have already made their profit. Investors will soon realize stated income loans are too risky and stop purchasing them.
    8. Almost anyone can get a stated income loan for $950,000.
    9. Stated income loans cost consumers hundreds of dollars a year because of higher interest rates.
    10. Stated income loans allow tax cheats to purchase homes easier.
    11. Stated income loans are not always faster than fully documented loans.
    12. Appraised values are often inflated. Underwriters are basing their decision on inflated home values, inflated incomes and inflated assets. The only “real” number is the FICO (credit) score. This is why underwriters have become focused on FICO scores.
    13. Rules are not enough, they must be enforced.

  20. bobbyj commented on Jul 18

    This article actually understates the problem. Prices have been flat or declining in the more bubblicious areas of the country for the past year. How are people going to be able to refinance into a new loan now that rates are even higher today than when their earlier loan was originated and their house hasn’t appreciated? If they could only afford the home by qualifying with a teaser rate on an ARM, with no equity in the home there’s no way they’ll be able to afford a fixed rate loan today.

    On top of this, how many billions of dollars in equity have been HELOC’d out to pay for SUV’s, stainless steel appliances, and boob jobs? For many people the house ATM has run dry, they have no equity left either. Will they be able to afford the rising interest on the HELOC’s? Probably not in many cases.

    For these people selling isn’t an option, unless they get lucky and find the greater fool to pay top dollar for their home. Most of these people will try to sell to get out from under the staggering mortgage payment only to find that the market has turned on them. With sales costs running 6-8%, they’ll need to bring a big check to the table to get out, even if prices have just been flat. I doubt they have the money. I think we’ll see a dramatic rise in short sales and bankruptcies as these ARM’s and I/O loans reset. I agree with Mr Bubbles; this will not end well.

  21. Economist’s View commented on Jul 18

    Fed Watch: Living on a Knife Edge

    Tim Duy with his latest Fed Watch: Living on a Knife Edge, by Tim Duy: Big, big week for monetary policy. Today, we get the PPI figures. Tomorrow, Fed Chairman Ben Bernanke marches up to Capitol Hill for his Congressional

  22. Tim commented on Jul 18

    My wife and I own and escrow office.

    This chart was for 2003. Fast forward to 2006.

    In 2005, 71 out of every 100 PURCHASE transactions (71%)our office closed were 100% I/O transactions. Many of the loans have pre-payment penalties and many structured to where the borrower pays their own property taxes.

    This is not a misprint.

    I get genuinely discouraged knowing that a few of the borrowers we see are going to default.

    I’m on the front lines of this market and firmly place this debacle on the lending standards over the past several years.

    I plead with people to be in a cash position (if possible)and spend within their means because we are at the very beginning of this change in cycles. The impact of the housing markets unraveling this time around will impact our country’s economy more than what experts are forecasting. I have a family and genuinely hope I’m wrong, but fear that this problem will rock the economy like I’ve never experienced in my 40 yr life.

    To be honest, I thought it was rather humorous to look at what people were doing a year or so ago, now I am very concerned that everyone will pay.

    This is not funny anymore.

  23. Evan Hodge commented on Feb 29

    Recessionary times seem to put everything in slow motion. Everyone sits and waits for positive change before acting on anything which in turn produces the snowball effect to deeper recessionary levels. I am afraid we have only scratched the surface. Where will this country be come 2012?

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