ARM'd and Dangerous?

Another nice post from Jonathan Miller on his Matrix blog, "Foreclose Already So We Can Get Back To Normal" (http://matrix.millersamuel.com/?p=568). Jonathan does his usual fine job of trying to help everyone keep the numbers in context.

He asks a question toward the end of his post about why the Midwest seems to be getting hit unusually hard with foreclosures in spite of the fact that both coasts saw higher price spikes in home values and a higher percentage of "exotic loans." Interesting question.

Jonathan's question reflects a popular bias these days towards directly linking the rising foreclosure rates to default rates on some of the higher risk loans that have become increasingly popular - ARMs, interest only, negative amortization, etc. There's undoubtedly some truth to that: high risk loans are more likely to be defaulted on than traditional loans, and the more of them that get funded, the more we're likely to see in the RealtyTrac foreclosure database.

But our fascination with these loans and their impact on foreclosure rates may have had something of a blurring effect on how clearly we view the overall foreclosure market. Under "normal" circumstances, we'd probably look at the Midwest rates and chalk them up to higher-than-average unemployment rates (a very strong predictor of foreclosure rates) and lower-than-average house appreciation rates coupled with weak housing demand. That's a pretty reliable formula for high foreclosures: No job + no equity + no homebuyer = distressed homeowner. And it probably accounts in large part for what's happening in states like Ohio, Michigan and Indiana.

That doesn't mean that we shouldn't be concerned about the potential effect of the "exotic loans," however. We've seen numbers that suggest that as much as $300 million in ARMs will re-set this year, with another $1 billion due to re-set next year. For homeowners who've been paying an interest-only 4% teaser rate, the cost of home ownership is about to go through the roof. Those dramatic increases, along with skyrocketing energy prices and increases in credit card payments (also due to rising interest rates), could push a lot of homeowners toward default. In a worst-case scenario, this could have a devastating effect on the housing markets, driving down housing prices and creating a "negative equity" spiral of sorts, and leading to the kind of massive increases in foreclosures that some of the gloom and doom types have been predicting.

Often a bellweather of the real estate market, California will probably be the state to watch as all of this unfolds, given the sheer volume of the market, the sky-high housing prices and the number of non-traditional loans. As a homeowner in the state, I know I'll be watching with more than passing interest.

What effect do you think ARMs will have on the foreclosure rate? Let us know.