Toxic Mortgages: Act II?

Story Highlights:

• The number of monthly mortgage rate resets for Alternative A-paper (Alt-A) and option adjustable rate mortgages (ARMs) are scheduled to rise in the period ahead.
• Some fear these escalating rate resets will lead to higher levels of mortgage defaults and exacerbate economic troubles—and perhaps even trigger another financial fallout.
• Unlike with subprime, the problems associated with resetting Alt-A and option ARMs rates have been anticipated for some time.
• The fallout from these rate resets will likely be less severe than some anticipate—the government and banks are much more prepared now.

________________________________________________________________________

Subprime fears seem to be easing, only to be replaced by new worries. Some see toxic mortgages as a two-act play, and subprime was merely part one. Next up—Alt-A and options ARMs.

The number of monthly mortgage rate resets for Alternative A-paper (Alt-A) and option adjustable rate mortgages (ARMs) are scheduled to rise in the period ahead. Some proclaim these escalating rate resets will lead to higher levels of mortgage defaults and exacerbate economic troubles—perhaps even trigger another financial fallout.

However, unlike with subprime, the problems associated with resetting Alt-A and option ARMs rates have been anticipated for some time. Many of the espoused fears over rate resets are based on estimates tied to current mortgage default trends—but government policy (existing and proposed) could change, or at least slightly alter, those trends' course.

Already, the Fed's aggressive monetary easing and commitment to keeping rates low are driving down the interest rates on which most adjustable rate mortgage loans are based. ARMs typically offer a fixed interest rate for a period of time, then resets that rate periodically for the remaining years of the loan. The reset rate is usually some interest rate (LIBOR is a common one) plus a spread (a fixed amount usually decided at the time of loan signing). So even though banks may demand a higher spread on new loans signed, the lower interest rate environment means folks with soon-to-reset Alt-A ARMs may actually find themselves with quite an agreeable rate. These borrowers are in less trouble than they would have been had these mortgage products reset 12 or 18 months ago.

Holders of the most "toxic" of ARMs—option ARMs—could face more problems than those with Alt-A. Borrowers with option ARMs are allowed to move into negative amortization—contributing to higher default risks down the line. Even so, these products represent less than 2% of the $11 trillion-plus mortgage market (much less than the ~$1.6 trillion subprime mortgage market). Plus, rate resets on these loans will take places in stages, not all at once. Fitch Ratings estimates $29 billion in option ARMS will reset in 2009 and $67 billion will reset in 2010.

Banks, well aware of potential implications from escalating ARMs rate resets, padded balance sheets in preparation of continued deterioration in mortgage markets and mortgage resets. Financial institutions' problems earlier this year were not solely the fault of subprime—misguided accounting rules and regulatory action compounded a downturn in housing prices, leading to frozen credit markets. In turn, the freezing of credit have severe implications for financial institutions and the general economy. Such accounting policies have since been suspended, and government action have since become less muddled.

The stage is still set for more mortgage defaults in the period ahead. But there are significant differences between now and when subprime problems exploded. Government policy will likely continue to target the problematic residential mortgage arena—though it remains to be seen what President-elect Obama's plans are—and the lending environment is becoming generally more favorable.

Curtain call for Alt-A and option ARMs may be around the corner, but it's still uncertain whether they will take center stage.