Analysis: Loans Coming Due

Friday, June 9, 2006 | Those of you who have been following my stories will know I’ve been placing a lot of emphasis on the large proportion of interest-only and negative-amortization loans that have been issued in San Diego and nationwide in the last few years.

The reason I’ve been harping on about this so much is pretty simple. Last year, 76 percent of the new loans issued in San Diego were either interest-only loans (in which the borrower only pays the interest on their loan for a fixed period of time, usually five years) or negative-amortization loans (in which the borrower doesn’t pay off even the full interest payment each month, meaning their debt actually grows).

In essence, the borrowers of three-quarters of the loans issued in San Diego last year are not actually paying off any of the sum they borrowed for an introductory period. Their overall debt either remains the same, or increases for that time.

The primary reason people take out these loans is that they offer much lower monthly payments than traditional amortizing loans (the ones where you pay off a chunk of your actual debt each month in addition to the interest, fees etc. over a set number of years). They allow people who can’t afford more traditional mortgages to borrow money to get their foot in the door.

But, sooner or later, those monthly payments kick up substantially as the introductory periods – usually three to five years, run out. After the initial low-payment period, the payments can go up by several thousand dollars a month. In some cases, the payments more than double.

Now, that’s never a problem if the person who took out the loan has been sensible and realistic about their mortgage. If they have foreseen the higher payments and have made plans to begin paying the higher rates, they are home free. A good example would be the young executive, who took out an interest-only loan, knowing he would be making twice his salary five years down the line. Check out this guide to who should take out an interest-only loan.

What worries some economists is that 76 percent of people are not sensible young executives on the fast track to wealth.

So why all the interest-only loans? Well, take into account the fact that San Diego’s home prices have been rapidly escalating since 1999. With home values going up 10, 15, 25 percent a year, anybody who has owned a home has done extremely well for themselves recently. Anyone who entered the property market within the past few years, on any sort of loan, has built up a large chunk of equity in their home.

Having equity in your home is like a get-out-of-jail-free card for anyone who, realistically, can’t make the higher payments on their mortgage when the payments kick up. That’s because someone who has equity can just sell their home if they get in trouble, sometimes at a profit.

But if home prices don’t rise? If all those borrowers do not build equity in their homes as their homes go up in price? If the borrowers don’t get the job promotion, or even lose their job? Then they’re in trouble because they will not be able to sell their home for the same value or more than they owe the bank. Experts are worried that could mean many people walk away from their homes – foreclosing on their loans – which could, in turn, hurt home values for everyone.

Now, bear in mind that we’re not talking about a small number of people. For the last couple of years, a majority of the loans taken out in San Diego have been interest-only and negative-amortization loans. That means there are a whole lot of people who have a lot to lose if their house doesn’t go up in value.

The key question that I’ve been chasing for some time is when the introductory period on all these loans ends. In other words, when do all those payments start jumping up? Last week, I found out.

Bob Visini, vice president of marketing at Loan Performance, LLC in the Bay Area, told me a number of his clients in the real estate industry are trying to figure out that same question. The latest figure, he said, is that an estimated 5 percent of the total amount of money currently owed in mortgages nationwide will be owed through so-called “exotic loans” that will see their payments rise this year.

Five percent’s not that many. But between now and 2010, Visini estimated that about 25 percent of loans nationwide will have reset. Visini stressed that no-one knows exactly what the figure is, but that, over the next four years, one dollar in every four dollars lent in mortgages in the United States could reset to the higher, non-introductory rates.

Visini based his calculations on the dollar amount of mortgage debt. In other words, he said 25 percent of all money loaned for homes will be affected by the rate reset. That’s an important distinction because it doesn’t necessarily mean 25 percent of loans are affected – just 25 percent of the cash amount that’s been loaned. However, Visini said that measuring the dollar amount is the most accurate way to estimate the effect of resets.

Now, bear in mind, that 25 percent is a nationwide figure. Nationwide, people have either not needed to or chosen not to utilize these “exotic” loans (see my chart on the left). A far greater proportion of borrowers took out these loans in San Diego than around the rest of the country. Indeed, according to Loan Performance’s figures, the rate at which negative-amortization and interest-only loans were taken out in San Diego has been double the national rate since 2002.

Therefore, it’s not a stretch to estimate that some 50 percent of money borrowed through mortgages in the region will be wrapped up in reset interest-only or negative-amortization loans by 2010.

Of course, if home prices rise reasonably over that period – and lots of people think they will – many of those borrowers will be absolutely fine.

Christopher L. Cagan is the director of research and analytics at First American Real Estate Solutions, a massive real estate services company. He recently authored a research paper entitled “Mortgage Payment Reset: The Rumor and the Reality.”

In his paper, Cagan argues that the actual number of mortgages that will end up in foreclosure – that’s when the bank seizes a home after the borrower fails to make their payments – is a “slice of a slice.” Because home purchase borrowing has been largely sensibly managed, Cagan writes, many borrowers have sufficient equity in their homes to see them through a period of price reductions, even when their monthly payments reset.

Of the purchasers who are unable to refinance, Cagan said in an interview, most will find some way to hold onto their property. American borrowers are not necessarily “intoxicated serial financers,” he writes, and the use of exotic loans to get people onto the property ladder is actually “reasonable and sensible asset management.”

Cagan’s argument is essentially that homeowners have been able to tap the equity in their home to use for responsible, sensible purposes. He writes:

“If one’s home value increases dramatically, and money can be borrowed at very low rates, usually with tax-deductible interest payments, why not pay off a credit card debt at 18 percent or higher non-tax-deductible interest? Why not purchase an automobile or pay off college tuition? This is nothing other than reasonable and sensible allocation of resources,” reads the research paper.

That positive outlook for the real estate market extends to San Diego.

Cagan said San Diego is not all that different to the rest of the country. Most home purchasers will have planned ahead for the day their payment bumps up, Cagan said, and the impact of the loan resets will “sting, but will not break the economy.” However, when he heard just how many exotic loans have been taken out in San Diego, Cagan admitted that tough times could be ahead for the city.

“That’s going to be an area of stress,” he said.

Stress, but still not stress to the breaking point, Cagan said. Many San Diegans, he said, even those who are financed up to the hilt and who do not see their home values increase in the next few years, will find some way to pay that higher mortgage payment.

Now people, by all accounts, fight tooth and nail to hold onto their homes. But in the scenario that prices do fall – and remember, that’s a very big assumption – a lot of people could be left unable to refinance their loans. Even if all those borrowers who are unable to refinance do manage to keep making their payments, many economists agree the repercussions for the local economy could be serious.

Imagine the holders of at least a quarter of all the borrowed money for housing suddenly losing several thousand dollars a month in disposable income. That means fewer trips to the grocery store, fewer meals out and fewer expensive vacations.

So that 50-percent figure looks quite innocent at first, but taken in its proper context, it could prove very significant indeed.

Please contact Will Carless directly with your thoughts, ideas, personal stories or tips. Or send a letter to the editor.