"The big wave of foreclosures is still coming"

Blogger's note: We got an interesting email from a mortgage banker today who raises a point we agree with: the housing mess is far broader than a "sub-prime meltdown," as it is often called in shorthand. Yes, sub-prime is the first part of the market to collapse, and is driving current foreclosure numbers; but a bigger problem lies ahead:

"Remember that the current spate of foreclosures relates mostly to: overbuilding in hot spots, fraudulent loans (mostly people falsely claiming they'll occupy a property) and a relatively small number of borrowers whose subprime rates got jacked way up.

"The big wave of foreclosures is still coming: people who DO occupy their house and who did not necessarily commit fraud to get the loan, but simply took out an Option ARM and have watched their loan balance grow as their house value has dropped.  Those loans allow a low payment for 4-5 years (while the loan balance may be climbing), and since they only jumped in popularity after fixed rates spiked in mid 2003, most of those Option ARMs have not yet even seen the big payment adjustment that's coming.  When their payments double (as they will), many of those borrowers will find themselves with too little equity to either sell or refinance (especially if they had 2nd mortgages on TOP of their Option ARMs).  Throw in the tighter underwriting standards that have been imposed recently (making refinancing that much tougher) and you have a still-coming perfect storm.  The coming crisis is the "Option ARM crisis", which will make the "subprime crisis" look minor in comparison (at least as far as how real estate values are impacted).

"The Option ARM foreclosures will only start in mid 2008 and will climax in 2009-2010. The biggest purveyors of Option ARMs have been Countrywide and Washington Mutual. The percentage of homeowners with Options ARMs is highest in California. Think of an Option ARM as a bomb with a five year fuse. Millions of fuses are still burning."

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Photo Credit: LATimes

Comments

[investorguy]

Finally... someone to quiet the "they're all scammers and idiots" front. I have too many friends in the category he describes. They're good people, smart professionals who took what at the time was a smart risk to provide for their families.

[Rob]

And here I was worried about a little dead-cat bounce in the market.
Tsunami warning....Pick up you drinks and get off the beach.

[uhoh]

*blink*

I'm afraid the only thing I can say to that is "Oh Sh**"

[avraam jack]

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When house prices drop fifty percent, foreclosure will be a smart move.
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Everybody paid too much and now its is time to give the overpriced houses to the lenders.
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Then you can all buy them back at a reasonable price.
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[Cal]

Someone, whose name I cant remember, said "It isn't the borrowers that are subprime, it is the loans". The loans were structured to maximize their appeal to investors, which will tremendously increase the pressure on the borrowers who didnt understand just exactly what they got themselves into.

The one silver lining for the borrower is that they can drop a loan that hit its 115% equity cap back on the investor and let them deal with a house that is even lower value than the loan was originally made. So it may be a case of the hen outsmarting the fox.

The foreclosure issue we are seeing right now is a function of the 2/28 loans, the option arm fun will be a whole different ballgame.

[Inland Empire]

There will be more to come that's for sure. However, I notice that mortgage companies are starting to aggressively campaign refinancing so I think will be able to get new loans.

[Rob]

Cal,
Smart point. Unfortunately, Banks and appraisers are still orbiting Neptune looking for a place to land. Just a matter of time before they run out of fuel.

[TrentPatrick]

The addition to the principle that option arms are adding right now is just a drop in the bucket campared to the value drop that is going to affect borrowing in the future. People will be trying to refinance their 5/1 and 7/1 loans in the next 1 to 3 years and not having enough equity or income to qualify.
Lets hope that the California legislature doesn't get into the lending regulation like what just happened in Nevada. They just stopped all stated loans. What do they think will happen when the 80-90% of the borrowers who didn't qualify, have to refianance when their loans roll over and none of them qualify? Nevada just signed up for a massive foreclosure market.

[Hula Girl]

Boy, do I feel stupid. I put 25% down w/ a 5.625% over 30 yrs.. I can't walk away without losing a lot of D'OH. Do you think it's too late for me to get a 2/28 115% loan? Seem like only the suckers went conventional. BTW it's w/ Countrywide. Uhgh.

[Cal]

Trent:"Lets hope that the California legislature doesn't get into the lending regulation like what just happened in Nevada. They just stopped all stated loans. What do they think will happen when the 80-90% of the borrowers who didn't qualify, have to refianance when their loans roll over and none of them qualify? Nevada just signed up for a massive foreclosure market."

Stated W2 is much different than Stated Self Employed, Stated W2 makes no sense, Stated Self Employed makes some sense. But even Self Employed you should be able to document cash flow. People act like there is this massive underground economy and everyone is making mad cash that they arent telling the IRS about. Now if that true, then the government shouldnt help them continue the practice and if false the borrowers are lying.

The biggest issue with stated income is that the lenders were using it to qualify applicants they would normally reject. I cant tell you the thousands upon thousands of times I have seen, "The DTI doesnt work, I'll have to go stated" on the broker boards.

But in the end I dont think it will matter much, the secondary market doesnt want stated so regardless of regulation the stated W2 buyer is out of the market.

[Cal]

A semi-random sampling of zillow homes picked by just clicking on the for sale icons in the San Fernando valley. Feel free to go pick your own:
http://www.zillow.com/Charts.htm?chartDuration=10years&zpid=19913440
http://www.zillow.com/Charts.htm?chartDuration=10years&zpid=20179401
http://www.zillow.com/Charts.htm?chartDuration=10years&zpid=20004027
http://www.zillow.com/Charts.htm?chartDuration=10years&zpid=20049872
http://www.zillow.com/Charts.htm?chartDuration=10years&zpid=20147223

Notice everything that happened before 2004 (which would be considered a substantial rise in home prices) and everything that happened after 2003.

http://www.billcara.com/CS%20Mar%2012%202007%20Mortgage%20and%20Housing.pdf

p.19
2004-2006 Alt-A originations went from 5% of originations the previous 2 years to 15% in 2004, 18% in 2005, 20% in 2006

p.23
Subprime went from 11% to 16% of all originations from 2003-2004 and comprised 20% of all securitized originations in 2006

p.36
Interest Only and Negative Amortization Share of Originations went from 6% in 2003 to 25% in 2004, 29% in 2005, and 23% in 2006

http://about.countrywide.com/presentations/docs/ARM%20NAHB-10.25-06%20FINAL%20slides.pdf
p.9
Shows how refinance market peaked in 2003, in a normal market that would have been the peak of the boom. Instead lenders with infrastructure expanded for growth and fighting for market share loosened underwriting guidelines even further each year in order to maintain profit growth even in the face of dropping origination volume. High fee loans were pushed and no borrower was turned away.

Here are interest rates during this time:
http://www.bankrate.com/brm/graphs/graph_trend.asp?tf=1800&ct=Line&prods=1,33&gs=275,250&st=CA&c3d=False&web=brm&cc=1&prodtype=M&bgcolor=&topgap=&bottomgap=&rightgap=&leftgap=&seriescolor=

While interest rates were low it is all short term money, the long rates weren't so much dramatically lower to make such a huge difference.

It wasn't a new paradigm, it was an unsustainable credit bubble. Yet people still deny it. As a matter of fact many realtors/Loan officer types and people like Mozilo say we HAVE to go back otherwise these unqualified people will lose their homes. Makes perfect sense..

[John T Watts]

No matter what the reason for the current market, the real trick will be to recognize the bottom at the right point in time and start snapping up foreclosed properties before prices start going back up again. Most people will still be waiting for the bottom after it has already happened.

[Anonymous]

Another loan that no one has mentioned is the interest only loans. There are plenty of people who took out 2/28 with an interest only option for 5 years. These people can afford the first few payment hikes, but when they have to start paying back principal, they are done. This fuel will add to the foreclosure fire.

It won't fix the market to stop making stated loans. Making them provide bank statements or tax returns help, but I'm a mortgage fraud investigator for a still alive subprime company, and I see at least 3-4 sets of fraudulent bank statements a day. People are desperate and will always try to find a way to get their loans......

[Justin McCarthy]

Confessions From A Former Mortgage Broker:

It's surprising to me that this is one of the first articles I've seen about this other shoe that will drop...

This bottom calling (by Moody's most recently) is truley rediculous. I am a former Mtg. broker who listened to a WAMU account exec during a meeting proudly announce (2-3 years ago) that 80% of WAMU's portfolio holdings were Option ARMs, AKA: Pick a Pays, Cash Flow ARMS or Toxic Time Bomb Loans. The implosion of these loans, of which CA has the highest percentage, are going to make the subprime problem look like a walk in the park by comparison, folks.

Just to give you an idea, 2 years ago there was a tremendous number of Option ARMs with 620 FICO's, stated income, a paltry 2 months of reserves required, combined loan to value of 90% of a unquestioned, overinflated appraised value. Many chose a 40 year minimum payment term which, in effect, facilitated the Neg Am feature of the loan by reducing the minimum payment more and increasing the fully indexed rate.

This may sound like Chinese Algebra to many of you, but bottom line is that since banks like WAMU had an initial recast mark of 125% of the loan amount, many of these loans (even though I'd bet my bottom dollar that most of these borrowers are upside down today) won't start recasting to a higher payment for 3 more years...

These bottom callers that are saying Q408 are clueless...

[Justin McCarthy]

Cal,

That is my big fear with this market, that the secondary market completely does away with buying any security with stated income included-- How will all of these people refi? What NV did was to make it a crime for the LO or MB to fill in the income. It's been routine for LO's to suggest that borrower leaves income blank or LO fills in income before mailing to borrower.

My gut feel, from past experience, is that about 50% of the borrowers who went along with a prefilled income would not do it if they had to input their own inflated income-- They see in print that it's a felony to lie on the 1003 and I'm sure every stated loan going forward will need a signed 4506.

Assuming any kind of regulation, the only pragmatic approach here would be to not squelch stated income loans completely-- the effects would be disasterous to high cost areas like CA-- but to raise FICO requirements (which they've done for the most part to 700+) and drop max LTV's and CLTVs to something in the neighborhood of 80%, instead of the 90%+ that's been routine up until recently.

The effects of squelching stated income loans get exponentially worse when you combine any new difficulty in getting them with the general difficulty of getting Jumbo loans, equity drops, higher reserve requirements, etc.

[yours truly, Johnny Dollar]

Remember the days of the radio commercials that hyped "wrap around loans" and "creative financing?"
Oh, give me a home where the buffalo roam and the phone doesn't ring at the dinner hour.
Erik Estrada and Chuck Woolery. Now that gives a home buyer confidence.

[investorguy]

And the liquidators are getting ready 8-)

I got an email from one of my Midwest Realtors with a spreadsheet of 760 properties from Ocwen. They were asking Realtors to pass the list along to investors for bulk buying. Clearance sale time. Based on previous experience with Ocwen, you could easily get a dozen or more SFRs there for less than 20 cents on the bank -- not retail -- dollar for each. The deals are out there, folks. You just have to know where to look. There were only a half dozen properties in LA, but they're serious bargains if you have rehab money -- you could be all in for half of market.

[Justin McCarthy]

Hey investorguy,

Are you sure you don't want to wait a year?

http://www.iht.com/articles/2005/06/16/business/rates.php

Can we do this here?

[investorguy]

Justin: if you can buy cheap enough now, do it. Consumers wait. Investors buy against the herd and when the numbers work.

I am looking at a package of a dozen REO properties with one bank in a Midwest city for $325K. Once the inspections are in, I can probably cut off another $75K. They need an aggregate of $200K in rehab. All in for $525K or less. The collective ARV -- even knocking 10 percent off for a slow market -- is more than $1 million. But the key number is $10,000 a month or more in rental income. Even if I flip half of them to other investors after rehab and tenanting -- one is a $25K accepted bank offer that is worth $175K retail. I could put it $25K into it, put it on the market at $125K, sell it in week and pocket $75K -- I'll still have $4500 a month and $300K in Hip Pocket National Bank.

Problem is that it's hard to equal those numbers in LA. Nothing cash flows here. Profits here today are still in lowball rehabs and resales (buy at 50% all in, list at $75%) with seller financing.