Strong opinions, weakly held

It’s not subprime, it’s negative amortization and ARMs

Herb Greenberg has a lengthy repost of an email from a mortgage industry veteran who says that the troubles in the mortgage industry are only beginning:

Sub-prime aren’t the only kind of loans imploding. Second mortgages, hybrid intermediate-term ARMS, and the soon-to-be infamous Pay Option ARM are also feeling substantial pressure. The latter three loan types mostly were considered ‘prime’ so they are being overlooked, but will haunt the financial markets for years to come. Versions of these loans were made available to sub-prime borrowers of course, but the vast majority were considered ‘prime’ or Alt-A. The caveat is that the differentiation between Prime and ALT-A got smaller and smaller over the years until finally in late 2005/2006 there was virtually no difference in program type or rate.

This is definitely one of those “read the whole post” items.

The vicious cycle that has driven the housing industry is reversing upon itself. It probably started with lower lending standards. More people could get approved for mortgages, so demand for housing rose. That caused house prices to go up, which created a market for more exotic mortgages that allowed people to buy houses without putting down money or eating the monthly payment on a standard fixed-rate mortgage. These exotic mortgages enabled people to buy more house than they could with a traditional fixed rate mortgage, and enabled people with less money to buy houses in expensive areas. That in turn drove demand and caused houses to rise even more. The catch was that as long as houses were appreciating, people could keep refinancing to keep the interest rates on their loans from resetting.

Now we’re seeing the inevitable reversal. When houses stopped appreciating so rapidly, people started seeing their loans reset to rates they couldn’t afford in the first place, and now they’re seeing foreclosures. That hurts the banks, who in turn tighten up their lending standards, and that results in less homes getting sold, and thus less appreciation and even drops in home prices in some areas. The cycle that caused home prices to spiral upward sure looks like it’s going to cause them to spiral downward. Here’s what Greenberg’s correspondent says:

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.

I think we’re in for a lot more pain.

And I don’t understand how people with a household income of $175,000 can afford a million dollar home. If you buy a million dollar home and put only 5% down, your payments on a 30 year mortgage at 7% are about $6,300 a month. Mortgage lenders will tell you that your mortgage payment shouldn’t be more than 35% of your take home income, which means for a $6,300 payment you need to be taking home roughly $18,000 a month. That means you need to be taking home $216,000 annually, after taxes, health insurance, and all the other stuff that gets deducted from your paycheck.


  1. This arithmetic looks totally crazy to me. In this country it used to be considered unwise to lend more than 2 1/2 times annual income, against a ten per cent deposit. Times have changed, but more than 3 1/2 times would be hard to justify, I think. Mind you, I live in a small, grotty house, and my mortgage payment is less than 20% of my income, which means I sleep better. But even so, lending the amounts you discuss looks completely nuts from here.

    I take it that “ARM” is “Adjustable Rate Mortgage”

  2. So, silly question: Is that housing price shift going to happen through a drop in dollar amounts, or inflation? If it’s inflation, get in now ’cause you really want the bank holding that money…

  3. I think plenty of people here are paying over 50% of gross income in mortgage, because after all, if you didn’t get in NOW you might NEVER be able to afford a house since those 15-20%/year price increases were obviously never going to stop or reverse.

    Which sounds (and is) pretty crazy but if you believed it it made some kind of sense, since the bank holds most of the downside risk in the event of foreclosure, and you get all the upside on a hugely leveraged asset. FREE MONEY!

    Even perfectly good borrowers paying 35% of gross on a fixed-rate mortgage are going to be foreclosing if there is a 30-50% drop in prices. If your house is worth $500k now but you bought it for $800k with $100k down, you have entirely lost your $100k down payment and now owe $200k more than the house is worth now. That’s a pretty sharp financial turnaround.

    If you used your house as an income source with equity withdrawals based on yearly appreciation you may also be used to living well above what your work income might provide, and plenty of people seem to have been doing that too.

  4. ARM is “Adjustable Rate Mortgage”, yep. I have always thought ARMs are kind of crazy (fixed rate mortgages put all the interest rate risk on the bank), but for real thrills Google “negative amortization”.

  5. Thanks, Rafe. I just did. Excuse me while I move to Lapland, paying cash for my new home. It will come with access to a lake and plenty of firewood.

  6. Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes.

    am I the only one bothered by this apples and oranges math? I mean, he didn’t give a number for the households making over 75k, and yet he takes 10% of total households to be a 90% reduction from that (undefined number). I seriously doubt that all SF households make over 75k…

    as for adjustable rate mortgages, they have existed long before all the current craziness, and can make sense. for example, we have one, and the maximum rate after the shift is capped. for 7 years we’re paying 4%, and then maybe (1) we’ll sell for school system reasons, (2) we’ll refinance, having decided to stay, or (3) we’ll pay up to 8%, which was pretty normal a decade ago and still isn’t bad. (or (4) we’ll pay off the mortgage, which would rape our savings but still be possible.) this is hardly crazy math!

    of course, this is also the very normal end of a continuum that seems to extend into the stratosphere (including all the folks paying down none of their principal, who would have been better off renting!)…

  7. I agree with you about the bad math regarding the annual income necessary for a million dollar home. And I also believe that things are going to get a lot worse before they bottom out.

    All this makes me glad we made relatively conservative decisions when we bought a newer, larger home five years ago: 6% fixed-rate 30-year mortgage, the loan amount was well around 2x our annual income at the time, bought in an area that wasn’t suffering from greatly overpriced homes.

    The only ‘lower lending standard’ we took advantage of was only putting 3% down (basically, covering closing costs). But between what we’ve paid on the mortgage in 5 years (not that much, of course) and a modest increase in the home’s value, our home could lose 25% of its current value before we go underwater. Since we don’t live in an area that was greatly inflated, I’m fairly confident we’ll continue to owe less than the value–unless things get even worse than I’m anticipating.

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