Recast

The foreclosure crisis is not nearly done. It's just beginning. The key is that "exotic financing" will lead to monthly-payment increases for homeowners EVEN IF interest rates remain at these historically low levels. These exotic loans "recast" to regular old amortizing loans ~3 or 5 years after the original loan date. We will see record default levels this fall.

Don't trust me, trust IrvineRenter of the Irvine Housing Blog.

From Today's IHB:



There are three types of ARMs: (1) amortizing, (2) interest-only, and (3) negatively amortizing. When prices reached the practical limit of fixed-rate mortgages, many people turned to adjustable rate mortgages to increase affordability because they have lower interest rates. At first people turned to amortizing ARMs, but that soon gave way to interest-only ARMs and finally to negatively amortizing ARMs.

When the FED aggressively moved to lower interest rates, many cheered that the ARM crisis was averted; at best it was delayed. The assumption most people made is that all the ARMs written are amortizing ARMs. There is no payment shock with an amortizing ARM unless interest rates rise; unfortunately, reality is that very few of the ARMs still utilized by borrowers are amortizing ARMs.

The first wave of the foreclosure crisis was subprime. That wave has crested, and its devastation is nearly done.

The second wave that is building now is caused by the deteriorating economy and ARM mortgage recasts (Calculated Risk has a good post on this). As I wrote in The ARM Problem, it is not the reset of interest rates that is the problem, it is the recasting to a significantly higher payment caused when the mortgage goes from interest-only to fully-amortized. The negatively amortizing ARM, also known as an Option ARM is shown in yellow on the chart above. It is the most toxic loan product ever conceived. The Option ARM and the interest-only ARM—and their associated recasts to amortizing loans—are the two loans responsible for the second wave of the foreclosure crisis.