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Adjustable-Rate Mortgage Resets Deflated the Housing Bubble

Posted: 26-12-2008 | Views: 227

The loan reset issue is not confined to those who bought late in the bubble rally of the Great Housing Bubble. Many borrowers are homeowners who refinanced to take advantage of more favorable loan terms. Most loans originated in the later stages of the bubble rally were adjustable rate mortgages. When these mortgages reset to higher payments, most borrowers defaulted, and their properties went into foreclosure.

During the Great Housing Bubble, prices rose dramatically in nearly every market nationally. With such a dramatic increase in prices, one would expect the total home equity for homeowners to increase dramatically as well. If fact, the opposite occurred; home equity declined during the rally of the real estate bubble. By the end of 2007, home equity as a percentage of home values was at record lows. Where did all the equity go? Existing homeowners spent it, and many new homeowners had such low downpayments, that they had very little equity to begin from the start.

Refinancing and home equity withdrawal is the primary reason home equity did not rise as prices increased. There was a great deal of conspicuous consumption in the bubble rally, particularly in California. It seemed every house had two luxury cars in the driveway, the malls were always full of shoppers, and every homeowner was busy competing with her neighbor to see who could look richer. Many also spent their "liberated" equity to acquire other properties which was a major driver of the prices in the bubble rally.

Aggregate home equity statistics can be misleading because approximately 30% of US households have no mortgage at all. Also, during the bubble rally, home ownership increased 5% nationwide, and many of these new homeowners were subprime borrowers who utilized 100% financing. This will have some impact on home equity statistics, but it is not sufficient to cancel out a 45% increase in home prices without massive home equity withdrawal. If the home equity statistics are viewed in the context of those households that have a mortgage, total equity nationwide was around 35% in 2006.

The initial price declines caused by defaulting subprime borrowers set the stage for defaults by Alt-A and Prime borrowers by lowering property values. At the time of this writing, the Alt-A and Prime borrowers have not yet faced the prospect of their loans resetting to higher payments as they start facing resets in 2009 that continue through 2011; however, it is not difficult to speculate on what will happen.

Both new homes and foreclosures are must-sell inventory. The presence of must-sell inventory in the market forces prices lower. Builders aggressively cut prices in many markets in 2007 and 2008, and it did not help sales. The builders will be forced to lower prices more in 2009 and beyond until prices bottom in the new home market. Foreclosures increased dramatically in all markets in 2007 as the pressure of large debt loads overwhelmed many borrowers. The number of new units and foreclosures is not a problem in a healthy market, but in a declining market with large numbers of REOs, this must-sell inventory drives prices lower.

The lowered property values will make it difficult for these borrowers to refinance because they will no longer meet the more stringent loan-to-value ratios that will be required to refinance. It is likely many of these borrowers will not be able to afford the payment at reset, and they will lose their homes just as the subprime borrowers lost their homes. If Alt-A and prime borrowers had utilized conventional mortgages as they had in the past, they would not be facing the mortgage reset time bomb, and they could simply ride out the subprime debacle just as many homeowners did through the declines of the early 90s. However, it is different this time. This time, the loans they have taken out are going to ruin them. It's not the borrowers, it's the loans.

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