A "classic double bubble"

Good morning. Repeat after me: It's not just a sub-prime mortgage crisis, it's a mortgage crisis. Or, as PIMCO's Paul McCulley writes, it's a "classic double bubble" -- one bubble is the asset, the other bubble is the lending against that asset.

One bubble is housing, the other is mortgage lending. Not just sub-prime lending. All of it.

If you don't believe me, read E. Scott Reckard's piece in today's L.A. Times about growing troubles with Option ARMs.

Option ARMs, Reckard writes, "were the easiest and most profitable home loans for lenders and brokers to make for much of this decade."

Why did borrowers like them? Simple: Option ARMs allow you to buy maximum house for minimum initial monthly payment. They are not particularly complicated or confusing. You buy now and pay later.

"... more than 75% of option ARM borrowers have been making only the minimum payments, analysts at Standard & Poor's Corp. said last week. As a result, the delinquency rate on option ARMs already is jumping and is likely to keep rising sharply, S&P said."

Why was there a bubble in mortgage lending? Because mortgage lending, particularly products like option ARMs, was wildly, shockingly profitable. According to John Diamond, a Chino broker, while a broker might earn $4,500 for selling a $300,000 fixed-rate loan, the commission could total $12,000 on an option ARM of the same size. "These loans drove the whole industry from late 1999 through late 2006," Diamond said. "It was just about the only thing any broker wanted to sell."

Don't blame just the brokers. Borrowers wanted these things.

Your thoughts? Comments? Insights? E-mail story tips to peter.viles@latimes.com.

Comments

[TakeFive]

...oh yes, there will be blood...

For those that haven't seen it, here's the reset chart showing when the option ARMs kick in:

Tiny url: http://tiny.cc/reset

http://www.californiahousingforecast.com/display/
ShowImage?imageUrl=%2Fstorage%2Fivy%2520arm%
2520reset%2520schedule.png&imageTitle=812856-86
7041-thumbnail.jpg

[Ragnar]

I read the LA Times article on option ARMs. I cannot imagine signing anything without reading it first. Even if it's long and mega-complicated I will always read before I sign.

Option ARMs exist not only because they are profitable for lenders, but because there is consumer demand for them. It totally fits the American attitude of getting as much of something as you can for as little effort as possible. In this case, "maximum house for minimum monthly payment," which quite frankly, is a terrible way to live, no matter what your version of the American Dream is. But I guess this just comes from someone who does not like debt all that much and overpays as much as responsibly possible to pay off loans as quickly as possible.

[dynomite1]

Why not track some of these subprime loans back to their origins and put some people in prison ? I do not believe that the majority of these loans were legal in the first place. In many cases, lending guidelines were ignored or not followed.

[Cal]

"Don't blame just the brokers: borrowers wanted these things."

Well, they wanted a low payment.. many simply didnt realize what was really going on.

A person can sell you a "3% payment rate" and 99% of the people out there would think that means they get a "3% interest rate". They then see the payment they have to make each month being so low and think they've gotten a great deal. The realization comes later that their mortgage balance is going up and the actual interest rate they are paying is quite horrible relative to what a 30 year fixed loan was going for.

Interest only is a pretty toxic feature, negative amoritization is a VERY toxic feature. You dump that on the masses with lax underwriting and giving extremely high fees (YSP) to brokers for selling them.. it is no wonder they are so prevelant in the marketplace. Option arms were a huge part of the refi boom that started to slow in 2003, so lenders decided to offer them for purchases to keep volumes high. They thought they were being "safe" by offering relatively low Loan to Value ratios of 80%, but the brokers would put a second behind the first (a "silent second") and get 100% CLTV financing for the borrower.

The fact that they were so prevelant in refi means that there are homeowners who went through the boom and whose mortgage balance went up. Now that the boom is turning into a bust and these higher balances are coming due (due in the sense that once they hit their cap the minimum payment becomes Interest only at least which is still a tremendous jump over the negative amortization payment) there are huge swaths of resale housing tracks that will act like new home tracts during the bust. Low equity positions unable to deal with any financial strain by tapping home equity. Foreclosures will abound.

The bond holders were stupid for buying them, the lenders were stupid for offering them, the brokers were stupid for pushing them and the borrowers were stupid for not understanding what they were getting. Plenty of blame to go around.

I think Kate in the Valley has a friend in one of these loans who didnt realize they were in such a loan.

[Rich]

When I was going over the menu of mortgage options with a broker recently I was surprised to see some options like interest-only ARMs still available. I did some research and discovered that all sources described them as being intended mainly for buyers with significant other investments yielding better returns, or for certain buyers with irregular compensation like bonuses that would find it more convenient to pay principal as the funds become available. So there you have it, the 25% sounds like the number of borrowers who might make payments against principal on these type of ARMS (I realize these are not the only type of ARMs). The other 75% probably don't fit the profile but made a choice--apparently taking risk to get more house than they would with other types of mortgages. So perhaps, out of fiduciary responsibility to their shareholders, lenders should consider offering ARMs only to borrowers who can document that they fall into the category of intended borrower profiles for that type of loan? I don't want to see people's choices be taken away, but keeping investors happy enough to stay in the market is, as we have seen, vital to our own interests as borrowers...

[National Bubble]

I love it when real estate experts say this is all about subprime loans.
Anybody who lived in SoCal or Florida during the boom can tell you that the housing bubble was not just about subprime borrowers buying houses they couldn't afford.

It was also about prime borrowers getting interest only loans to be able to afford buying in high price areas using no documentation loans.
It was also about realtors scaring buyers with the "buy now or risk being priced out of the market" phrase.
It was about Alan Greenspan telling people that the use of exotic mortgages was a great idea.
It was about the Bush administration pushing the "ownership society" lie where everybody can and should own a home.

All this has very little to do with subprime loans and everything to do with greed in an "instant gratification" society based on debt and leverage.

http://www.NationalBubble.com

[Kathy]

Why did the writer of the piece use the euphism "fudged" instead of the more objective term "committed fraud" in the piece? Where are the editors? Someone commited a crime in these transactions and that should be stated unequivocally.

[Steve]

Classic example of blind faith. These people are so surprised that the market has recoiled so much, but they weren't very surprised back in 2005 when housing prices had tripled in the span of four years and incomes had remained flat.

What goes up, must come down. The boom was unprecedented in terms of home appreciation, and the bust will be just as unprecedented in the opposite direction.

[Ace]

Cal said 'Well, they wanted a low payment.. many simply didnt realize what was really going on.'

Ok, that may be true in some cases but not many. The loan is called 'Interest Only' or 'Negative Amoritization'. How can someone not know what is really going on? People who took out these loans were either REALLY stupid or gambled that their house would continue to increase in value by 20 percent per year.

I do agree that these loan types are toxic. But no more toxic than credit cards, pay day lending, rent to own, or leasing a car.

[Cal]

From that LA times last december:
http://www.nashuatelegraph.com/apps/
pbcs.dll/article?AID=/20061222/BUSINESS/212220342

"In 2003, only about 8 of every 1,000 people buying a home or refinancing a mortgage in California obtained a pay option loan, according to San Francisco-based data tracking company First American LoanPerformance.

Last year, 1 in 5 loan applicants received one.

In the first eight months of 2006, even as the real estate market began to weaken amid fears of a downturn, the appeal increased again. Nearly 1 in 3 California loan applicants are now choosing them. The state boasts about 580,000 active pay option mortgages, about half the U.S. total.

After four years of escalating prices, they’re the only way some first-time buyers can get into the market. But another group flocking to option loans are homeowners who find themselves stretched. For those beset by calamity, these are the loans of last resort."

"But the day of reckoning is arriving early. By paying the minimum, Hertzberg has increased the size of his loan in a little over a year from $320,000 to $332,616. His lender, Countrywide Financial Corp., recently sent him a letter warning that when his loan hits 115 percent of its original size he’ll run out of credit with the company.

That will happen in about two years if he continues to take the smallest payment option. Then his minimum payment will automatically go up 150 percent, to $2,848 a month.

“If I could afford that,” he said, “I wouldn’t have needed this loan in the first place.”"

[Corey]

Rich, you've articulated my thoughts exactly. All along it was about rising prices, prices going so high that they became almost comical. The whole sub-prime fiasco is the icing on the cake.

Since our house was built in 2001, when we purchased it, our neighbor's house has sold twice over the years at prices more than double what we paid for our house. And that house is smaller with few upgrades. I look at these buyers and think to myself "These people are insane. That house is not worth that kind of money." Of course my long-time friend who also happens to be a realtor is quick to point out that the house is worth whatever someone will pay for it (feel like I'm back in an Economics course). But in fact, that statement assumes that buyers are rational and have perfect information, which clearly has not been the case.

I look at this whole thing as a kind of economic natural selection. People dumb enough to get sucked into bad loans or overpaying for their homes will be weeded out by this bursting bubble. That's when I and others like me move in and buy on the cheap as rental properties.

And since some of you are probably thinking "Wow, this guy's heartless," you're right. I have no pity for people who are too lazy to research the different kinds of loans that are available before they actually sign on the dotted line. Anybody can go to a library, get on the internet, and get informed about different loan products, just like I did. I'm no genius, but I do spend some time doing research before making the biggest investment of my life.

[Joseph]

Lenders committed "Suicide"....We would not be seen what we see out there in the market place if it wasn't for them...

They defrauded, with the help of the Idiots in "Wall Street". The masses who were so stupid as to believe that the peak would never come.

Novice Real Estate Agents who did not know what the heck they were doing...

Financial instruments are complicated and you need honest professionals to help you understand them and make the right decision...

Regardless, California prices are not going to crash...The bottom will come till about 5-7 years...Prices will keep going down little a at time.

Coming soon: www.asktherealestateguy.com

Even with the "Obvious Bias" I see on this blog, I tend to like it.

[gary]

It was ll predicted long time ago by porgressive economist, Dean Baker. Here's a good read for all. http://www.inthesetimes.com/site/main/article/
bursting_bubbles

[Raul Garcia]

What we are wittnessing is the collapse of the worlds' largest ponzi scheme, promoted and set into play by the Bush administration.

Instead of recieving bonuses, those involved should be receiving hard jail time.

[Justin McCarthy]

Did a lot of these Option ARMs in the bay area. I always explained fully indexed (true) rate and the fact that it was variable vs. the teaser rate. These propgrams were complex to the buyer with various built in selling points that could strike a chord with a range of borrowers. The guilt of the broker really depends on the level of explaining that they did to the buyer: There were a lot of "trap doors" on a loan like this and required buyer to understand more than just the minimum paymnet. When indexes (like MTA, COSI or COFI) were down in the 2% hood, even if the margin was 3.7 on top of this, it didn't appear too risky. Now these indexes are near 6%. Minimum payment stays the same, but true rate is through the roof which accelerates neg am feature and brings closer to the recast point in which all bets are off and borrower pays fully indexed P & I payment while they're upside down. Also, in my experience many borrowers were reluctant to do these loans on their primary, instead using them to buy 2nd and (sometimes several) investment homes in order to have a break even cash flow while renting them out. They gambled and figured that even if they took 5% negative equity on a given property, but could carry it with a break even cash flow, they would come out ahead if housing market continued to yield 10-20% price increases. Many of these borrowers knew exactly what they were doing and relied on being able to walk away if market went south. I would bet that there's a higher proportion of investment homes in CA that have these toxic loans, making them even more of a foreclosure waiting to happen.

[Westside Bubble]

Good article in the Times, but hardly breaking news to followers of the housing bubble.

How much do The Times reporters talk to you, Pete? Or do they let you be the leading edge, and only take up a subject when it's escaped the blogosphere?

[anon]

Raul,

Bingo!

The biggest pump and dump in the history of the world created by the most corrupt regime in US History.

That's all you really need to know about the "bubble".

[MyLessThanPrimeBeef]

Seems like a classic Al Quaeda operation - first you give 'em one bubble, then as they busy themselves trying to put that one out, they let loose another devastating bubble, inflicting even greater damage.

Now, most of us Americans are being terrorized daily by the resulting carnage and the specter of more financial obscenity from people we thought were on our side - bankers, lenders, brokers, government regulatory agencies and Wall Street rating firms.

[Joseph]

Raul, Anon,

Keep your Partisan-Politics out of this blog...This Financial mess has been in the making for years under both Democratic and Republican Administrations...

Sub-prime loans were popularized in the early nineties...Government Grants (For Downpayments) were also introduced in the early nineties...

Stick to the facts....

[Rob]

I have to laugh every time I see Bush conspirators out here....

"and then God winked to Bush and the eye named Katrina made them go away, and it was good. Then God waved his hand to Bush and the light returned, and it was good....

[amir]

It's really hilarious to me how everybody and their aunt is blaming Bush. I didn't see Democrats fuming about high real estate prices or trying to regulate mortgages. The opposite was true, they were glad people of modest means were buying bigger houses. Politicians are all the same, they only deal with problems when they're too big to ignore.

This is free market capitalism. Borrowers wanted to buy houses they couldn't afford and lenders and banks agreed to lend them the money. Both will pay a horrible price while spending their money building and upgrading housing for the rest of us. Thanks guys!

The same happened with the internet bubble. Billions were invested by stock investors and wall street into research and development. Of course, most of that wealth disappeared, but it created a new world of technological possibilities for the rest of us. Thanks guys!

Of course, this very logical response will not work for the masses that will blame someone, anyone, but themselves.

[Ben Brown]

A new law needs to be written where a borrower in an emergency can initiate a minium payment at the FED discount rate (say 4.5%) with all interest frozen for a period of up to 3 years. If you owe $500K you pay $1875 month fixed plus taxes and insurance. This very modest provision would essentially exclude so-called Liar loans because they probably couldn't even make that payment. This would protect the honest homeowner/borrower and insulate the lender. Large corporations borrowing 100's of millions have these kinds of provisions. Why can't Jane and John Homeowner have the same protections?

[William Jones]

I hope people look at the chart that shows when the Option ARMS reset. What's interesting to note is how many will reset in 2010 - about 2.5 years from now!

Things actually look pretty good for the next six-eight months or so, which could prompt a false sense that, "Hey, we're through the worst of this" and actually ignite a "sucker's rally" in housing. Do NOT believe it.

[Enlightenment]

This chart was released early in 2007 and it is very obvious there are multiple flavors of ARMs and multiple waves that will crash down on the housing market. This graph is very important, so look at it very closely. This is why people have been saying this mess might not be over until 2011 or later.

http://www.irvinehousingblog.com/wp-content/
uploads/2007/04/adjustable-rate-mortgage-reset-
schedule.jpg

http://www.irvinehousingblog.com/2007/06/25/
houses-should-not-be-a-commodity

[Jimmy]

The option arm is a great product. In my case, I was able to purchase several homes by the beach ten years ago. Sure, my balance rose for a while, but I was able to purchase in some of the most expensive zip codes in SoCal. Now, my payments have risen, but no problem, so has my income. Plus, I have made millions and millions from my beach homes. It would be a shame if these products became unavailable. Without them, I would either be renting, or living in some older, undesirable area because I would have had to put 20% down on a fixed mortgage. Please, keep these products. They help people who want to take a chance to live the American Dream.