ARMs Aren't Always Behind Foreclosures

Adjustable-rate mortgages were common for overleveraged buyers, but they're not always the prime culprit behind foreclosures

by Prashant Gopal

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It's no coincidence that states with the largest shares of adjustable-rate mortgages—Nevada, California, Arizona, Florida, and Colorado—are also among the states with the highest levels of foreclosures. The link between ARM concentrations and foreclosures has become increasingly apparent in the year or so since the subprime loans that originated at the top of the market started resetting. But just because a state has a low exposure to ARMs doesn't mean it is immune to high foreclosure rates.

Take Texas, for example. Home prices in the Lone Star State are low and, as of November, 2007, only about 12% of mortgages were ARMs. But it ranked 14th in the nation for foreclosures, with a rate of one filing per 778 households.

"Like a Used-Car Lot"

David Zugheri, co-founder of First Houston Mortgage in Houston, blames aggressive lenders who he said would qualify almost anyone during the building boom. Developers were putting up houses farther and farther away from metropolitan areas, where land was less expensive, and filled the homes with subprime buyers, Zugheri said.

"I blame the builders who needed to unload their product and the nonprofessional loan officers," Zugheri said. "Everybody was putting loans together just to get them sold. We were treating the housing market like a used-car lot."

The problems are more dire in Florida, in November the second-worst state in the country for foreclosure rates, according to RealtyTrac, an Irvine (Calif.)-based provider of foreclosure information. Lower- and middle-class families who bought houses with no-money-down, adjustable-rate mortgages are seeing their payments triple, says Jane Bolin, an attorney and managing partner of Foundation Property Services, a South Florida property management company.

"Every community that at this time last year had no homes in foreclosure, now [has] three or four," Bolin said. "Sometimes these families are highly educated. They just weren't aware that this predatory lending was happening."

Some states are in better shape. Among them are North Dakota, South Dakota, Iowa, Kansas, Mississippi, and Nebraska, all of which have the lowest exposure to ARMs as well as the lowest percentage of foreclosures.

Strong-ARMed Subprime Borrowers

It's not the loans alone that are causing the problems. Places with heavy concentrations of nontraditional loans and plunging home prices also typically have overextended buyers, homeowners with poor credit who couldn't qualify for conventional loans and speculators who planned to flip properties for a quick profit.

"Because subprime loans tend to be ARMs, places with high ARM shares are more subject to credit problems," said Celia Chen, director of housing economics at Moody's Economy.com (MCO). "Those resets that occurred last year and will occur this year will make future foreclosure rates look bad."

About $470 billion of loans reset in 2007. This year a further $385 billion of subprime and other nontraditional loans are expected to reset, according to Credit Suisse (CS). Treasury Secretary Henry Paulson introduced a plan late last year to head off massive foreclosures by freezing rates for certain subprime borrowers (BusinessWeek.com, 12/6/07), but critics say the plan won't stop the crisis from deepening.

Prime borrowers—at least so far—have avoided serious foreclosure problems because they qualified for lower interest rates and typically have bigger paychecks and bank accounts to dip into. But delinquencies have started to pick up for so-called option ARMs, which allow prime borrowers to decide every month on the amount they'll pay: a 30- or 15-year fixed rate, an interest-only payment, or a lower minimum payment.