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August 19th, 2009

PART THREE: “In Defense of Arms”

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Here is Part Three of HSH VP Keith Gumbinger’s article “In Defense of ARMs”:

ARMs when rates are high

As noted earlier, ARMs were developed in a time when fixed-rate mortgages (FRMs) were prohibitively expensive. Rates were well into the double digits in the early 1980s, and few borrowers were interested in locking in those high rates for a full 30 years, even if they could qualify for them. The earliest ARMs didn’t offer any discount on the initial rate — no ‘teasers’ here — but instead the opportunity that your mortgage rate and monthly payment would decrease as market interest rates returned more toward normal levels.

Because of this, ARMs can be a very good, valuable choice when interest rates are high, because there is an opportunity for the borrower to benefit, perhaps significantly, when interest rates decline from their peaks.

ARMs when rates are low

Of course the reverse is also true. When interest rates are low — at or close to historical lows as they were earlier this decade — the only way they can actually move is upward. And so we wonder how many homebuyers asked their lender: “With interest rates at rock-bottom levels, why should I get a mortgage whose interest rate is far more likely to rise than fall?” And how many lenders pointed this out to their borrowers? Was there no realization — on either side — that interest rates couldn’t get much lower, and that higher monthly payments were all but a certainty?

We wonder about the mania so evident in the recent housing boom, which fostered a “buy a house at any cost” kind of mentality. There’s much, much more to homeownership beyond “Can I afford today’s monthly payment?” Since owning a home is generally a longer-term prospect than, say, a car lease, the proper question to ask is “Will I be able to afford tomorrow’s obligations?” At the very least, this is a concept which used to keep prospective homebuyers awake at night. Over the past few years? Not so much.

Further Audience Segregation

While at least some homebuyers who selected ARMs probably did so to help close the affordability gap, a sizable percentage of others probably saw a chance for a quick profit and selected ARMs for their low initial cost — not realizing that the floor could fall out of the market, trapping them in their investment(s). Some have called these people “flippers.”

At one point, second-home investment purchases (non-primary residences) made up more than 25% of the marketplace. It’s a reasonable bet that many of the loans against these properties were short-term PayOption ARMs or those with Interest-Only (IO) payments. An investor with a short time horizon obviously wants the lowest carry cost for his or her investment if the intent is to sell it a short while later. With the market shifting so dramatically at the end of the housing boom, and demand collapsing so quickly as interest rates rose, a speculator may have ended up holding the property longer than anticipated, and as prices began to soften, the chance of making any money on the investment faded. Meanwhile, the carry costs of the property continued to increase — rising rates and monthly payments, property taxes, maintenance,etc.

What’s the investor to do? Can’t sell without a loss; can’t afford to carry the property indefinitely. Don’t want the property any more; and there’s no risk of losing a primary home (so there’s zero desire for a loan modification, even if it was available for non-owner occupied properties). If you’re badly strapped for cash, your credit may be suffering already, so you may not care about the damage there, either. The home falls into foreclosure… another “ARM failure”.

That leads us to another item. As the ongoing analysis of failure of all those ARMs continues, the term “occupancy fraud” comes up quite often. This is situation where a borrower claims they purchased the home to live in — i.e., a primary residence — but really had intentions of flipping it quickly or, perhaps, of renting it out while marketing it. Such a home is listed in the failure ranks as “owner-occupied,” as though the owner is being put out on the street, but that’s not the case. Rather, an empty and not-lived-in house is returned to the ranks of inventory. A portion of the failure ascribed to ARMs are these shadow investors — probably just regular folks — who made bad bets, but they are also included in the “ARMs which failed” category.

-Click here to read Part One

-Click here to read Part Two

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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