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ARM Resets and Foreclosures: A Fading Concern

March 12, 2008 -- One of the major issues of the mortgage mess has been said to be the expectation of massive hikes in homeowners' monthly payments when billions of dollars of adjustable rate mortgages (ARMs) are reset (adjusted) in 2008. The conventional thinking has been that ARM rates would skyrocket from the discounted rates they started with, threatening to push untold numbers of homeowners into default.

That's no longer the case, especially for borrowers holding 'prime' ARMs. Circumstances have, for now, acted to favor ARM holders. Instead of facing a sizeable payment hike, they may see little change in their payment. Many, in fact, could enjoy a decrease in their monthly payments.

Most ARMs made in the past several years have been 5/1 Hybrid ARMs. After five years, the interest rate is due to be adjusted to an index plus a margin, subject to a interest rate 'cap' (typically 5%). Such rate adjustments are designed to bring the payments closer to market rates. Among the most common indices which govern interest rate changes for these products are the 12-month Libor index and the one-year Treasury constant maturity index. To the one-year Treasury, a common markup (margin) of 275 basis points (2.75%) is added; to the Libor, a 250 basis point markup is typical.

At the beginning of 2008, there was indeed reason to believe that rate resets would see homeowners facing huge payment increases. As the credit markets in general have seized up, however, investors have been desperately looking for investments offering a decent return. Gold and other precious metals have seen such an influx of cash that their prices have reached historic highs. Ditto for many commodities, including oil -- which is why, despite ample supplies, gas prices are north of $3 per gallon.

That same "flight to quality" instinct has hit many traditional investment interests as well. US Treasuries, always a favorite in troubled times, have been in such demand that the yield on the One-Year Treasury Constant Maturity (a.k.a. one-year TCM) -- a widely-used ARM index -- has plummeted from 3.42% in December to just 1.66% as of this week.

The result? A typical ARM tied to this index, and assuming an industry-average margin of 2.75%, would be adjusted to 4.41%. If rounded to the nearest one-eighth percent (also an industry standard), a holder of such an ARM would pay just 4.375%. A borrower with a loan of $150,000 taken in 2003 would see his monthly P&I payment slide from $794 per month to about $754.

ARMs tied to the monthly 12-month Libor index are also benefiting. The index, which peaked last year at over 5%, is now about 2.5%. Adding a typical 250 basis-point margin brings that loan to about 5% -- not much different from its initial rate five years ago.

For subprime ARMs, markups over indexes are much higher, but the fall of the underling interest rate can mke those loans at least somewhat more palatable. According to Treasury Secretary Paulson, "a typical subprime ARM resetting in December might have increased from 8.5% to 10.8%; in today's lower interest rate environment it may reset to only 9%."

Of course, a fair percentage of loans are failing even before getting to the initial rate reset, and even a slight downward revision in monthly payment can't cure that particualar problem.

Jay Brinkmann, vice president of research and economics for the Mortgage Bankers Association of America noted that

About 40 percent of all foreclosures are homeowners with prime or subprime loans who couldn't make their payments before the reset, Brinkmann estimated in an interview. Another 23 percent are borrowers who received some form of loan modification, typically a freezing or a reduction of their rate, and then default, he said.

Forty-two percent of new foreclosures in the fourth quarter were people with adjustable-rate subprime mortgages, given to borrowers with limited or tainted credit records, according to the report. Those types of loans accounted for about 7 percent of all mortgages, the report said.

"It comes down to an overstretching of buyers to get into homes they couldn't afford and an overextending of credit by lenders who were more willing to take risk," Brinkmann said.

Another 20 percent of new foreclosures were prime adjustable-rate mortgages, which accounted for 15 percent of all home loans, according to the report.

Interesting tidbit:

Nationwide, more than half the borrowers who lose their homes through foreclosure never answered their lenders' calls or letters, according to Freddie Mac. And an MBA analysis found that 23% of loans in foreclosure last fall were to homeowners who had no contact with their lenders, and that an additional 18% were to absentee owners.

UPDATE (Spring 2009): This Bloomberg Business Week article notes that "interest rates dropped to historically low levels and the wave of resets could now be delayed until well into 2010."

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