Mortgage resets: Record bill coming due

NEW YORK (CNNMoney.com) -- More than two million subprime adjustable rate mortgages (ARMs) are poised to reset at much higher rates in coming months, worsening an already suffering housing market.

Borrowers who took out hybrid ARMs in 2004 and 2005 to secure low "teaser" rates for the first two or three years of the loan may see their monthly mortgage payments climb by 35 percent or more.

Consumer groups and politicians worry that hundreds of thousands of subprime ARM borrowers will be unable to keep up with their mortgage payments and will lose their homes.

"In October alone more than $50 billion in ARMs will reset," according to Mark Zandi, chief economist and co-founder of Moody's Economy.com. That's a record, according to Zandi.

A buyer in 2005 with poor credit and limited means might have signed on for a $200,000 2/28 hybrid ARM, locking in a fixed rate of 4 percent for two years. After paying $955 a month, the bill would now be set to spike to $1,331, a 39 percent increase.

Until recently, rising home prices bailed out many ARM borrowers in trouble. They could raise cash with cash-out refinancings or home equity lines of credit. If worse came to worse, they could sell the house and get some money back.

But prices have stabilized or slipped in many markets. (Latest home prices.)

As a result, Doug Duncan, chief economist for the Mortgage Bankers Association (MBA), is expecting as many as 600,000 home owners will get into trouble with perhaps half of them actually losing their homes.

One of the reasons for the worsening situation, according to Zandi, is that just as the number of subprime ARMs being underwritten was reaching a high, the quality of loans was hitting new lows.

"There were increasingly poor quality loans made starting in the spring of 2005," he said, "with the poorest of all made during the fall of 2006."

Lenders approved many borrowers who had little chance of being able to afford the payments two and three years out. They approved applications without any proof of income or assets ("liar loans") and others that barely could make the low teaser-rate payments. Some borrowers chose interest-only ARMs, which left the principal of the loan untouched. Regulators are urging tighter standards.

"Lenders wanted to keep the pipeline flowing," said Zandi, "and were hopeful that prices would grow again."

The hardest hit areas will fall into two categories, according to Duncan. The regions battered by basic economic storms - think Detroit, Cleveland, St. Louis and other old industrial centers - and high-growth areas where home markets went crazy earlier in the 2000s and where home prices are now falling

Subprime ARM lending was most common in some of those once red-hot areas. According to Zandi, three quarters of all those loans were made in the California, Nevada, Arizona, Florida and Massachusetts markets.

"Prices there are falling quickly, particularly in Florida and Las Vegas," he said. (Florida foreclosures are set to spike.)

There will be more downward pressure on prices as delinquencies, foreclosures and short sales add inventory to markets.

Another factor is that regulators and lenders are attempting to tighten loan underwriting standards, meaning fewer credit-damaged applicants will get approved, lowering demand for homes.

The tightening mortgage-loan standards could also result in short-term foreclosure spikes. Home owners with resetting ARMs, for example, may not qualify for refinancing under the stricter oversight. That could lock borrowers into unaffordable loans and they could lose their homes.

Another increase in supply, according to Josh Rosner, managing director at financial research firm Graham Fisher & Co, will be from investment properties coming back on the market. There was a precipitous burst of buying homes for investment purposes earlier in the decade. In 2005, about 40 percent of all purchases were of second homes and the majority of these were for investment purposes.

As returns on these investment properties decline, owners will bail out, increasing the listing backlog and depressing prices further. The effect of a foreclosure rise and home price slide on the nation's economy may be hard to predict but it will have an impact.