The post below is by a guest author and a friend of this blog. Robert J Bernabe is a student of the US mortgage market and has been involved in the Industry for over 25 years at various levels, including operating several very large retail mortgage originators. There are few people out there who understand the mortgage business as well as he does.

-- Faisal Laljee

Is the subprime mortgage mess going to spill over into other parts of the credit spectrum? I guess it depends upon who you ask.

I don’t think you need to ask anyone. I think the answer is an obvious “yes”. Why?

Let’s start with the subprime mortgage market. For the most part, the borrowers are comprised of low to middle income households that have a big blemish on their credit history that will cure given time, or have bad borrowing and payment habits and have habitually poor credit standing. The vast majority of these households have limited borrowing capacity. Because of their limited income and credit rating, most of these borrowers must look for intermediate ARMS, which have low fixed rate payments for a short period of time and then swiftly adjust to payments based on fully indexed rates.

The bread and butter of the subprime mortgage market over the past decade has been the 2/28 (fixed for 2, adjustable for 28). It’s also the bread and butter of the households I’ve described. These folks are habitual refinancers, mostly in the third year when the payments reset. They keep coming back, sometimes taking cash out of their properties, but mostly for the purpose of keeping the payments low. And each time they do this, they add thousands in fees and costs to their loan balances, effectively borrowing the cost to refinance over the life of the new mortgage.

Bad habit? Absolutely! For consumers and the industry!

No one seemed to care too much until just recently. It doesn’t take a rocket scientist to figure out that the habitual refinancer is out of luck when interest rates rise. You see, there is a very simple inverse relationship between interest rates and the housing market. Rates go up, housing declines. Any arguments?

Apply this to the borrower with a 2/28 subprime mortgage. He most likely levered the property the last time he went to the well. Now it’s time to go at it again, but there’s not enough equity in the property to finance the fees and costs to do so. Worse yet, his house might be upside down as is. So he’s stuck with a payment that is typically increasing every 6 months. On top of this, our borrower has probably lived and spent according to the payment for the FIXED term of the mortgage, and now he’s really in a pickle. Start selling some things, buddy (assuming you haven’t borrowed to buy everything in sight).

Anyone who didn’t see this coming some day has got to be checked out of reality. All we needed were increasing rates and declining housing prices, causing a squeeze on the ability to refinance out of the escalating payments. Add this to the high rate of credit consumption for non-housing related purchases, and you have the makings of what we see today.

So let’s get back to the original question by asking a question: what’s different between what I just described and prime borrowers with, say, 3/27 and 5/25 adjustable rate mortgages? For a sector of the prime market, I say “not much”. Sure, they have better credit scores, higher income and probably live in better neighborhoods. BUT, how many of these households require both parties to work in order to make ends meet? And how many of these households can withstand a 300 basis point increase (or more) in their rate without significant pain?

I can think of several states where there’s a problem brewing. California? Fits the bill in my opinion. Those intermediate ARMs were used to free up cash flow for consumption (I didn’t say savings or investment), buy more house, take cash out of rapidly increasing home equity, etc. And now they’re all faced with sharply increasing payments.

Sure the squeeze isn’t as bad – but it’s bad. These borrower’s homes are not exempt from declining values. These folks face similar economics when refinancing and will see similar consequences.

There is a difference for the prime market, however. That difference depends upon the choices made several years ago. For many who made the wrong choice, this whole problem could have been avoided. When rates are at 40 year lows (like they were not too long ago), why on earth would the typical borrower take on an adjustable mortgage? For the vast majority of Americans, it makes sense to take a fixed mortgage when rates are low and an intermediate ARM with rates are high, waiting for the right moment to lock in that lifelong, low fixed rate payment.

Fixing the primary cost of housing just makes sense for most people. Now many of those that didn’t adopt this philosophy are wishing they had.

Next time, I’ll talk about how consumer spending habits and the view of one’s home as an ATM have greatly contributed to the problems we’ll see over the next few years.

RJB