Why do ARMs have to reset to higher rates?

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Submitted by davidt1 on August 14, 2007 - 6:15am

If banks don't adjust rates up no one would lose their house, banks wouldn't have to take losses on foreclosures, the housing market would be in better shape and the stock market would not slow down. This would be good for everyone, no?

Submitted by JWM in SD on August 14, 2007 - 6:25am.

Ask the RMBS investors that question and see what response you get.

Read the bubble primer before you post silly questions.

Submitted by davidt1 on August 14, 2007 - 8:58am.

Is it silly to ask a question one seeks an answer to? It's a question of what would be better for the banks. Foreclose on properties and incur the loss and headache that come with it or reduce rates slightly and let the home owner keep the house. Thank you for your patience and understanding.

Submitted by FormerSanDiegan on August 14, 2007 - 9:12am.

Although, I don't think lenders will voluntarily reduce rates, one should consider potential scenarios for rates actually re-setting at reasonably low rates at some point in this cycle.

Nobody here seems to think that could happen.

First, it is instructive to consider the terms of many of these loans. For your more standard ARMS (Alt-A and Prime), they will typically reset to an index (e.g. 6- or 12- month LIBOR 6 month or 1 year treasury) plus a margin (e.g. 2.25%).

Consider that the LIBOR is at about 5.2-5.3 for the 6- or 12-month index. That means that for typical ARM loans resetting now, the rates would be something in the range of 7.45 to 7.55.

This is based on the terms when the loan was taken out.

If the economy tanks and short-term rates decline (as they have in 5 of the past 6 recessions), it is possible that loan resets could be in the 6% range or lower.

It's too late for many of the loans about to reset this year. But, this is a plausible scenario for loans resetting in the second wave of resets.

Submitted by PerryChase on August 14, 2007 - 9:15am.

For one thing, without cash flow, the lenders will soon close their doors. Looks at an Option ARM. The borrower pays the minimum but the bank books the whole amount of interest (a big chunk not paid) as income. How long do you think the lender will last with accrual income but no cash flow?

The loans don't reset then income cannot be booked, or huge write downs must be taken. Lender goes out of business and the executives don't get big bonuses.

Submitted by lendingbubbleco... on August 14, 2007 - 9:17am.

MBS buyers weren't making money on the 1% teaser rate....they were "betting on the come", so to speak. The banks made their origination fees, Wall Street made their securitization fees...now the MBS purchasers want delivery of the goods they paid for: interest payments at the reset rates, NOT teaser rates.

Submitted by Diego Mamani on August 14, 2007 - 9:30am.

No questions are silly. If an answer is on the primer, then a referral to it would be appreciated. What is really silly is not asking questions, or flaming those who do (after all, if you don't like a question, you could always ignore it.)

Interest rates are not set by any bank, they are set by the market. It's like asking, why doesn't Safeway lower it prices? That way the poor would be able to afford food and no one would hungry, right?

ARMs "don't have to" reset to higher rates. Rates could go up or down, as determined by the market. The market is comprised of hundred of thousands, if not millions of funding agencies, banks, consumers, foreign central banks, corporations large and small, etc.

In many countries, like the UK, etc., ARMs are more prevalent than fixed-rate loans. There's nothing inherently wrong with ARMs, contrary to popular belief in today's post boom environment. Fixed rates offer the convenience of fixed payments for the life of the loan, but we consumers pay dearly for that. Moreover, non-exotic ARMs have plenty of safeguards: a fixed rate period, a cap of how high rates can go for the life of the loan, a cap of how high any annual increase can be, and no pre-payment penalties.

Unfortunately, during the recent credit orgy (2001-2006) such safeguards were eliminated, especially in subprime loans.

Submitted by Fearful on August 14, 2007 - 9:40am.

There are no silly questions. There are only silly people asking questions.

Okay, that was uncalled for. Sorry.

Submitted by Navydoc on August 14, 2007 - 10:19am.

Congratulations on finding the best resource on the current housing mess in SoCal. Be warned however thet when you ask a question some here would consider "stupid" you expose yourself to some torment. Don't worry about it, it's an anonymous forum, and nobody really cares. I urge you to review some of the archives in this forum, it will greatly help get you up to speed as to why some will think you asked a stupid question.

Just remember one thing, banks are not in business to get you into a home. They are in business to make money, plain and simple. In order to sell their product, a home loan, (and make no mistake, it IS a product) they need to advertise. Recently the best advertisement has been these 2/28, 5/25 etc. loans in which you pay an introductory teaser rate, which is often 1-2% interst. These are the types of loans that are getting people into trouble. A normal ARM which is simply tied to the prime rate is no problem, you simply pay a slightly higher rate when the interst rate goes up slightly, but you break even when the rate goes back down. However, with these newer teaser ARMs the introductory rate isn't just a gift, they recoup the losses at the end of the loan period by raising the rates to a level EVEN HIGHER than what a normal ARM would adjust to. This is what is meant, by and large, by loans resetting. The banks simply will not continue to take a loss on the interest rate to "keep people in their homes".

Unfortunately these loans had the well known (in this foum anyway) of inflating home values beyond normal affordability in the median income range, as affordability became defind by the monthly payment at the teaser rate. The banks are suddendly going to become de facto homeowners when people can't make the payment at the new rates, and can't refi when the home is worth less than they owe on it.

I hope that helps, don't be afraid to post. Amid the flames someone will attempt to answer your question.

Submitted by SD Realtor on August 14, 2007 - 11:13am.

davidt welcome to the board. Have a thick skin and you will be okay.

Someone may have already mentioned this and I know we have had several posts on this as well.

For now, forget about who originated the loan. The entity servicing the loan is more important. Chances are like 99.999% that the original loan was sold. It was then bundled up and securitized and resold. The original terms of the loan are what makes it attractive to investors so that they get a return. The entity servicing the loan may not be able to change the terms of the loan such as the reset date, or the margin in the new rate. I am not knowledgeable enough to answer the question thoroughly. By altering the terms of the original loan, the entity servicing it may incur substantial liability to the entity that bought the security.

An earlier post in the thread brought up a good point that the possibility should be entertained. How would things be affected if there was a widespread rewriting or altering of the loans. It is hard for me to wrap my arms around how that can happen as there has been so much reselling, leveraging, and shuffling the decks of the tranches... It is worthy of discussion but I just don't see how it can happen. You see what I mean? The underlying mortgage for the homeowner is Lemon Grove who is about to get reset is all over the place now. Even Wall St may not know where the heck it is...

I think what you are seeing right now is interesting. Wall St is trying to inject money straight into the funds to prop them up. They are not changing the rate of return on them.

Once more, we had a poster awhile ago who worked in loss mitigation and he had some better insights into this.

SD Realtor

Submitted by davidt1 on August 14, 2007 - 11:54am.

Thanks so much. I appreciate your informative responses.

Submitted by SHILOH on August 14, 2007 - 12:26pm.

"Banks" will a lose $ if they don't up the interest rate.
They are not in the business of giving away money or giving a free service.

If the ARMs don't adjust up, then the lenders or in the case of the MBS (Mortgage Backed Securities) or (CDOs Collateralized Debt Obligations)....
Here are some numbers clipped from a story:
$800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations.

This is where the borrowed money originated. A lot of it was other foreign wealth poured into the US and lent out, diced up into securites and sold to investors, sometimes sold back to the foreigners. Maybe this was clever, a big transfer of wealth and debt...but I think it makes the US look worse, deceptive etc.

Money is lent to make money. If they keep the teaser rate or low interest rate, they don't make any money and US money is losing value plus inflation makes it worth about 3.5% less (around that) annually. Ie, if your boss gives you a "3.5%" raise and at the same time the cost of living goes up 3.5% then you aren't getting ahead.

Submitted by ucodegen on August 14, 2007 - 12:48pm.

@davidt1
RE:If banks don't adjust rates up no one would lose their house, banks wouldn't have to take losses on foreclosures, the housing market would be in better shape and the stock market would not slow down. This would be good for everyone, no?

Hopefully you have not been scared off of this page by some of the responses. Unfortunately you walked right into a community that deals with these things at a fairly complex level. Your question was kind of like: Why doesn't the stoplight turn green when I approach? It would be so much easier for me because I would not have to stop. type of question. I am going to get very basic here to try to explain. The bubble primer does not cover financing and how the banking industry works. I hope the fellow Piggitonians don't get too irritated here in my explanation. I am going to try to be simple. On a side note: davidt1's question only re-enforces what I have said about the state of financial education in the United States.

First, and the most important thing to realize; Money does not come out of thin air. Only the Fed has the ability to 'create' money. Banks can leverage money based upon assets on hand(deposits) by loaning that money out (and pays a percentage of the money back to the depositor as interest - ie CDs Certificate of Deposits).

The most simplistic form of mortgage financing is where it comes from a bank, and the bank holds the mortgage for the life of the loan. Because that money came from people's deposits at the bank, the bank will generally pay a interest rate into these peoples accounts for the use of the money. The bank effectively borrowed the money from your deposit to loan to someone for their mortgage. The mortgage holder then pays interest on the loan and you, as a depositor, get a cut of that interest because it was your money that was loaned out. What would happen if you had a choice between 2 CDs at different banks, one of them 3% and the other 5%. You chose the 5% because of better return. How would you feel if that 5% return suddenly became 2% on your CD because the person who was borrowing your money through the bank could not pay the interest rate?

The banks used to trade loan packages amongst themselves (peoples mortgages). This helped handle problems when people would close their CDs or transfer funds between banks. The fact that the trades were done within a small group also allowed the banks to keep the return rate on CDs artificially low (they would use your deposit in the form of a CD and pay you about 5%, while the mortgage that was funded by your money was paying 8%. The difference was profit for the bank (3%) on money they did not own). Around 1970 (I think I got the time period right), the ability to trade or pick up loan packages was allowed to the investing public. This closed the difference between what the bank would pay on a CD versis what it would earn on the mortgage (closed the spread). This process is known as securitization and produces such things as CDOs/MBS. It is also where the term tranche comes from.

Now we get to the whole interest rate deal and the Federal Reserve question. The Fed has 3 ways to influence the economy. Each of these ways has risks to the economy. The ways are:
1) increase money supply (print money). This is highly inflationary.
2) change the fractional reserve rate. This can put banks at risk of the fractional reserve rate is too low.
3) change the Federal reserve rate, ie. treasury interest rate. This is inflationary/deflationary depending upon whether it is an decrease or increase in interest rates respectively.

The Treasury Rate is also considered the Risk Free Rate of return. Risk Free because it is viewed that the US Treasury will not default on its debt. There is no risk of loss. If there is a risk of loss, you would expect to get a better rate of return to offset the risk of losing it all and getting nothing. If the Treasury Rate is 5% and a banks CD is 4%, you would be getting less than what could be had by a no risk investment in Treasuries (ignoring Treasury tax advantages). Therefore people with 4% CDs would want to cash those out and go for 5% Treasuries. This way, the Fed can push the return on CDs as well as the interest rate on Mortgages. Not mentioning the intra bank loan rates here. It adds even more complexity.

When it comes to ARMs, the bank is allowing the mortgage borrower the option of a lower rate, but with the risk of the rate going up should the Fed raise the Treasury rates. The bank has to anticipate what the Fed will do because very few CDs are 30year, but most mortgages are. They will need to make sure the return for their depositors is sufficient to keep deposits on hand to cover the mortgage. When a person cashes out their CD, the bank has to cover the withdraw from funds on hand/other deposits. Here comes the interesting part. You can see what the Banks think is going to happen to the interest rates by looking at the difference between 2/28 ARM interest rates and 30year Fixed interest rates for a high FICO score. The 30year fixed will be about 1% above what the Banks view as the average rate on Treasuries over a 30 year period (Note: This is an approximation)

Submitted by PerryChase on August 14, 2007 - 1:06pm.

A lender does not necessary need deposits to make loans. Money is created everyday by private entities -- stocks, debts, options, contracts, etc... Those are tradable and convertible into legal tender cash. As long as there's not a "run on the bank" we're fine. It's a psychological game of keeping up confidence in the system.

Submitted by ucodegen on August 14, 2007 - 1:33pm.

@Perry Chase
Money is created everyday by private entities -- stocks, debts, options, contracts, etc... Those are tradable and convertible into legal tender cash.

Not Correct. Money is in exchange for these items. They do not create money.
Stocks - partial ownership in company, on bankruptcy, 2nd/3rd succession on remains.
Options - ownership on a put/call that allows a person to sell or buy at a specific price. Allows time based arbitrage on a stock issue. The risk is that it will expire out of the money.
debt - you are exchanging your money which becomes the principal on the loan in exchange for a regular return and return on principal.

None of these 'create' money. The are all exchanges of form. You give up your money to get these, or if you originate these, you gain money in exchange for giving up specified rights or required payments. They are transformation in asset types. If the market was truly efficient, these transfers would result in exchanges of 0 net gain... but the market is not efficient in the short term.

Submitted by sdduuuude on August 14, 2007 - 1:45pm.

Because people would learn that making the wrong decision is OK and thus they would learn nothing.

Submitted by davidt1 on August 14, 2007 - 2:04pm.

I don't think I even know how to ask a question correctly. I know banks are not in business to help people, and I don't expect them to. What I am trying to ask is:

1. Currently when people can't make payments because their ARM resets, banks foreclose and try to sell at market value but no body is buying. Meanwhile, inventories keep piling up. Eventually, banks will have to sell at substantially lower prices.

2. Or they could work out some kind of deal with troubled home owners so they (banks) don't have to go through the trouble of foreclosing, losing the interest income and selling at a loss later.

What Would it be in the banks' best interest to do, 1 or 2?

Submitted by sdduuuude on August 14, 2007 - 2:21pm.

So, lets say I'm a bank and I loan 200K to some guy and his payment is $1000 for a while, then it jumps to $1500 and he defaults.

I'm thinking I want the guy out so I can sell now and get as much as I can for it. If I wait and things get worse, the guy may default anyway at $1000/mo. Then, not only do I have to go through the foreclosure process anyway, but I have have to sell the house for less than I could if I had foreclosed earlier.

Basically, a default to a bank means - this guy is bad news and I want out of the deal.

If it is an interest-only or neg-am loan, the principal isn't coming down at all anyway and I am 100% owner of a property that has declining value. Or, I am continuing to loan money to someone who has shown they can't pay it back.

Plus, if I could have $180K back to invest at the prevailing rate, and the prevailng rate is much higher than the rate the guy signed up for, even though he is paying on $200K, I may be better off investing less capital at a higher rate than taking the smaller payment.

i.e. if I can invest any gains from the sale of the house at 8%, I don't want the 4% teaser rate some guy paying me.

Also, when I said "they would learn nothing" - I meant the banks as well as the borrowers.

Submitted by ucodegen on August 14, 2007 - 2:26pm.

@davidt1
What Would it be in the banks' best interest to do, 1 or 2?

Depends on many things. The problem is that houses will not maintain their value, and that the person can not make close to the real interest payment. This goes into the more complicated area of discounting a notes value due to a change in underlying interest rates. If the house is currently worth more than the discounted rate of payments, it is better for the bank to foreclose. If the bank sees the house value dropping further (very likely) and the odds of the mortgage not remaining good at the reduce interest rate are poor, foreclosure is a better option to the bank.

Remember, many of these loans were NINJAs..
NINJA = No Income, No Job or Assets.

Submitted by 4plexowner on August 14, 2007 - 4:17pm.

So when the same person asks the same question a second time is it then OK to call them stupid?

Submitted by HereWeGo on August 14, 2007 - 4:29pm.

david-
That's a really good question. Loss mitigation will undoubtedly take some interesting twists and turns as this downturn unwinds.

Submitted by falcon_eyes on August 14, 2007 - 4:48pm.

I think davidt is a representation of majority US population who bought all these homes at the peak with the expectation that the bubble will continue forever.

While the smart dudes take advantage of this temporary bubble and cashing in quietly in the background.

Submitted by drunkle on August 14, 2007 - 4:56pm.

even if banks could chose to not reset arms, that wouldn't do anything to save anyone. the bank would either be reneging on its obligations to the debt owners or it would be buying back the debt and financing it on it's own. in the first case, the debt owners would scream bloody murder, sue the bank, drain its cash by dumping their holdings, destroy the bank's credit, etc. in the second case, the bank would have to have the cash to buy back far more obligations than it has in reserve. in effect, it would only be able to buy back as much debt as they have in cash. meaning only a small fraction of mortgages could be suspended.

now, if your mommy and daddy were the bank, then sure. they could give you more time, they could float you some, they could even forgive you of the whole thing. everything would be peachy and no one would freak out about anything. the percentage of people who have mommy and daddy supporting them, however, is very small. very very small. miniscule.

maybe that's why bush has no clue how to deal with the economy...

Submitted by edna_mode on August 14, 2007 - 6:09pm.

Ah, for scenario #2, you would have to assume the bank has the *authority* to renegotiate the loan! They may not own it anymore, despite still servicing (ie collecting payment) on the loan, because they repackaged it up like a bit of meat in a sausage and sold it as part of a mortgage-backed security (MBS). And picking out one tiny piece of meat to examine it more closely *after* it's been made into a sausage is pretty difficult, no?

If you were the sausage-buyer, you'd be pretty pissed off if it turned out that due to the rising cost of meat, they substituted in sawdust, right? You paid for all-beef sausage, you want it to perform like an all-beef sausage.

Same thing for the MBS buyer. People bought it at a certain price on the expectation of a certain quality of product, ie that all the mortgages in it would say, be paid off in 30 years at 5.5%. You'd be pissed off if after paying a premium now for a future cash stream, people could just change the terms after your money's gone, right? Just like biting into the sausage after the Del Mar Fair is over and finding what you can only hope is a green herb.

To complete the analogy, you are proposing trying to go back to the original butcher and complaining about the quality of his meat, which he had long ago sold off to the sausage maker. You may have a point, but the sausage maker was culpable for buying rotten meat. You can't pin the responsibility for fixing the situation clearly on one party anymore. You'd have to get the butcher, the sausage maker and whoever sold this "all beef patty" to you all in the same room to discuss how to make it all better. Similarly, the responsibility for fixing the loan is diffused across too many parties for it to try to re-negotiate, and it's not clear at this point who would have the authority to fix a contract that's been handled by so many people.

Submitted by HereWeGo on August 14, 2007 - 9:03pm.

You'd be pissed off if after paying a premium now for a future cash stream, people could just change the terms after your money's gone, right?

I'd be even more pissed off if the borrower just defaulted on the loan. I might be willing to negotiate if I could salvage a good portion of my premium that would otherwise be lost if the mortgager defaulted.

Submitted by PerryChase on August 15, 2007 - 10:49am.

now, if your mommy and daddy were the bank, then sure. they could give you more time, they could float you some, they could even forgive you of the whole thing. everything would be peachy and no one would freak out about anything. the percentage of people who have mommy and daddy supporting them, however, is very small. very very small. miniscule. maybe that's why bush has no clue how to deal with the economy...

That's a good one Drunkle.

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