Living in Chicago, one of second tier of real estate bubble cities, was part of why I decided to go “short the real estate market.” I also didn’t like where we lived and I felt that credit was being extended to people who were not creditworthy (especially given factors like declining real income and negative savings rates), so selling and moving had both quality-of-life reasons and risk management benefits.

Now, the evidence is starting to pile up that I might have been on to something. Calculated Risk points us to a story in BusinessWeek, “Nightmare Mortgates“:

The option adjustable rate mortgage (ARM) might be the riskiest and most complicated home loan product ever created. With its temptingly low minimum payments, the option ARM brought a whole new group of buyers into the housing market, extending the boom longer than it could have otherwise lasted, especially in the hottest markets. Suddenly, almost anyone could afford a home — or so they thought. The option ARM’s low payments are only temporary. And the less a borrower chooses to pay now, the more is tacked onto the balance.

The bill is coming due. Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules — often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can’t count on rising equity to bail them out. What’s more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.

There was plenty more going on behind the scenes they didn’t know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan’s interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they’ll soon be confronted with the choice of coughing up higher payments or coughing up their home.

(emphasis mine)

What’s saddest to me is that anyone is surprised by any of this. When history is written, the real estate bubble is going to look more like a giant asset-backed Ponzi Scheme than anything else. The initial investors were able to get their cash out as more and more people, driven by anecdotal tales of friends who made fortunes in housing and press releases from the National Association of Realtors about how housing prices only go up. Once the pool of credit-worthy applicants for the scam started to run thin, higher-risk loan products were cooked up and pushed out into the world to keep the party going.

Now evaluating this from a risk assessment perspective, let’s distill it out.

1. Option ARMS “might be the riskiest and most complicated home loan product ever created.”
   The people taking on Options ARMS tend to be people who either cannot qualify for “traditional” (30 year fixed) mortgages, are so blinded by greed (We can afford it, we’ll just use an Option ARM), or actually believe the NAR tripe about, “You should buy all the house you can afford.” Which leads to…
2. People buying Option ARMS are not, I strongly suspect, people with a firm understanding of the intricacies of complicated loan products. I would love to see a survey how many people with an Option ARM understood just how risky these notes were when they signed on. In that same survey, I would also ask how many of those people understood that under the revised US Bankruptcy code, you can no longer just mail in the keys and walk away from a house.
3. Hidden Agendas and “plenty more going on behind the scenes they didn’t know about.”
   Bruce Schneier specifically places the question of what hidden agendas people might have when managing risk in Secrets and Lies. Here, the loan officers and brokers were being incented (paid) to give preference to a high-risk loan product. Who would have me believe that they didn’t emphasize the upside (”low payment!”) over the downside (”your payment will double and you could lose your house!”)? The final nail in the hidden agenda coffin comes if you consider that the people “selling” these loans are brokers, so they’re not stuck holding the trash in the case of a default, meaning that they have no disincentive against selling people a note that they will default on.

Another way to look at it is through my Three Question model:

1. Does this solve a problem I have?
   Yes. I want to own a house but can’t afford one. An Option ARM lets me buy the house I want when I otherwise couldn’t.
2. Does this solution actually solve my problem?
   No. I still can’t afford a house, but the Option ARM makes it look like I can…for a while. Then, reality kicks in and now I can’t afford a house any more. At this point, it’s forclosure time and I’m now in worse shape than I was before from an access-to-credit perspective.
3. Is this a cost-effective solution to the problem?
   It seems to be up front, and if all I’m shown is the up-side (”Now I can afford a house!”), then it might seem to be. But throw in the Hidden Agenda, and it’s game over. It’s not a cost-effective solution, but the people with the expertise to tell me that are being paid extra commissions to keep their mouth shut.

What’s the end state? As BusinessWeek says:

The option ARM is “like the neutron bomb,” says George McCarthy, a housing economist at New York’s Ford Foundation. “It’s going to kill all the people but leave the houses standing.”

So that’s the reason for leaving the burbs. it sounds like you got out just in time. I must admit I have wacched the articles on the bursting housing bubble with almost a perverse fascination over the last year, especially after our experience with the oil crash of the 80’s and 90’s. For that reason I am sitting tight where I am (in a tight house, i.e. small) for the time being. Housing prices in Houston are still fairly hot, in contrast to the coastal markets, and are still rising.

It is interesting that you are currently renting from one of the very f’d borrowers that the article describes. You should have mentioned that as a footnote to your article, and the risk that you are taking by being the renter on the other side of an upside-down loan situation.

B.

An alternate view is that there is nothing wrong with ARMs and that a crisis is not forthcoming. People with ARMs (like myself) wanted to get the best rate and are prepared to accept fluctating market conditions (which our pay is indirectly linked to).

Jim Cramer (of Mad Money fame) claims that we will just refinance ARMs at the current (low) rate. No disaster.

Stu

Stuart,

You’re the exception to the rule. Hopefully, the rule won’t drag you down with it.

While the stance that you can refinance would be true in a rising price scenario, prices are no longer rising in most markets due to excessive inventories. As a result, people can’t refinance their mortgages due to being underwater on the note.

Also, if that were truly the case, we would not see foreclosure rates at record levels, homebuilder confidence collapsing, mortgate application rates collapsing, and the market capitalization of homebuilder stocks trading below book value. Check out Calculated Risk for hard data.

Anecdotally, I can say ther here in downtown Chicago, prices are already falling fast and yet the building goes on. A quick browse through realtor.com shows huge variance in asking prices for comparable properties–not a sign of a healthy market. I’ve seen the same “for sale” on properties in my neighborhood for months, the only change being new ones added.

Oh, yeah, at a 47% accuracy rate (as of earlier this month), Jim Cramer underperforms a flipped coin. And that’s with a huge audience of people responding to his tips and creating favorable market movement.