Student Question: Mortgage Markets

I have a question for you about this real estate mess that is going on with the market right now. What is going to happen to the people who are signed up for these ARM loans and the rates will be adjusting soon? They're not going to be able to refi because more than likely the value of the house is much lower than the loan they are stuck with. Are they going to be forced into foreclosure? It seems that is the only option for these people in this situation. I know on the Indymac Federal Bank website, they will consider re-writing your existing mortgage if you are in default and going to face foreclosure, but nothing is being done to prevent the problem from reoccurring in a year from now. So, if you have a loan that you know will be a problem in the future, I guess you have to default before you can get help? These loans were still being written two years ago and if you were signed up for a 3 yr ARM, the fun hasn't even started yet. I'm just curious on how you think the future is going to look for these people who are stuck.

REPLY
Yes, what you describe is at the core of this current financial crisis. Way too many people, borrowed way too much money, to buy way too expensive homes. This process was encourage by the Federal government (for several decades, Democrats and Republicans were in a competition to report the highest levels of home ownership during their terms in power) and by government sponsored enterprises, such as Fannie Mae. Federal tax deductible mortgage interest paid on first, and second, mortgages on homes also helps to encourage housing consumption.

The fact that many of these mortgages are adjustable rate is just the icing on the mess. As interest rates increase, you will see a sharp increase in default rates in adjustable rate mortgages. Now the Federal Reserve has to be very concerned about keeping interest rates fairly low which could cause problems with the value of the US dollar and inflation expectations.

These poorly underwritten and often adjustable rate mortgages are clogging-up the financial system because of the expectation that many more will default in the future, making these mortgage bad investments. Financial institutions, and all other owners, holding these mortgages or mortgage-backed securities cannot get them off their books (sell them) because no one wants to buy this junk. One of the few large scale sales of mortgage-backed securities from a while back realized an 80% discount (the purchase paid about 22 cents on the dollar).

My grandfather, who had a lot of old fashioned commonsense and was very conservative with his finances, had an old rule-of-thumb that you should not borrow more than 2 times your gross annual income to buy a house. Although this might be a little too conservative, especially in some of the higher cost of living areas, I would say a maximum of 3 times would be prudent. However, due to the run up in housing prices and lax lending standards, many people have borrowed 4 to 5 times, or more, their annual gross income.

I am afraid that we will continue to see and hear more about foreclosures. However, you don't need to fear that everyone will be out on the streets (this should not be a major concern as long as employment markets holdup). Many of the foreclosures will result in people downsizing to houses and mortgages that are more affordable (from 4 or 5 times gross income to around 2 or 3 times). The average house price in Arlington is around $150,000 so a family earning $50,000 could own a comfortable house under the 3x gross income rule-of-thumb. Finding affordable housing in other areas of the country will be a lot more difficult. If the old school rule-of-thumb of 2 to 3 will in-fact apply, then housing prices in high housing cost markets may have to adjust substantially.

If anyone out there is having difficulty with making mortgage payments, you should contact your mortgage company immediately. Foreclosure is a very expensive process for the mortgagee. It is usually a much better deal for the mortgagee to work something out with the mortgagor (the borrower), if possible. The Indymac website is a good example of a mortgagee willing to work with mortgagors to prevent foreclosures.