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From The Mailbag

Exotic mortgage foreclosure rate for December is over 100 thousand homes. Soft markets and higher ARM rates have caused record numbers of mortgage defaults over the last five months.

In the article, RUNAWAY MARKET, I which I wrote and posted on my website on July 4, 2006 I warned that the housing bubble was about to burst. A year earlier, on June 21, 2005, I wrote a piece in SHORT TAKES, warning that the explosion of exotic (interest-only) toxic loans using adjustable rate mortgages was going to have a catastrophic impact on the US economy when that bubble burst. Those behind the runaway real estate market and the rapidly escalating but unsustainable price of homes helped feed sometimes unscrupulous mortgage brokers with the means to sudden wealth in order create new construction jobs to bolster a sagging economy as thousands of American industrial jobs were lost as American factories boarded up and moved to Mexico, and the Near and Far East .

In June, 2005 outgoing Fed chairman Alan Greenspan warned the Bush Administration and the American people that the use of exotic mortgages to bolster the housing market was a mistake of monumental proportions. In RUNAWAY MARKET I warned there was a sizable hole in the good luck bucket and that potential buyers would get "sticker shock" over the skyrocketing price of homes and, as interest rates began to inch upward, not only would the bottom fall out of new and existing home prices, many of those who purchased exotic mortgages would find themselves in jeopardy of losing their homes.

Two weeks ago in BEHIND THE HEADLINES I noted that the Federal Reserve had established new guidelines on exotic mortgages to prevent mortgage companies from qualifying buyers for homes they won't be able to afford when the payments mature. That may prevent new home buyers from moving into homes whose mortgage payments, in three to five years, will consume 50% to 60% or more of the household income, placing many of those homeowners in bankruptcy.

December home foreclosures, nationwide, rose to 109,652. That number was down 9% from November, but it was up 35% from a year ago. Over the last decade, America's banks have foreclosed on approximately 2 million homes—and they are now sitting on an inventory of over 5 million unsold foreclosed homes nationwide.

As Greenspan predicted in June, 2005, subprime adjustable rate mortgages with exotic features not only artificially drove up the prices of new home prices nationwide, it also drove up the foreclosure rate on adjustable rate mortgages with 2-, 3- or 5-year modified tier payments. That view is supported by statistics which indicate that many of the homes with exotic ARM mortgages purchased in the spring and summer of 2004 ballooned in the summer of 2006 just as the real estate bubble burst. Many of those homeowner were not able to refinance out of the ARM mortgages because the payment levels on the traditional loans exceeded the thresholds for their income levels. They were stuck with toxic loans that were going to bankrupt them sooner rather than later. Toxic mortgages are a ticking bomb waiting to explode.

With the housing boom imploding in many areas of the country, there are now far less eager takers for artificially overpriced homes. Nationwide the housing market is on a downward spiral that will ultimately shave 25% to 30% off the resale price of almost every home in the country. That economic trend is eliminating the primary avenue of escape for many homeowners who are facing the threat of foreclosure—dumping the dream home. Sadly the county tax appraisers will be two to five years behind that curve in reappraising the tax values of those homes since the county government will have already committed those tax dollars to increased services within the community.

Slowing home sales combined with rising ARM interest rates and the need to refinance inflated mortgages in markets where home prices are edging downward has created a dilemma for overextended home owners. So has trying to qualify for traditional mortgages when you don't have enough income to qualify for the refinance you are seeking. As a result, when the consumers can't dump the dream home that has become the Nightmare on Elm Street, they end up in bankruptcy court and lose everything.

As the White House, Congress and the Fed conspired to create a new industry that could offset the job losses resulting from America's industrial giants exporting their factories to the third world, the bankers and merchant princes realized that the retail prices didn't matterif the monthly payments were low enough to attract buyers. The shortsighted American consumer can be counted on only to look at the immediate price, not the long term consequences of buying under toxic terms. The globalists on both sides of the aisle in Congress, the White House and the Fed bankers behind Utopia needed to keep the economy growing in order to prove to the voters that their utopian agenda of creating a seamless global economy would benefit everyone.

To do that, Congress had to protect the bankers and merchant princes from potential default by the American consumer whom they were going to financially overload in order to keep the economy afloat—and keep the Fed from collapsing. To accomplish this Congress enacted the Bankruptcy Abuse and Consumer Protection Act [BAPCPA] which was signed into law by President George W. Bush on April 20, 2005.

BAPCPA "rectified" nonexistence consumer abuses by protecting America's lending institutions rather than the consumers the law purports to protect. Congress insisted BAPCPA was necessary because US bankruptcy laws had lost its power to shame. Filing bankruptcy, Congress believed, was no longer viewed as a stigma. For that reason the law had to be modified to prevent the consumers from using it as a convenient debt eraser. When University of Illinois law professor Robert Lawless testified before the US Senate Judiciary Committee on Dec. 6, 2006, he noted that Congress appears to believe that "...[t]he decision to file bankruptcy was made to sound as if it were a lifestyle choice."

Banks and other lending institutions which contribute millions of dollars to the campaign war chests of politicians on both sides of the aisle lobbied Congress for over a decade to toughen bankruptcy laws. BAPCPA makes it harder for consumers who are grossly overextend to get out from under the debt. Banking industry lobbyists managed to fill the legislation with provisions to benefit banks, credit card companies, small loan companies, credit unions and any other organizations that provided loans—or whom receive contractual payments from the consumer.

Several bankruptcy judges, lawyers and academicians specializing in financial law testified before the Senate Judiciary Committee hearing, warning the Senators that the existing bankruptcy laws did not need to be "fixed," and that the draconian provisions in the new law would have a negative impact on the economy in spite of the testimony from Georgetown Law Professor Todd Zywicki who claimed that existing bankruptcy laws were a tax on the economy and that the recommended changes in bankruptcy law found in BAPCPA would lower interest rates—and retail prices. The reverse happened because interest rates are a devise used by the Federal Reserve to slow or encourage spending. Interest rates are not lowered by the banking industry because they made sufficient profits.

Interest rates on 30-year home contracts fell steadily from 1980 to 2005, from 13.74% down to 5.34% With the passage of BAPCPA, interest rates on a 30-year mortgage are inching up. By January, 2007 the fixed rate was 6.26%. By late spring or early summer, the 30-year fixed rate will be around 7% as mortgage lenders, fueled by the fears of Freddie Mac and Fannie Mae, and an inventory of over 5 million empty homes whose loans were guaranteed by HUD. Approximately 34% of those foreclosed homes were sold to underqualified families who received hybrid ARM loans that should never have been approved. The mortgage broker knew it when he manipulated the loan, the mortgage banker knew it when he approved the loan, and the bank that ended up with the paper should have known—and would have taken the time to find out if the loan was not guaranteed by HUD.

Here's how the hybrid ARM works. Options are set over a period of 2, 5, 7 or 10 years (or whatever the lending company and the home buyer agree works best for all parties). Borrowers have up to four choices how to pay the mortgage. First, they can make fully amortized payments that will retire the 30-year note on schedule, hoping that interest rates remain low enough that they don't take a beating when the ARM increases. They have the option of doubling up on their payments, or using an expedited payment plan where they pay their mortgage every three weeks instead of once a month. Using an expedited schedule, they will pay off their 30-year mortgage in about 22 years.

They can opt to pay only the interest for the modified payment period. If the home buyer exercises an interest only option for, say, five years, their 30 year mortgage will become a 35-year mortgage. Or, they can opt for a modified payment that does not even cover the interest due on the principle, adding additional interest onto the back-end of the note. (Let's imagine the home buyers took a $300 thousand option loan with a margin of 2.75% on an index of 3.347 with an initial rate of 1.25%. Under the fourth scenario, the minimum monthly payment would be $997.78. [The interest-only payment would be $1,524.25. The 30-year amortized mortgage payment would be $1,817.40.]

The home buyer, using the minimum payment option would end up making monthly payments of about half of what their mortgage payment should be. Two things will impact his payment, and most likely, his ability to keep the home. First is the ARM. Most ARMS have a 7.5% annual cap. After the initial "grace period," the interest rate will adjust based on the the prime. Every quarter percentage point adds an additional $20.00 per $100M. If this buyer had a $300 thousand mortgage, a quarter percent move in prime would add $60.00 a month to the mortgage payment. A half percent spike would add $120.00 to the monthly payment, and a full percent, $240.00.

Now, let's assume that buyer had a 5 year option on a $300 thousand home the family bought when the land rush began around 2001, and they were paying the minimum, $997.78. Let's assume the prime held for the entire 5 years. On the anniversary of that note, the mortgage payment would jump from $997.78 to $1,817.40. Since most who buy toxic mortgages do so because they don't have enough discretionary income to qualify for a traditional mortgage, the odds are better than even that this home owner will be in financial trouble from that point. Add to that, in January, 2007, the ARM jumps a half point, adding $120.00 more to the mortgage. Now the home owner is paying $1,937.40 and he's trying to sell in a market where the housing bubble has either burst or its leaking badly. This buyer is an excellent candidate for foreclosure—and possibly bankruptcy. Sadly, the buyer will likely have no equity in the home. In fact, he will be saddled with a debt larger than the resale value of the home.

Exotic loans—more appropriately referred here as toxic loans—have seasoned. The Federal Reserve recently issued new guidelines that will greatly curtail the use of exotic loans since those who qualify will be buyers who would qualify for that same dwelling using a traditional fixed rate mortgage.

Sadly, thousands of home owners who purchased their homes creatively using toxic mortgages recommended by mortgage brokers interested in commissions only and not what was best for the buyer (i.e., putting them in homes they could afford). As a result, scores of home buyers have—or shortly will—learn that they have homes that cannot be disposed of at a profit and, in some cases, cannot be disposed of without taking a substantial loss that most likely will not be offset by equity. The homeowner will walk away only after incurring a new debt to pay off the mortgage shortfall in order to avoid foreclosure or bankruptcy. In a article which appeared in USA Today on April 3, 2006, the Gannett paper estimated that 7.7 million exotic ARM mortgages had been sold and that approximately 1.1 million of them would end up in foreclosure.

Once again you have my two cents worth.