Getting Knocked Down by Prime ARMs

Prime ARMs went to borrowers with good credit because they were less likely to default, right? Wrong

by Prashant Gopal

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We've been reading a lot lately about how subprime mortgages have submarined the economy. Lenders and banks have been taken to the woodshed for irresponsibly giving money to home buyers with poor credit just so they could bundle up the mortgages and resell them as toxic residential-mortgage bonds. But, while there's no denying the subprime problem, on closer look it's clear that even prime borrowers were taking on more debt than they could afford.

How bad is it? In Arizona, between the third quarters of 2006 and 2007, there was a 902% rise in foreclosures started against homeowners who had prime adjustable-rate mortgages, known as ARMs, according to the Mortgage Bankers Assn. ARMs, whether prime or subprime, are the real culprit in the housing crisis because they've allowed too many people to buy homes with almost no money down, with the hope that they could flip the properties or have rates drop before the loans reset.

The rise in prime ARM foreclosure starts isn't isolated to a few states. Nationally, foreclosure starts related to prime ARMs jumped 253% in the third quarter of 2007 when compared to a year earlier.

"The fact is the pain of the changing real estate markets is affecting more than just subprime borrowers," says Keith Gumbinger, vice-president of HSH Associates, a New Jersey-based financial information publisher. "It's more important to think of it as perhaps an ARM problem and a rate reset problem, not just a subprime problem."

Rising Foreclosure Starts

Arizona, Florida, Nevada, and California, which all had the greatest rise in prime ARM foreclosure starts in the third quarter of 2007, also have a heavy concentration of investor-owned properties. Many investors, who bought homes they hoped to resell quickly using no-interest loans and other mortgages with low teaser rates, got hurt when the housing bubble popped. Some investors are simply walking away from homes that are now worth less than what they owe to the bank (BusinessWeek, 1/3/08).

Maryland and Virginia, which also are among the states that have seen the greatest increase in prime ARM foreclosure starts, might have been hurt by an oversupply of new construction, which borrowers typically financed with variable-rate mortgages. Maryland prime ARM foreclosure starts increased 229% during the 12 months ending in the third quarter, 2007. Virginia, which like Maryland includes high-priced Washington, D.C., suburbs, had a 369% year-over-year increase.

Oregon, Massachusetts, and New Jersey also saw huge jumps in such foreclosure starts, in part because buyers with good credit in those states used ARMs to pay for homes that might otherwise have been out of their reach. Of course, nobody would be complaining about ARMs if home prices were still rising.

"There was so much competition for mortgages over the last couple years that the definition of prime became less and less stringent," says Addison Wiggin, publisher of Baltimore-based Agora Financial, which publishes investment advice for individuals. "Even in the prime market, you had people taking on larger loans than they historically were able to handle."

Refinancing and Option ARMs

Borrowers with good credit are in a healthier position than subprime borrowers because lenders see them as less risky candidates for refinancing and are willing to put them into fixed loans. But not all prime borrowers can qualify for refinancing, particularly if they owe more on a mortgage than the house is worth or if they've lost their job and can't meet salary or other underwriting requirements. Refinance applications from borrowers have surged in recent weeks, according to the Mortgage Bankers Assn., which doesn't break out prime and subprime applications.