The concept of rate shock is getting a lot of press and a portion of it is pretty scary. Here is a compendium of things that are being said about potential rate adjustments of ARMs, option mortgages, and who might bear the blame if there is what one article termed "a neutron bomb" that would wipe out the borrowers while leaving the houses standing. There are, of course, always individuals and companies that will benefit from any catastrophe and those are also getting their share of attention in the press.



BusinessWeek.com has just published a stunning article (resulting in the neutron bomb reference above, ) that postulates that the fallout from "exotic" mortgages - i.e. interest only and option mortgages - will reach far beyond homeowners who took on these obligations either not understanding the ramifications or thinking they could game the system. According to the article Nightmare Mortgages, Wall Street, and especially hedge funds (in which many individuals, 401(k) and traditional pension programs invest) have also bought these loans and the risks associated with them. "The option adjustable rate mortgage might be the riskiest and most complicated home loan product ever created. (It) brought a whole new group of buyers into the housing market, extending the boom longer than it could have otherwise lasted." However, the article continues, there was more going on behind the scenes. Brokers were paid more to sell option ARMs than other mortgages and lenders were allowed to claim the full monthly payment as revenue even if the borrower paid the minimum and the loan's interest rates and fees might have been set by hedge funds rather than the banks.

The article claims that banks don't have to report on the number of these option loans they have written but they represented "at least 12.3 percent (of all mortgages written) during the first five months of this year." While they have been popular on the coasts where the market is especially overheated, "through March 31 of this year, at lest 51 percent of mortgages in West Virginia and 26 percent in Wyoming were option ARMs."

And, not only did these exotics prolong the boom, they may well worsen the bust. "They also betray such a lack of due diligence on the part of lenders and borrowers that it raises questions of what other problems may be lurking. And most of the pain will be borne by ordinary people, not the lenders, brokers, or financiers who created the problem."

However, while the author of Nightmare Mortgages feels that "ordinary people" will bear the pain, it is not prudent to overlook the fallout that may affect investors and banks. If lenders are indeed booking non-existent payments and then are hit with massive defaults with no hope of recovery we could be looking at some devastating damage upstream. The cavalier attitude toward commercial real estate lending in the 1980's led to massive failures of banks and savings and loans in the 1990s. One can only hope that this left some sort of an impression on those institutions that survived that debacle.

BusinessWeek.com also says that the option ARM is not necessarily a product whose time has come and gone. "Despite the housing slump, option ARMs totalling 77.1 billion were written in the second quarter this year."

The complete Business Week article is available here.

And, as BusinessWeek.com noted, in spite of the recent bad publicity attending the "exotic" mortgages, they continue to be promoted and publicized. Motley Fool has an interesting article this week in which the writer, Seth Jayson, waxes furious about an ad running in a Washington, DC area newspaper placed by a major national homebuilder. The ad offers "a variety of living arrangements at what seem like rock-bottom prices." For example: "3-4 bedroom garage townhomes... $1,174 per month." Or this one: "Single family and manor homes... $1,478 per month."

However, the builder discloses, "in microscopic print, that these payments are in fact based on teaser (interest) rates of 2.75%, a rate that disappears after one year. After that, you're stuck with a 6.25% rate on a 40-year mortgage. You got that right, 40 years".

Using the big builder's own on-line calculators, Mr. Jayson played with these "teaser" offers and he says, "...forget $1,174 per month my friend." After that first year is over and the mortgage adjusts payments go toward $2,081 per month. That's right, 75 percent higher than the teaser payment in the ad -- which seems to exclude insurance, taxes, and mortgage insurance.

Here is one explanatory table offered by Mr. Jayson.

Teaser Rate
Years 2-40
30-Year
Payment & Interest $1083 $1788 $1940
Tax & Insurance $183 $183 $183
Mortgage Insurance $110 $110 $110
Total Monthly Payment $1376 $2081 $2233

These figures assume a $350,000 home, 10% down payment, and the builder's auto-generated tax and insurance figures which Jayson stated he thought were on the low side of reality. As you can see, there's an incredible difference between ad copy and abject reality

Mr. Jayson does a good deal more number crunching in his analysis which can be read in its entirety here.

A lot of people will only be too happy if rate shock starts shaking people loose from their homes or causing financial upheaval. There are several websites that make their money by dealing in foreclosures and investors who sit on the sidelines just waiting for a disaster to happen. They are apparently doing very well.

A bit more about this later in the week.