Why Option ARMs May Rattle Markets Soon
Option ARM mortgages may be yet another threat to our wealth. They will certainly add to the downward pressure on home prices. Let's see if they might rattle markets in general.
Option ARMs were created a few years back during the real estate mortgage mania that ultimately resulted in the collapse of real estate and the mortgage market. They were heavily marketed until about a year and a half ago, some time after the subprime crisis hit. People started seeing them for the disaster they've turned out to be.
An Option ARM allows you to pick one of three payments. Here's an example of typical optional payments: 1) this payment is the traditional kind that pays interest and some of your principal 2) this payment pays only the interest due 3) this payment is so small that an amount is actually added to your mortgage principal. Note: under this option, the principal of your mortgage increases over time!
Can you guess which payment many people choose? Yep. They go for the smaller payments - many choosing the one that winds up increasing the principal of their mortgages over time. Madness!
Now these toxic products are beginning to default. You see, the payments weren't set in stone. The payments adjust over time. Guess which way. Yep. Up. And now people can't make the re-set payments. A new subprime-type collapse is in motion. It may not be as bad as the subprime collapse. We won't know how this will directly impact the economy or the financial markets for a while, but the process has begun. Millions of people are involved. We'll see even more mortgage foreclosures than we've already seen, pushing even more homes onto the already saturated real estate market.
My firm had one client introduced to these Option ARMs by their friendly banker. These folks weren't stupid, but they were a bit desperate. They had a re-setting mortgage (from an "adjustable rate" mortgage) and couldn't afford the new payment. (They already had the mortgage when they came to us. We hardly ever recommend adjustable rate mortages, never mind Option ARMs.) Fortunately they told us about the bankers proposal. When we analyzed the mortgage, it was our first real look at these bizarre products.
They had those three choices I mentioned above: pay the usual interest and principal payments you'd find in a traditional fixed-rate mortgage; pay interest only; pay a lesser amount. Naturally the lesser amount looked attractive to the client.
That was the first time I actually saw one of these Option ARMs. Obviously we pointed out the problems this product might present to our client, who had no idea what would happen to their mortgage if they paid the smallest payment (i.e., they would owe more and more money over time).
Fortunately for them, they saw the light and we helped them find an appropriate mortgage using our contacts. The banker who recommended the Option ARM struck us as clueless. Who knows how many of these he pushed on other customers.
We then did a little investigating and found out that mortgage brokers, bankers and others responsible for selling mortgages were given higher commissions or bonuses when they pushed option ARM's. I guess we shouldn't be surprised. Isn't that so consistent with the greedy actions of so many people in the financial services industry over the last few years?
I wonder now how many millions of home owners may lose their homes because they will not be able to meet their payments. Not that I'm feeling sorry for them all. But my experience with this one client tells me that not everyone really had any idea what they were getting into. This wasn't a case where the homeowners weren't qualified for a mortgage, and should have known better than to take on so much debt. It was a case where the mortgage itself was confusing to them. I don't know if the people responsible for designing and pushing these twisted products should be prosecuted in any way, but they certainly should be ashamed of themselves.
As for whether markets will be rattled by the coming wave of defaults, I think it depends on the degree to which people wind up actually walking away from their homes and dumping more of them on an already saturated market. And what I've seen so far are only guesses as to how many people will wind up in this position. If the market has already priced in the correct number, then it shouldn't affect the markets at all. But if the number turns out to be higher than anticipated, then we can add this to a growing list of items that threaten to undermine our financial system this year.
Option ARMs were created a few years back during the real estate mortgage mania that ultimately resulted in the collapse of real estate and the mortgage market. They were heavily marketed until about a year and a half ago, some time after the subprime crisis hit. People started seeing them for the disaster they've turned out to be.
An Option ARM allows you to pick one of three payments. Here's an example of typical optional payments: 1) this payment is the traditional kind that pays interest and some of your principal 2) this payment pays only the interest due 3) this payment is so small that an amount is actually added to your mortgage principal. Note: under this option, the principal of your mortgage increases over time!
Can you guess which payment many people choose? Yep. They go for the smaller payments - many choosing the one that winds up increasing the principal of their mortgages over time. Madness!
Now these toxic products are beginning to default. You see, the payments weren't set in stone. The payments adjust over time. Guess which way. Yep. Up. And now people can't make the re-set payments. A new subprime-type collapse is in motion. It may not be as bad as the subprime collapse. We won't know how this will directly impact the economy or the financial markets for a while, but the process has begun. Millions of people are involved. We'll see even more mortgage foreclosures than we've already seen, pushing even more homes onto the already saturated real estate market.
My firm had one client introduced to these Option ARMs by their friendly banker. These folks weren't stupid, but they were a bit desperate. They had a re-setting mortgage (from an "adjustable rate" mortgage) and couldn't afford the new payment. (They already had the mortgage when they came to us. We hardly ever recommend adjustable rate mortages, never mind Option ARMs.) Fortunately they told us about the bankers proposal. When we analyzed the mortgage, it was our first real look at these bizarre products.
They had those three choices I mentioned above: pay the usual interest and principal payments you'd find in a traditional fixed-rate mortgage; pay interest only; pay a lesser amount. Naturally the lesser amount looked attractive to the client.
That was the first time I actually saw one of these Option ARMs. Obviously we pointed out the problems this product might present to our client, who had no idea what would happen to their mortgage if they paid the smallest payment (i.e., they would owe more and more money over time).
Fortunately for them, they saw the light and we helped them find an appropriate mortgage using our contacts. The banker who recommended the Option ARM struck us as clueless. Who knows how many of these he pushed on other customers.
We then did a little investigating and found out that mortgage brokers, bankers and others responsible for selling mortgages were given higher commissions or bonuses when they pushed option ARM's. I guess we shouldn't be surprised. Isn't that so consistent with the greedy actions of so many people in the financial services industry over the last few years?
I wonder now how many millions of home owners may lose their homes because they will not be able to meet their payments. Not that I'm feeling sorry for them all. But my experience with this one client tells me that not everyone really had any idea what they were getting into. This wasn't a case where the homeowners weren't qualified for a mortgage, and should have known better than to take on so much debt. It was a case where the mortgage itself was confusing to them. I don't know if the people responsible for designing and pushing these twisted products should be prosecuted in any way, but they certainly should be ashamed of themselves.
As for whether markets will be rattled by the coming wave of defaults, I think it depends on the degree to which people wind up actually walking away from their homes and dumping more of them on an already saturated market. And what I've seen so far are only guesses as to how many people will wind up in this position. If the market has already priced in the correct number, then it shouldn't affect the markets at all. But if the number turns out to be higher than anticipated, then we can add this to a growing list of items that threaten to undermine our financial system this year.
Comments