In the Wake of the Sub-Prime  Meltdown: A Brave New World

Commercial real estate owners-and homeowners-are justifiably concerned about the condition of the mortgage industry. The myriad of news stories about the sub-prime mortgage debacle and the ensuing financial crisis beg the following questions: How did we get here? What's

Mortgage and Rate Primer

The mortgage and lending industries contain principal elements that often move in tandem with each other. Below is a glossary explaining some of the terms:     Discount Rate - The interest rate charged by the Federal Reserve for short-term loans to member banks. The Fed can raise or lower this rate.     Federal Funds Rate - The interest rate banks charge each other for the use of Federal Funds (funds deposited by commercial banks at Federal Reserve Banks). It changes daily and is a sensitive indicator of general interest rate trends. The Fed can also raise or lower this rate.     Prime Lending Rate - The lending rate banks charge creditworthy institutions. It is generally set by banks according to the Fed Funds Rate.     Treasury Bill Index - One of the common indices ARMs are tied to. A mortgage may link to Treasury maturity rates of 1, 2, 3, 5, 7, or 10 years.     Federal Cost of Funds Index - Another of the indices ARMs are tied to. The Federal Cost of Funds Index is calculated as the sum of the monthly average interest rates for marketable Treasury bills and marketable Treasury notes, divided by two, and rounded to three decimal places.     Certificates of Deposit Index - Another of the common indices ARMs are tied to. This index is the 12 month average of the monthly average yields of three-month certificates of deposit. (It is calculated by averaging the previous 12 rates of the 3 month CD rate.)     Eleventh District Cost of Funds Index - Another of the indices ARMs are tied to. The 11th District represents the savings institutions headquartered in Arizona, California and Nevada. The cost of funds reflects the interest paid for savings accounts, money borrowed from commercial banks, and other sources. The 11th District Cost of Funds index is used primarily for ARMs with monthly interest rate adjustments.     London Interbank Offer Rate or LIBOR Index - One of the other common indices ARMs are tied to. While some LIBOR rates link to the value set by the British Bankers Association (BBA), most are tied to a monthly LIBOR released by Fannie Mae. The Fannie Mae LIBOR uses the same sources as the BBA but is ultimately calculated differently. If your ARM links to the LIBOR, find out which of these values the mortgage links to.

ahead for the mortgage market? Is there a light at the end of the tunnel? And what are my options as a mortgage holder or seeker?

Current Environment: How Did We Get Here?

In the early 2000s, in the midst of a housing boom, lenders felt more confident about providing mortgages to customers whose poor credit histories prevented them from buying homes in the past. These sub-prime mortgages required little documentation-so borrowers offered scant verification that they could repay the loans. Sub-prime mortgages were then packaged and sold to secondary and tertiary markets-as mortgage-backed securities, asset backed securities, collateralized debt obligations and collateralized mortgage obligation investment instruments.

When mortgage holders began to default on their loans, not only was a credit crunch created among lenders, investors also began to sell off securities purchased in the secondary and tertiary markets. This negatively impacted mortgage lenders even further. And the increasing instability of the mortgage industry has led to continuing uncertainty and periodic panics in the financial markets creating a vicious circle that has become a full blown financial crisis.

Is There Light at the End of the Tunnel?

On August 17th, the Federal Reserve Board dropped the discount rate on short-term loans and also extended the repayment period to ease pressures in the banking and lending system. The Fed may further lower the discount rate in the future to continue providing liquidity relief and may also lower the funds rate at the September 18th Federal Open Market Committee meeting or before. That would trigger potentially lower interest rates for a variety of borrowers. When the Fed lowers the fed funds rate, banks tend to lower the prime-lending rate thus easing credit in the mortgage industry.

The ultimate solution is that mortgage lenders will have to move toward quality. Similar to venture capital funds that overextended themselves by investing in unviable Internet businesses in the late 1990s, the mortgage industry will have to restructure and focus on value. There has been irrational exuberance in the mortgage market and the bubble has burst but the industry will rebuild in time and be stronger and more reliable.

What's Ahead for the Mortgage Market?

Until that restructuring happens in the industry, however, things will get worse before they get better. This is due to the fact that over the next year or so, millions of Adjustable Rate Mortgages (ARMs) will reset from initially low teaser payments to higher rates. People with equity in their real estate may have the option of refinancing to an ARM with different terms or a fixed rate mortgage. However, real estate owners with negative equity in their property have dramatically fewer options.

This is particularly true for ARM holders who purchased their properties in the last couple of years. These owners may find themselves between a rock and a hard place when it comes to the quandary of negative equity. Property equity is determined by the current market value of the real estate (established through appraisal) less what is owed on the existing mortgage.

Most real estate owners have lost equity due to the slump in the housing market. And those who signed ARM contracts in the past couple of years have paid little of the existing mortgage due to initially low payments. This double whammy, so to speak, compounds their negative equity problems.

Now that the mortgage industry has become more risk averse, the higher the negative equity on a property, the more difficult the challenge of refinancing becomes. Borrowers who can't meet the higher ARM reset payments and those that can't refinance may face foreclosure.

Differences Between Fixed and Adjustable Rate Loans

What are ARMs and why are they contributing to the mortgage meltdown? ARMs were introduced into the mortgage market in the 1970s. They have become rampant over the past several years and are one of the foundational tools upon which the sub-prime mortgage market was built. Here are the crucial differences between ARMs and more traditional fixed rate mortgages:

• ARM payments tend to be initially fixed and low then usually increase or decrease periodically based upon shifts in interest rates. With a 3-year ARM, for example, the payment is fixed for three years and then reset to a fluctuating rate. After the adjustment period, some ARMs shift as often as every month, although some adjust only once every year.
• Adjustment rates on ARMs are tied to an underlying index or benchmark. Common indices that ARMs link to include: Treasury Bills, Certificates of Deposit, Eleventh District Cost of Funds, Federal Cost of Funds and the LIBOR. In addition to the index rate, many ARM contracts have a margin stipulation. The margin requires the holder of the mortgage to pay a rate that is a specified percentage higher than the adjustment index. An ARM tied to the LIBOR, for example, may have payments of LIBOR + 1 percent where the LIBOR is the adjustment index and the 1 percent is the margin.
• Fixed Rate Mortgages, in contrast, are predictable in nature. Payments are linked to the interest rate at the time of the contract and are unaffected by economic shifts. Fixed rate mortgages are paid off in varying time periods, commonly 15, 20 and 30 years.

Tips for Mortgage Holders and Seekers What are your options in the current environment? Here are three ideas to consider: 1. If you have an ARM, think about switching to a fixed rate mortgage in these uncertain times. Get an appraisal of your home to determine the equity value as a first step. 2. Weigh the pros and cons of investing in a high-price property under present conditions. Although it is a buyer's market in terms of value, a jumbo mortgage is required for any amount above $417,000 and, in the current environment, interest rates on jumbo loans are volatile and escalating. 3. Examine your current mortgage contract and future loan agreements carefully. If you have an ARM or are considering one, know the underlying index your rate is tied to, when the mortgage will reset or shift to adjustable payments and what the margin is. Also, be aware that many loans contain a "due on sale" clause, which enables the lender to demand full payment if the borrower sells the mortgaged property.

(In a future article, we'll explain the possible tax implications of declining home prices)