Housing slump worsens -- Magnified by “exotic” loans

October 11, 2006

The nation’s largest homebuilder, D.R. Horton, reported that fourth-quarter new home sales fell 25% from a year ago. Even worse, cancellations of purchased homes rose to 40%, up from 29% in the same time last year. K.B. Home orders for the same time period fell 43% from the prior year’s level.

The National Association of Homebuilders (NAHB) forecasts an 11.5 percent decline in housing starts this year, followed by another 11.7 percent drop in 2007. Housing should hit bottom by the middle of next year.

The NAHB/Wells Fargo Housing Market Index (HMI), which is a survey of homebuilder confidence, declined in September for the eighth month in row. The HMI hasn’t been this low since February 1991.

Compounding this housing decline is the high percentage of homeowners who have “exotic” loans. These include:

• Interest-only loans, which are adjustable rate mortgages (ARMS’s) that never pay against the principal. The rates are generally fixed for the first 3 or 5 years, and then adjusts based on the current Fed Funds rate.
• Negative Amortization loans,which offer an extremely low payment rate for the first six months to a year. However, the interest rate is a few points above the Fed Funds rate. During the “grace” period, the unpaid interest gets added to the principal. When the “grace” period is over, these homeowners must pay a few points above prime to a larger principal than when they bought the house, thanks to the upaid interest accrued during the "grace" period.

In 2005, over 30% of home mortgages were “exotic” loans. In addition, 1.3 million ARMs with teaser rates below 2% were taken out in the past two years, according to research done by Christopher Cagan of First American Real Estate Solutions for BusinessWeek.  Of those, 21.5% have negative equity, where the market value of the home is less than the amount owed.

What It Means:
No doubt about it, we are in a full-blown housing downturn, similar to the one in 1991. The difference this time is the high percentage of “exotic” mortgages, which weren’t as prevalent 15 years ago.

As the market declines, more and more homeowners will find themselves owing more on their homes than they are worth, a situation known as being "upside-down". They will be trapped, because even if they sell their homes, they will have to find more money to pay off their mortgage. The new bankruptcy laws will mean these homeowners will have to pay the debt for years to come.

Most of these loans have been sold in the secondary market, as packages of "mortgaged-backed securities". As these loans default, the holders of these securities, usually individual investors, will suffer the losses.

Action Steps:
If you are in an exotic mortgage, ask your lender or your mortgage broker about the relative cost to switch to a fixed-rate mortgage or 5/1 ARM or 3/1 ARM, which have fixed rates for the first 5 or 3 years, respectively. Sometimes lenders will let you switch without incurring the application costs.

If you have mortgage-backed securities in your portfolio, talk to your financial planner about getting out of them.

Source: DR Horton web site, KB Homes web site, National Association of Home Builders web site, BusinessWeek web site