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   ARTICLE   |   From Scotsman Guide Residential Edition   |   March 2006

Market Matters

In a potentially unstable market, property values and mortgage payments are key

Mortgage brokers and borrowers have expressed two large questions about the market’s future: 1. “Are we going to see a sharp drop in housing values?”; and 2. “Will the prominence of so-called ‘exotic mortgages,’ such as option ARMs, actually end up hurting more borrowers than they’re helping?”

Although there is no definitive answer to either question, both are worthy of further investigation. Upon analysis, the market’s guiding factors and option ARMs’ future are intertwined and addressable on their own separate terms.

Housing values

Let’s say that a sharp drop in property values is one of 20 percent or more and that “prolonged” refers to a 10-year period. The cause of this scenario lies in a simple equation: The price of any commodity falls when supply exceeds demand. As such, housing prices will fall sharply when the number of homes for sale far exceeds the number of buyers. Further, it is likely that any decrease in housing values will occur in some cities and not in others.

The real question, then, is: What would cause the number of sellers to far exceed the number of buyers in certain cities?

When cities’ businesses are highly dependent on a single industry and collapse, no jobs are left. People leave, and no one moves into the area until prices fall to an attractive level. Situations include those in Long Beach, Calif.; Dallas; and on a larger scale, the Rust Belt (i.e., the area roughly between Chicago and New York City).

Another answer might be speculation, which can incite price spikes and dips. The speculation could be that instead of people buying their houses to live in, they bought them for the same reason they bought Internet stocks in the 1990s — greed. This speculation only occurs in certain markets. In a moderate recession, for example, we might see a decrease in property values in areas that primarily contain second homes.

Yet another factor is what I call “economic optometry.” Many people who purchased homes in the past year simply could not see the big picture and would not believe that prices would ever come down.

This belief also exists on the seller side, as shown in the halt of increases in housing values in hot markets. Sellers are putting their homes on the market at “Would you believe?” prices, and prospective buyers are saying, “No, I would not believe.”

Seeing decreasing or even stable prices, prospective buyers will choose to not enter the market until they are confident that prices will not decrease. As such, many homebuyers and would-be sellers may soon have their vision corrected.

The option-ARM factor

In addition to their concerns about housing prices, borrowers also might be worried about their mortgage payments. Here, there are two issues: 1. The impact of higher mortgage rates on the market and prices; and 2. The effect of “exotic” mortgages such as option ARMs.

There surely will be people who bought their home with an option ARM and will choose to sell when faced with actually having to start paying off the loan. The idea that option ARMs may cause a wave of selling and further decline in values makes a few presumptions.

A popular assumption is that many homeowners are draining their equity by making payments of less than the interest. Faced in a few years with loan balances that exceed the property value and with the necessity of paying off a loan balance that is now 110 percent of the original loan amount — and having to do it in 25 years — these homeowners may be unable to afford the payments. They may not have the option of refinancing because of a lack of equity. Thus, they may have to sell.

I do not doubt that this will happen to some people. But the evidence that I have gathered from loan officers leads me to believe that this number is small. Therefore, I do not believe that the option-ARM factor will have a significant effect on the housing market.

Mortgage professionals must take a responsible stance, however. Those of us who originate mortgages need to temper maximizing our income with a sense of responsibility. There are situations in which option ARMs are excellent choices, and there are situations in which they are inappropriate. For example, if potential borrowers are going to buy a house with an option-ARM loan and intend to stay in the property long-term, they should be asked: “Will you ever be able to afford to start paying off this loan?”

Option ARMs should not be used to make an unaffordable property affordable. A few months ago, for example, a borrower in Phoenix called me about a potential purchase in the San Francisco Bay Area. He and his wife wanted to purchase a $1.5 million home, and they could afford a $300,000 down payment.

He asked me if I could get them an option ARM so that they could buy the home.

“Certainly,” I said.

He then asked if this made sense in the long term, and when I asked if they intended to stay there for a long time, he said yes. I told him that he had to consider if they could ever make the payment on a $1.2 million mortgage, either fully amortized or even interest-only. He said they would not.

This was a situation in which an option ARM was inappropriate. There are cases in which option ARMs are appropriate and can provide people with financial opportunities that they might not have with any other loan products, however. For instance, option ARMs are appropriate for:

  1. Borrowers who want to buy a home today that they can afford three years from now. The profile that I often have is of a young couple: The husband is a lawyer, and the wife is a doctor. They are both at the start of their careers and certain that their combined income in three to five years will be 50-percent to 100-percent greater. They can buy the house that they can afford in three years and can start by making interest-only payments for a while.

  2. People with irregular income (e.g., commercial real estate agents whose income comes in the form of two checks a year). These people can make minimum payments in income-lean months and can make up the difference from their next large paycheck. In general, this might be appropriate for any family for whom average commission income is greater than average base.

  3. A purchase situation in which, for the next year, money must go toward repairs rather than toward the mortgage.

  4. People with income property who would rather not have to spend $500 in negative cash flow each month and instead give up equity now for cash flow.

Used correctly, option ARMs provide opportunity and convenience. Used incorrectly, they can be a prescription for disaster.

Brokers who understand which borrowers would benefit from exotic-mortgage products as option ARMs can better serve their clients in a potentially volatile housing market.


 


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