The potential loan losses from new types of adjustable-rate mortgages issued since 2004 is relatively small, according to a recent study.
Defaults on these loans could result in $110 billion in losses nationwide over the next five years, less than 1 percent of the total amount of home loans sold in 2004 and the first three quarters of 2005, said Christopher Cagan, an economist at First American Real Estate Solutions, a division of Santa Ana, Calif.-based title insurer First American Corp., which conducted the study.
“It’s not great, and it doesn’t break the economy,” Cagan said. He said the loan losses would be spread out over the next four to five years because not all distressed borrowers will find themselves in trouble at the same time.
Cagan claims his study is the first to calculate the amount of loan risk based on homeowner equity associated with so-called hybrid ARMs. These loans allow borrowers to make little or no down payments along with low monthly payments for a fixed initial period. However, after the fixed period, the payments adjust upward based on prevailing interest rates. If rates rise sharply, the payments could rise sharply as well – increasing the risks that borrowers might default.
But Cagan said the risk won’t be that great. Using data from LoanPerformance, a real estate research firm that was acquired by First American last year, he found that the ARMs most at risk of default were those with low initial “teaser” rates of 2 percent or less and whose borrowers had less than 15 percent equity. This pool represented about $70 billion in potential losses out of $1.8 trillion in ARMs issued in the last two years.
The problem for many will arise when these loans adjust to market interest rates. For instance, borrowers paying 1 percent on a $300,000 mortgage – or $965 a month – would see their payments jump to $1,799 if their loan were to reset at a 6 percent rate, Cagan said.
Combined with their having little or no equity and a softening housing market, many of these borrowers are likely to find themselves in a “can’t pay, can’t sell, can’t refinance” situation in which default may be the only recourse, Cagan said.
However, he found that there was a small number of Southern Californians who face significant default risk. Out of 300,000 people who bought homes in Los Angeles and Orange counties last year, he estimated that fewer than 10 percent have the type of ARMs that he deemed to have the highest risk.
Yet, the potential for greater borrower distress could ratchet up if the economy worsens and the unemployment rate rises, said Edward Leamer, a UCLA economist.
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