March 15, 2010 at 12:45 PM
Back in December 2008, 60 Minutes reported that a second wave of mortgage defaults was still to come. The concern was that this “second wave,” comprised of defaulted Alternative Documentation Loans (Alt-A) and Adjustable Rate Mortgages (ARMs), would deepen the US recession. These risky loans have made a strong contribution to the national recession.
In an interview with investment fund manager Whitney Tilson, 60 Minutes’ Scott Pelley asked, “What you seem to be saying is that there is a very predictable time bomb effect here?" Tilson’s response was, “"Exactly. I mean, you can look back at what was written in '05 and '07. You can look at the reset dates. You can look at the current default rates, and it's really very clear and predictable what's gonna happen here," Tilson says.
But that bomb never went off. Tilson projected 70 percent of the country’s $500-$600 billion dollars worth of ARM loans would default. Pelley described the situation as a, “next wave of defaults, which everyone agrees is inevitably going to happen …” Here we are 18 months later and foreclosure rates seem to be tapering off. So, just what happened?
Understanding Alt-A Loans and ARMs
Alt-A and ARMs were in danger of default mainly because of the nature of the loans. Alt-A loans allow those with good credit ratings to borrow without providing the traditional documentation to prove income or assets. Approval for these loans was based almost solely on an individual’s credit score. They were designed for the recently divorced, entrepreneurs, self-employed individuals, and those who receive commission-based pay. But at the height of the real estate boom, these loans were offered to just about anyone. In many cases, individuals abused the simplicity of this loan process and failed to consider how they would make the mortgage payments over the long-term.
ARMs are mortgages with low initial fixed interest rates that switch to variable rates at a set time. Many signed up for ARMs with the intention of refinancing before the fixed-rate period ended. But those still holding these mortgages when the real estate market collapsed found themselves unable to refinance. The value of their homes declined so much that there was insufficient equity to pay off the ARM.
The Real Second Wave
But rather than an explosion of defaults in a second wave, we saw a strong, steady increase that eventually began to slow. Only a small portion of homeowners resolved their defaulted mortgages through short sales. According to ABC News, only 168,000 defaulted loans were modified under the Home Affordable Modification Program (HAMP). Those remaining sit in HAMP negotiations or wait in a bogged-down court system, pending foreclosure.
The number of new foreclosures is down, despite an overwhelming bankruptcy rate. Time Magazine reports that personal bankruptcy filings are up 35% over last February. It is assumed that many of those going through bankruptcy are also trying to modify home loans. Those that fail will inevitably see their homes hit the foreclosure market. Many of the loans defaulting today occurred because responsible borrowers lost their jobs in the recession and could no longer make their mortgage payments. This is the true second wave.
Changes on the Way to Help Homeowners
The Obama administration recently announced plans to aid the “second-wave” homeowners who defaulted “through no fault of their own.” But previous efforts in the Home Affordable Modification Program (HAMP) program have had little effect on foreclosure rates. Part of the problem is that HAMP only requires Fannie Mae and Freddy Mac loans to be modified. Lenders have no requirement to modify other loans. In addition, several changes to the program since its inception have left much confusion over the correct procedures for lenders to follow. Homeowners who fail to educate themselves fall to the mercy of often poorly trained bank employees.
The new changes will require lenders to cut or even eliminate mortgage payments for qualified unemployed borrowers. Banks would be forced to cut payments until they meet 31 percent of the borrower's income for as long as six months, even if the income is only from unemployment insurance. Lenders could even suspend payments on the mortgage if necessary.
For homes “underwater,” the new rules will encourage banks to reduce loan balances and refinance individuals into new FHA loans. Federal incentives will be double previous inducements. However, the new plans will take six months to initiate, which will translate into more defaults and more foreclosures. The number of foreclosures is likely to worsen before it improves.