Study defends option ARM mortgages

Unfortunately this paper will be used by mortgage brokers to talk buyers into using ARMs.

This paper laughably argues that buyers will pay more than the minimum when interest rates are low and reduce their luxury purchases to pay the mortgage when interest rates go up. I believe the reality is that many buyers simply make the minimum payment always. They feel their luxury budget is already non-existant.

Random interest rates aren't the situation we find ourselves in today. We have had historically low interest rates and they are much more likely to go up than down. Especially taking into account introductory teaser rates.

As long as housing is appreciating faster than the negative amortization, life is good. Lenders will only allow the negative am to go so high relative to the house value before foreclosing. High LTVs mean there is very little room to move early on.

The situation we find ourselves in today, higher interest rates and falling housing prices, even the author of the paper would agree are likely to lead to foreclosure for ARM borowers.

I'm certainly not going to argue with stochastic expectation integrals, but this is a good case of very precisely getting the wrong answer, it simply doesn't take into account actual human behavior.

The low rate cycle was an accident waiting to happen. Let's ignore teaser rates, and look at a fully amortizing ARM. At 1% T-bill, the rate would be close to 4%, $250K mortgage for $1200/mo. When the T-bill hit 5%, and the rate went to 8%, that payment is near $1800/mo.

The reference to the 'perfect world' is great. Because in the perfect world, the borrower here either had a low debt to income, and used the $600 savings to pay off the car, kill off a credit card, or float their expenses till the spouse graduated and started work, or went back to work after maybe staying home with a newborn. In the perfect world, the $1800 at least appeared on a spreadsheet and was known as the second year adjusted rate.

You see, 1200 to 1800 is enough of an issue. Add the teaser rate, dropping the first payments to $600, and negative amortization, increasing the $1800 to $2000, then double all numbers for a loan of $500K, and you can see how it goes from reckless/ignorant to insane.

Oh - in the perfect world, every one of these were at 80% LTV or less, but even then as they adjusted, too many houses coming on the market still depresses prices. I didn't read the whole story mentioned by the OP, for 65 pages I need to print first, but the papers starts in the perfect world, where there seems to be more intelligence regarding the numbers. JOE

I liked the section where they talked about how good a benefit to the consumer it was if early prepayment penalties were high, since if the bank knew it was difficult for the consumer to leave they'd then give the consumer the best possible benefits.

It reminded me of one of those "studies" that prove communism is the best economic system.

An article on page C1 of today's (Oct-24-2007) Wall Street Journal indicates that people using option ARMs are getting into trouble at higher tates than those with conventional mortgages. For most people, who are not as rational as the actors in economists models, option ARMs are a bad idea.

Countrywide's New Scare 'Option ARM' Delinquencies Bleed Into Profitable Prime Mortgages By RUTH SIMON and JAMES R. HAGERTY 'It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS.

Mr. Mozilo told investors in September 2006 that he was "shocked" so many people were making the minimum payment. He called a sampling of borrowers to find out why. The "general answer...was that the value of my home is going up at a faster rate than the negative amortization," he said. "I realized I was talking to a group...that had never seen in their adult life real-estate values go down."

The temptation to use these loans was strong. A borrower with a $520,000 mortgage at a 30-year fixed rate of 6.05% would pay $3,134 monthly. With an option ARM carrying a 1% introductory rate, the minimum payment in the first year plummets to $1,673.

But after a specified period, often five years, when borrowers must start repaying principal and meeting full interest payments, monthly payments can more than double. If the balance outstanding gets too high -- the ceiling generally is 110% to 125% of the original amount borrowed -- borrowers can face sharply higher payments even sooner. Some borrowers could find themselves in the painful position of owing more than the value of their home.'

May I offer one more point, additional, not to the contrary?

ARMs don't go back that far historically speaking. They were not around in the 70's for the run up in rates that finished with an 18% T-Bill (am I off here?). So, given much of ARM history is in the time period that has had a fundamental trend that's just now reversing, why is anyone surprised the data shows this to be the best choice? For most of the decline in rates, it was.

For an analogy, I offer this.

me that from 1980 to 1999 the average return is 18.3% with a STD deviation of 12.6%. Only two negative years, at -4.8% and -3.1%. With the benefit of hindsight that goes back many decades prior, I know this snapshot is just that, a (too small) window of time that can result in wrong conclusions.

Even in the 90's, when I was asked for ARM advice, I produced a spreadsheet which showed both best case, further drops in rates, and worst case, rates going up the full adjustment to the maximum rate over

3-5 years. More than ever, I don't claim ARMs are evil per se, but I do think that one had to be properly qualified which clearly wasn't how these banks ran their business. JOE

"joetaxpayer" wrote

I may be stating the obvious, but has it occurred to others that banks offering ARMs calculated the cost of massive foreclosure and found it far less than projected income? The banks can count as benefits (1) non-defaulting mortgage payers either paying higher interest rates, refinancing (and so generating nice fees for the banks), or selling (and so generating more fees for the banks), etc.; and (2) defaulting mortgage payers leaving the banks a home that, even auctioned well below market value, pays the banks (and/or their ilk) a nice sum.

Granted: This has thrown the various creative instruments for financing home loans into a tizzy, with quite an aftershock on investors in these instruments. Plus people thrown out of their homes are people who are going to tend to be less than productive at their jobs, which can affect the whole economy, relying overwhelmingly as it does on blue collar labor. Plus, after being put through the mill for home costs, with what will they pay for health insurance? No health insurance means less health, which means even less domestic productivity.

So banks (and their ilk) arguably are profiting mightily (with some exceptions) and per plan. The rich get richer; the poor (and overwhelmingly poorly educated as well) get poorer. Desperation results; crime rises. The ensuing economic and sociologic meltdown ultimately produces more regulation of those who hoard money.

These are my thoughts after reading about home auctions in the NY Times as well as ones happening soon where I live (out West). These auctions are going to make some people a pretty penny.