The Nefarious and Inevitable Impact of Affordable Mortgages

As we have examined market forces which determine home prices will continue to place downward pressure on transaction values. The impact of Housing Bubble created distortions will dramatically impact the economy, further reinforcing current house price trends. But the most nefarious force influencing home prices going forward will be the structural remnants of the Affordable Mortgages which were the very cause of unsustainable housing prices.
Economic Time Bombs

Mortgages with adjustable rates enticed buyers to purchase houses with temporarily low payments. Each of these mortgages was an economic time bomb due to explode when the interest rate adjusted. Lenders and buyers never anticipated that those time bombs would explode based on the availability of refinancing options, a robust demand for houses and the expectation of rising home prices. When the housing market crashed equity evaporated, refinancing options disappeared and the demand for homes dried up.

As rates have reset, the economic time bombs have started to explode. Thousands of mortgages will reset every day for years to come. At minimum, the higher interest rates stress the homeowner and reduce after-mortgage disposable income, detracting from consumer spending. In many cases though, interest rate resets trigger foreclosures.

Adjustable rate mortgages provide us with a steady, visible and quantifiable source of foreclosures through 2012. These are the structural remnants of the affordable mortgage generated Housing Bubble.

Of even more concern, what will inevitably be the worst performing mortgage classes and products in history, have yet to begin to reset in large numbers. Fitch estimates that Option ARMs which won’t begin to reset in large numbers until 2009 may default at a rate close to 50%. It would be no surprise if foreclosure rates exceeded this level based on an understanding of how these mortgage products work, and in what markets they are concentrated. Option ARMs, issued at the zenith of the valuation bubble, have allowed mortgage balances to increase while the value of the home backing the loan has declined rapidly.

What makes affordability mortgages truly nefarious is that their existence represents a persistent, structural impediment to the stabilization of the housing market. Many underwater mortgages will inevitably result in foreclosure, yet these mortgages are serviceable under the introductory or optional payment interest rates. When an adjustable mortgage hits the reset date or when the Option ARM loan balance triggers a reset, the foreclosure results. There are millions of these foreclosures looming over the next four years. We know they will occur, we know the time period during which they will be triggered, but there is little or nothing that can be done to defuse these time bombs. Many home owners understand that foreclosure is a certainty, but are incentivized to stay in their homes until the reset occurs because the introductory interest rate still represents a low cost source of housing.

No one can accurately predict when housing prices will find a bottom given the large number of forces which will dynamically affect the market for the next several years. But anyone who understands the mechanism that determines the price of houses at the margin and who grasps the volume of impending foreclosures through 2012, can conclude that the housing market is years away from finding a stable bottom.

The residential real estate market has little chance of meaningful recovery until 2013, and there is a material likelihood that prices will fall in real terms beyond that date.
Other Sources of Foreclosures

While less easy to quantify there are other sources of foreclosures which will represent a material source of such transactions going forward. In fact, the primary source of foreclosures has historically been normal business cycle friction. Foreclosures will proliferate as the economic downturn continues irrespective of the structural supply created by affordable mortgages.
Job Losses

The business cycle contribution to foreclosures is just beginning. Considering that past foreclosure cycles have been driven primarily by lost jobs, there will be considerable volumes resulting from the economic slowdown. Unemployment has begun to rise but is likely to worsen materially as credit tightens, consumer spending declines and negative wealth effects impact the economy.

Voluntary Foreclosures

A new source of foreclosures has begun to develop and may grow into a material source of home losses.

It may be in the best interest of homeowners to willingly default on mortgages, even if they have the ability to continue to service them. These people may have jobs and sufficient income to service their mortgages, but doing so would make no logical sense. How far underwater must an individual be to walk away from their mortgage? In California, where median housing prices have declined by more than 30% and some markets are down by 60% we may begin to find out.
The costs are known to the home owner. The borrower would see his or her credit damaged for a period of years. The benefits depend on individual circumstance but can be imagined. A buyer can rent an equivalent abode for less money per month than it takes to service the market mortgage rates. Additionally, the owner would eliminate a large sum of debt for which he or she is responsible. Why would an owner pay a high monthly payment to keep a house worth much less than the value of the loan into perpetuity. The savings requirement necessary to buy one’s way out of the underwater mortgage may make it untenable.

I am not advocating this strategy, simply observing the individual economic incentives which will inevitably lead to such behavior. While these borrowers will have defaulted on their individual responsibilities, the lenders should never have lent money to purchase dramatically overvalued properties with terms that might result in or encourage such behavior. Both parties are culpable.