Many less creditworthy borrowers may lose their homes when interest rates on a flood of adjustable-rate subprime mortgages reset next month.
Even a recent sharp fall in mortgage interest rates, which could make the potential transition from an adjustable-rate to a fixed-rate mortgage less painful, will do little for those with the weakest credit because lenders have all but closed their books to the riskiest borrowers.
The ARM resets will hit hard the subprime borrowers and therefore we have a huge amount of trouble ahead of us, said Torsten Slok, senior economist at Deutsche Bank in New York.
About $75 billion in adjustable-rate U.S. mortgages are going to reset in the fourth quarter, most of which will emerge next month. Of the loans resetting, around 75 percent are subprime mortgages, Slok said.
Subprime ARMs are going into foreclosure at an annual rate currently of 13 percent, up sharply from 6 percent two years ago. This rate will climb even higher over the coming two years as a result of the ARM resets ahead, he said.
Most of these borrowers are going to have a really hard time trying to refinance and with an expected payment shock of about 30 percent higher on average, many will not be able to afford their homes, he said.
Many of the ARMs resetting in the coming months were originated during the housing market's heyday in 2004 and 2005 when easy credit ran rampant.
The primary mortgage market, where loans get originated, has changed significantly over the past few months. A sharp rise in defaults in the subprime mortgage market, which caters to borrowers with poor credit histories, has caused lenders to tighten requirements, making it more difficult for those with weak credit to get a home loan.
Some market observers say even borrowers with an unblemished credit history are having a more difficult time getting a loan.
The adjustable-rate mortgage does not offer a whole lot of value right now, said Greg McBride, senior financial analyst at Bankrate Inc., in North Palm Beach, Florida.
The conforming 30-year fixed-rate mortgage stood at 6.50 percent last Wednesday, down from 6.71 percent on August 1. But during this same time period, the rate on a five-year ARM rose to 6.45 percent from 6.36 percent, McBride said.
McBride expects rates on conforming 30-year fixed-rate mortgages, which are loans guaranteed by housing finance giants, Fannie Mae and Freddie Mac, to fall around another 0.15 to 0.20 percentage point in its next interest rate survey, which will emerge Wednesday.
Interest rates on fixed-rate mortgages are often pegged to U.S. Treasury yields. Treasury yields have dropped sharply in recent weeks on raised expectations of a rate cut from the Federal Reserve. The next Fed policy-making meeting is scheduled for September 18.
The ARM is a product with higher instances of delinquency and default and therefore the rates are incorporating a higher risk premium, he said. Federal Reserve Chairman Ben Bernanke has said the subprime mortgage market will probably deteriorate further and I have to think that he was looking at the month of October when he said that.
The majority of subprime ARMs are going to reset at rates 2.5 percent to 3 percent higher than their original loan, Deutsche's Slok said.
That is not peanuts and exactly why people should be worried about subprime, he said. We are really in for a horrible situation for the housing market over the next six to 12 months.
Jim Baird, chief investment strategist at Plante Moran Financial Advisors in Kalamazoo, Michigan, said the increasing difficulty in getting a home loan will exacerbate the impending ARM reset situation.
Tighter lending restrictions will make it difficult for subprime borrowers to refinance and, with higher monthly payments, many will face a default or foreclosure with very few options, he said.
The Mortgage Bankers Association last week said the rate of U.S. home loans in the foreclosure process rose to a record high in the second quarter of 2007.
If all rates were falling that would be great news for the
housing market, but that is not the case, said Bob Walters, chief economist at Quicken Loans, an online mortgage lender in Livonia, Michigan.
More homes going into foreclosure will add to an already unwieldy supply of homes for sale.
Supply is just one if the things working against housing right now and reduced mortgage cash is another one, Walters said.
The National Association of Realtors last month said the supply of existing single-family home sales was at 9.2 months' in July, the highest level since October of 1991 when it was 9.3 months.
(Additional Reporting by Patrick Rucker and Joanne Morrison)