News & Analysis This Month/Supplement - Keep Your Eyes On Rate Shifts In Mortgages

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Papa & Baby Doc's Crimes

Must learnedly read, too; in part, of intellectual rigor

Two years ago, when the housing market was roaring along, I called a mortgage broker on the West Coast and asked for some help. I told him that I wanted to interview some recent home buyers who had taken out an adjustable-rate mortgage — one of the big drivers of the boom — and he was nice enough to pass along a short list of names.

One of the buyers was a business consultant in her 40s. She told me about her charming new house and the fact that she expected it to be a good investment, even if it had cost a bit more than she wanted to spend. Then I asked about her adjustable-rate mortgage.

Confused, I called the broker again to see what was going on. A little while later, I got a sheepish e-mail message from him explaining that her loan did, in fact, have an adjustable rate. She just hadn’t realized it.

Now, I think this was an honest misunderstanding in which the broker believed that he had explained the terms of the loans more clearly than he had. And the mortgage ended up being a good one for the buyer anyway: she recently decided to move to a new area and sold the house before her rate jumped.

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This fall $50 billion in home loans will switch to a higher amount.

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But the fact that this confusion could have occurred neatly captures the ridiculous state of the home buying business in 2005 and 2006. The fallout is going to last a long time. House prices will need years to work off their irrational values, more people are going to lose their homes and Wall Street can probably look forward to some more nasty surprises.

In fact, the mortgage meltdown has arrived at something of a turning point. So far, most of the loans gone bad were among the worst of the worst. Some were based on outright fraud, either by the lender or the borrower. In many cases, buyers were never going to be able to make their monthly payments and were instead banking on a rapid appreciation in home values.

But the pool of people falling behind on their house payments is starting to widen beyond this initial group, and adjustable-rate mortgages are the main reason. Starting in the spring of 2005, these mortgages began to get a lot more popular, largely because regular mortgages no longer allowed many buyers to afford the house they wanted.

They turned instead to a mortgage that had an artificially low interest rate for an initial period, before resetting to a higher rate. When the higher rate kicks in, the monthly mortgage bill typically jumps by hundreds of dollars. The initial period often lasted two years, and two plus 2005 equals right about now.

The peak month for the resetting of mortgages will come this October, according to Credit Suisse, when more than $50 billion in mortgages will switch to a new rate for the first time. The level will remain above $30 billion a month through September 2008. In all, the interest rates on about $1 trillion worth of mortgages, or 12 percent of the nation’s total, will reset for the first time this year or next. A couple of years ago, by comparison, only a marginal amount of mortgage debt — a few billion dollars — was resetting each month.

So all the carnage in the mortgage market thus far has come even before the bulk of mortgages have reset. “The worst is not over in the subprime mortgage market,” analysts at JPMorgan recently wrote to the firm’s clients. “The reason for our pessimism is that loans originated in late 2005 and all of 2006, the period that saw peak origination volumes and sharply decreased underwriting quality, are only now starting to reset in large numbers.”

It isn’t hard to figure out what will happen when buyers who were already stretching to afford a house are faced with suddenly higher payments. Many will manage. They will cut back on other spending, or they will refinance their mortgage and get a new one they can afford. Others, like the buyer I interviewed two years ago, probably planned all along on selling their homes after a few years. For them, the artificially low initial rate was a no-lose proposition.

But there are also likely to be a shocking number of people who lose their homes. From 1994 to 2005, some 3.2 million households were able to buy homes thanks to subprime mortgages or other such loans, according to an analysis by Moody’s Economy.com. About 1.7 million of them will probably lose their homes to foreclosure when all is said and done. More than half of the homeownership gains from subprime mortgages will be erased.

The flood of those homes onto the market will further depress house prices. So will the newfound conservatism of mortgage lenders, which will make it harder for tomorrow’s buyers to get a mortgage. (Thank goodness.) The S.& P./Case-Shiller index of home prices covering 10 major cities has fallen about 3 percent since its peak last summer. Two or three years from now, JPMorgan predicts, the index will have fallen 15 to 20 percent. Adjusting for inflation, the decline will be worse.

The big unknown is whether the housing bust will cause a recession or a bear market. Most people who have looked closely at the mortgage market argue that the answer is no and that the damage will be contained. Subprime loans still make up a distinct minority of the mortgage market. Over all, only 3.4 percent of mortgage holders are currently behind on their payments. And as Victoria Averbukh, a former mortgage analyst at Deutsche Bank now teaching at Cornell, points out, “The housing market is still a limited portion of the U.S. economy.” Consumer spending has slowed recently, but is still fairly strong. Corporate balance sheets and the job market seem fine.

Rationally, the argument for optimism is pretty compelling: the economy’s strengths do look big enough to overcome its weaknesses. Yet even many of the optimists confess to an uncomfortable amount of uncertainty. There has never been a real estate bubble like the one of the last decade. So it’s impossible to know what the bust will bring, especially when there are still so many mortgages that are about to get a lot more expensive.