Attack Of The ARMs

The New York Times had an article yesterday about adjustable rate mortgages (ARMs), and the threat they pose to recovery. I have noted in the past that prime mortgages are beginning to default as a result of the poor economy. Since ARMs can be prime or subprime, I'd expect to see problems across the spectrum of credit quality regarding these products. ARMs will almost certainly prolong the housing market's problems even when fixed rate mortgages begin to perform better.

The Times' begins its piece as a sort of human interest story about a gentleman who makes $100,000 as a television camera operator (clearly, I'm in the wrong business) and initially paid $2,200 on his $618,000 ARM. That mortgage amount has grown to $680,000 due to his low initial payments. His home is now only worth $400,000. It then gets into some analysis saying:

Now Mr. Clavon is part of what many economists say is a looming threat to a housing recovery: more than a half-million option ARMs scheduled to reset in the next four years, at rates many homeowners cannot afford. His mortgage payments have risen to $2,700 a month because of a clause he did not notice on his contract, and are scheduled to rise above $4,000 in two years.

Here's a Times source with some sobering and valuable analysis:

"Everyone's been focused on subprime, but we're more concerned about this," said Todd Jadlos, managing director of LPS Applied Analytics, which analyzes data for the financial industry. "By the time subprime defaults had increased 200 percent, in June and July of 2007, option ARMs had gone up 400 percent. People just didn't notice because the overall numbers weren't as high."

Ugly. I've had some internal grappling with the problem of ARMs. Anyone who regularly reads what I write knows that I'm rather skeptical when it comes to financial regulation. But I worry that these ARMs can be so dangerous, that I'm not sure they're worth keeping around. Another Times' source explains part of the problem:

"This was a loan meant for sophisticated investors, or people who expected their cash flow to increase over time," said Elena Warshawsky, a residential credit analyst with Barclays Capital, which expects 81 percent of the option ARMs originated in 2007 to default, with many ending in foreclosure.

"But then they were extended to all sorts of buyers. Now it wasn't people hoping their income would grow. It was people hoping their house price would increase" so they could refinance or sell, Ms. Warshawsky said.

And I agree that sophisticated borrowers with pristine credit, a high net-worth and a huge down payment maybe should be able to qualify for am ARM. But a part of me wonders what the point of that would be. Would it really be so bad to force them into a fixed-rate mortgage?

Oh, and 81%. That's an epic fail if I've ever seen one. I certainly hope she's wrong, but I worry she's right. I expect that we'll be dealing with the ARM problem for several years to come.