ARM Resets: Tsunami Ahead

If all real estate is local, it's also true that what's ailing the market can sometimes spread from one area to the next. That seems to be the case with home foreclosures and the role of two particular kinds of alternative mortgages, which have yet to achieve the villain status of the subprime market.

Earlier this week, Diana Olick wrote about the fact that despite continued increases in foreclosures, many analysts are describing the rate of increase as "moderating" (see story here). Unfortunately, this might just be another calm before the storm gets worse. With increased job losses and higher costs, defaults will continue to rise. Home builders, Hovnanian and Toll Brothers reported more losses this quarter and Toll forecast lower revenues in the quarter ahead. Also looming is the next wave of loan recasts.

Last year, everyone was worried that the resets on subprime loans would force borrowers into higher interest rates and payments. This element of the housing slide and credit crunch has subsided a bit. Akiva Dickstein, Managing Director of Fixed Income Research at Merrill Lynch explained, "Subprime and ARMs have become less of a problem recently because short rates have come down so much. If the Fed decides to raise rates the issue will return. However, even without reset difficulties, subprime and Alt-A loans are slipping into default at very high rates. The concern about future resets has given way to concern about borrowers equity erosion."

However, the Option ARMs and Interest Only (IOs) loans scheduled to reset in the next few years will add more trouble. These loans represent about 15% of securitized loans and some have negatively amortized, increasing the payments and making refinancing more difficult. According to data from Barclay's, about $300 billion in option ARMs and $820 billion in IO's are set to recast. The results could be payment shocks over 80% for option ARMs and over 60% for IOs according to Barclay's.

Option ARM Recast and Payment Shock Forecast

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So when things are "moderating", it appears to only be for the time being. Does this mean that the home builders like Toll Brothers , Pulte Homes or Centex will fall more? Not according to Jim Cramer. Cramer projects a housing bottom by June, and recommended the Housing Index as a way to play the sector. Either way, over the coming quarters, pay attention to news from these builders as well as the Financials including banks like Citigroup and the GSE's, Freddie and Fannie .

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