May112009

Temporary Affordability and the Third Foreclosure Wave

People buying for cashflow are not concerned with resale value because they do not intend to resell. Profit and loss for a cashflow investor is determined by its income not its resale costs decades into the future. The Federal Reserve with the blessing of the Treasury Department of the US Government is orchestrating 4.5% interest rates to entice cashflow investors back into residential real estate. Without cashflow investors this mess will never get cleaned up.affordability_ceiling

If prices fall low enough, and if interest rates drop low enough, returns to cashflow investors become very large. In fact, they come to be greater than all competing investments in the marketplace. Under those circumstances, money will flow back into residential real estate, and the plethora of foreclosures both on the market and in the pipeline can be absorbed by cashflow investors seeking superior returns. The next several years represent a once-in-a-generation opportunity for cashflow investors to pick up long-term holds generating superior cash returns. If lenders are stupid enough to inflate another real estate bubble later, profiting by appreciation would be a nice bonus to the cashflow investor.

The very low interest rates also create opportunities for people to purchase 20+ year homes at or below rental parity and avoid the pain of further price declines; however, this is the harder play. Few properties in Irvine are trading at or below rental parity, but they are common in desirable areas of Riverside County (Yes, there are desirable areas there). This NOT a play where you overpay today and wait for appreciation to catch up to you. It only works if you are saving money over renting.

If there are properties in which you would be willing to live for the long term, and if they can be had for at or below rental parity, then you are only hurt by rising interest rates and declining prices if you must sell while resale values are depressed (an event that happens more often than most believe). Eventually–cue the 20 year holding time–fundamentals will rise to support prices at higher interest rates. On an inflation adjusted basis, you can never recover from overpaying up front, but in nominal terms, there will come a point when you can get out at breakeven. Keep in mind, you are trapped in an underwater situation once interest rates start going up and values start going down; however, you are trapped in a property that still costs you less than renting, so you are far better off than the typical homedebtor trapped in their homes today.

Do I recommend this play? No. But it is a legitimate way to acquire a property with 4.5% interest rates and not get burned. I still recommend waiting until (1) prices are even more depressed, (2) the foreclosure crisis begins to wane and (3) interest rates are higher. You will get a better price, and you have the possibility of refinancing into a lower payment if interest rates drop again. You can refinance into a lower payment, but not into a lower debt.

One of the first problems of the developing bubble was identified by bubble watchers as early as 2003; the widespread use of adjustable rate mortgages during a period of low interest rates. Once interest rates go up, so do the payments on ARMs, and so do the foreclosure rates.

There are three types of ARMs: (1) amortizing, (2) interest-only, and (3) negatively amortizing. When prices reached the practical limit of fixed-rate mortgages, many people turned to adjustable rate mortgages to increase affordability because they have lower interest rates. At first people turned to amortizing ARMs, but that soon gave way to interest-only ARMs and finally to negatively amortizing ARMs.

When the FED aggressively moved to lower interest rates, many cheered that the ARM crisis was averted; at best it was delayed. The assumption most people made is that all the ARMs written are amortizing ARMs. There is no payment shock with an amortizing ARM unless interest rates rise; unfortunately, reality is that very few of the ARMs still utilized by borrowers are amortizing ARMs.

The first wave of the foreclosure crisis was subprime. That wave has crested, and its devastation is nearly done.

The second wave that is building now is caused by the deteriorating economy and ARM mortgage recasts (Calculated Risk has a good post on this). It is not the reset of interest rates that is the problem, it is the recasting to a significantly higher payment caused when the mortgage goes from interest-only to fully-amortized. The negatively amortizing ARM, also known as an Option ARM is shown in yellow on the chart above. It is the most toxic loan product ever conceived. The Option ARM and the interest-only ARM–and their associated recasts to amortizing loans–are the two loans responsible for the second wave of the foreclosure crisis.

The third wave will come when everyone still clinging to their adjustable rate mortgage is wiped out by higher interest rates. Everyone who does not refinance into a fixed-rate mortgage while interest rates are this low, and the fools who actually buy a property with an ARM while rates are at historic lows will all be wiped out during the third wave of the foreclosure crisis. The timing of that wave is much harder to predict because nobody knows when interest rates will climb.

Four and one-half percent interest rates almost guarantee a third wave in the foreclosure crisis. Perhaps everyone will purchase with or refinance into a fixed-rate mortgage and this crisis will be averted. I doubt it. Based on what is still happening in our mortgage market, it looks like this third wave is still coming.