Adjustable-Rate Mortgages Are Still a Problem

 | Dec 27, 2012 | 3:00 PM EST
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One of the residual effects of the housing boom and bust is the large percentage of adjustable-rate mortgages still being carried by the money-center banks.

Between 2000 and 2007, adjustable-rate mortgages became an increasingly popular tool for giving mortgagors the ability to leverage their purchasing power with lower monthly payments.

The most popular of these were the loans that allowed for capitalized interest expense, which also caused negative amortization. These kinds of loans were originally introduced by World Savings in California in the 1980s and then expanded to the rest of the country in the '90s.

Shortly thereafter, Bear Stearns created a mortgage-backed securities platform for these kinds of loans, and products similar to those World Savings offered were made available through Washington Mutual and Countrywide.

When the housing bubble began to collapse in 2006 and 2007, about 10% of the outstanding first trust residential loans were of this type.

The loans held by World Savings were absorbed by Wachovia and then by Wells Fargo (WFC). The Washington Mutual loans were absorbed by JPMorgan (JPM), and the Countrywide loans were absorbed by Bank of America (BAC).

Over the past four years, there's been a lot of speculation about a another housing bust that would be caused by these loans eventually adjusting into monthly loan payments that would be above what the mortgagors could pay.

These loans are all tied to short-term interest rates, and because the Fed has kept short-end rates so low throughout this period, the payments on these loans have not increased to the point that a new wave of defaults would occur.

Many of these loans are still outstanding, though, because the mortgagors are unable to refinance into fixed-rate loans because of negative home equity.

At Bank of America, 28% of its retained mortgage portfolio is still adjustable. At Wells Fargo it's about 32%, at JPMorgan it's about 50%, and at Citigroup (C) it's about 40%.

Although these numbers have steadily decreased in the past four years, they are still very high and pose a risk to the banks in the event that the Fed begins moving short rates up again before these loans have been restructured or paid off by way of home sales, short sales or foreclosure.

It's not an imminent issue, but it is something that investors in the money-centers need to be aware of. For each 100-basis-point increase in the fed funds rate, the monthly payments on these loans would increase by about 15%.

That level of increase is enough to cause defaults on these loans to rise, causing problems for the housing industry and the banks again. 

The Obama administration is considering addressing this issue finally by allowing mortgagors who have loans that are not already backed by Fannie Mae or Freddie Mac to refinance into a new fixed rate, regardless of home equity.

If such a plan can be made to work and if the banks can unload this risk, it could end up being beneficial to the banks, borrowers, the housing industry and the economy overall. 

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