ARM Payment Shock a Myth?

Home with foreclosure sign
Home with foreclosure sign

We've been talking a lot recently about the "next wave" of foreclosures that would be driven by adjustable rate mortgage resets. In a research note today, FBR's Paul miller is taking an interesting tack: "While we remain very concerned about the impact of continued job losses on default rates, our analysis suggests that payment shock from ARM resets should not be a problem, as long as the Federal Reserve can keep short-term rates at record lows."

At face value, that makes total sense. Interest rates on the 30-year fixed are hovering just above 5 percent, historically low by any measure. Borrowers may, as Miller notes, benefit from the rates resetting lower. How much are we talking here? Miller:

While it is very hard to quantify the exact outstanding amount of any one type of mortgage, as banks do not really give detail down to the loan type, we know that $5.3 trillion in ARMs were originated from 2003 to 2006. Additionally, ARMs composed 45% to 50% of the origination market from 2004 to 2006. We estimate that there are roughly $500B of option ARMs outstanding, with roughly $150B expected to reset over the next two years, and another $1T of 5/1 IOs outstanding, of which $200B to $300B are expected to reset in the next two years.

Now here's my problem with Miller's thesis. Many of the ARMs that we're talking about are "pay option ARMs". These were those wonderfully innovative and unique loan products that enticed so many borrowers/investors during the height of the housing market to jump into loans they could never afford. Why? Because you can choose to pay whatever you like for a while. So guess what most borrowers chose? And then it comes back to bite you. Yes, many of these loans could reset to manageable rates, but they will also hit the limit, that is when the amount deferred hits a certain percentage of the total loan and then is required to be added on to the monthly payment. At that point the interest rate will have much less to do with the amount of the monthly payment.

The borrowers who got into these loans were either investors who expected to flip the home quickly or borrowers who expected to gain income in a short time. Not a lot of either of those going on right now. And however low the interest rates are when the reset occurs, it will never be low enough for a borrower who has recently lost his/her job or taken a pay cut.

And then there's my concern that mortgage rates may bump up a bit next year, as many of these loans are resetting. The mortgage market has been benefiting from the artificial infusion of government cash, i.e. the Federal Reserve buying up $1.25 trillion in agency MBS. That program is nearing an end, and while we may get some clues as to its future at when the Fed meeting wraps up tomorrow, without the program interest rates could rise nearly a full percentage point.

So suffice it to say, yes, the ARM reset problem may not be what we thought it was, but it didn't just vanish.

Questions? Comments? RealtyCheck@cnbc.com