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A House of Pain

The curious thing about a bubble is, when it bursts, you can't believe people actually behaved the way they did. (Remember, in the late 1990s, backing up the truck and buying the QQQQ for clients? Nah, not you.) Consider what a sweet temptation the residential real-estate market became: From 1995 through 2004, the money spot of the crazy bull market in residential real estate, the average real price

THE CURIOUS THING ABOUT A BUBBLE is, when it bursts, you can't believe people actually behaved the way they did. (Remember, in the late 1990s, backing up the truck and buying the QQQQ for clients? Nah, not you.) Consider what a sweet temptation the residential real-estate market became: From 1995 through 2004, the money spot of the crazy bull market in residential real estate, the average real price of a home jumped by 40 percent, according to Federal Reserve Bank of New York. Indeed, the drum beat of continually rising housing prices, particularly in New York and other cities on the coasts, got so heated that otherwise prudent people (and lenders) began to view residential real estate as a “sure-thing investment.” In other words, the masses began to speculate — and lenders were happy to help.

And like speculators in the stock market, many buyers would do anything — risk be damned — to get their piece of the pie. To carve off that slice, property buyers would avail themselves of so-called “toxic” mortgages, the various adjustable-rate mortgages that allowed homebuyers to overstretch by paying a low-teaser interest rate for a year or two before the loan would reset at market rates. The politicians can talk all they want about “predatory” lending, but one banker at one of the nation's largest banks said it was more like “irrational-borrower behavior.” He says, “You are borrowing hundreds of thousands of dollars, and you don't know that an ARM is going to change? C'mon.”

The math on home buying is simple: Don't spend more than half of your gross pay on a mortgage. Yet, either too many people didn't do the math, didn't care, or reckoned they'd find some money between now and when the loan was to be reset. Like many financial advisors around the country, Mark, a certified financial planner in New Jersey who wished to remain anonymous, had first-hand experiences with clients who happily piled on potentially catastrophic risk. In 2004, Mark had a client who was willing to risk her nest egg so that her son could buy a house. Because her son couldn't scrape together the money, she pledged her $1 million stock and bond portfolio as collateral in securing a loan for her son with a large brokerage firm based in Manhattan. At the time, margin interest was cheap, the stock market was healthy, home prices were rising and everything looked great. The transaction, under those conditions, seemed like a clever bit of financial engineering. Her son would get his dream house, made possible by the historically low-teaser rates of an adjustable-rate loan; she could have the pleasure of helping him and enjoy a tax-deductible loan; and the broker would collect a slice of the margin interest, and various other fees involved in the transaction.

As a CFP, Mark advised against the transaction, pointing out that her son was stretching to buy the house in the first place, and for him to continue to make monthly mortgage payments, the interest-rate environment would have to continue to stay at historically low levels. Worse, Mark feared, if mortgage rates rose — which, at the time, most were expecting — her margin interest costs would rise, and the son might have trouble covering his monthly nut, to say nothing of ever paying her back.

Guess what? His mortgage shot up when the teaser rate expired, the housing market cooled, and the house couldn't be sold for what he bought it at. (Also, interest on margin debt doubled, so her borrowing costs were suddenly less attractive.) Luckily, stocks hadn't yet taken a dive. Otherwise she was facing taking a giant hit to her net worth. As it was, though, the transaction was costing her big time, as the son was having trouble meeting his mortgage every month. She would either have to give him more money, or he would shortly be forced to sell. How was the situation resolved? “By the death put,” Mark says. “She died a year or so ago [just as the plan was starting to unravel], and the kid inherited her estate.” An unfortunate solution to a vexing problem.

As a financial advisor, one of the toughest tasks is having to manage down clients' rosy expectations. Too often, you have to play the skeptic, the sourpuss — the one who has to point out that the party will likely end, and the best-case scenario will one day give way to the worst-case scenario. Yet Mark says the risks of “creative” mortgages aren't always properly presented to clients. In the roaring real-estate boom of the 2000s, “These loans were routinely positioned as not risky,” Mark says.

Indeed, nearly 25 percent of all mortgages — about 10 million — feature adjustable rates. About 1 million of the 7 million or so borrowers who took out adjustable-rate mortgages (ARMs) over the past 2 years are considered high-default risk, and the owners could lose their homes. By some estimates, the cost to the banking industry could exceed $100 billion. Making matters worse, most ARM loans were made in the hottest markets in the country, many of which have since cooled; for instance, in California last year, more than half of all loans were interest-only or payment-option ARMs.

If you haven't done so already, it's time to completely reevaluate your clients' risk profile for real estate. And it's time to question the basic underlying assumptions about residential real state, which had, until recently, enjoyed a “can't miss” status as an investment. It goes without saying that you have to force any real-estate-happy clients to understand the basics of mortgages, “creative financing”, and the possible impacts on their cash flow.


There are many good reasons to make use of adjustable mortgages (buyer plans to stay only for a year or two). And there are good reasons for using a securities margin account as a kind of bridge loan for a down payment (to avoid tax liabilities, say, or the buyer isn't selling the old house yet).

But to buy “more house” is probably not a good reason to get creative. That's easy to say now. About 2 million adjustable-rate mortgages are scheduled to be reset to higher rates in 2007 and 2008. About $400 billion in loans are expected to be reset higher from July 2007 through 2008, estimates Deutsche Bank. And that will be painful for many. As it is, about 15 percent of all sub-prime ARMs are 90 days past due, the Fed says, while just 1 percent of prime mortgages are seriously delinquent.

Tom Spalla, a mortgage professional with Automated Lending in Denver, began seeing the trend in the spring of last year, when concerned financial advisors began sending him clients to refinance ARMs. Those loans were rising by “25 percent or more during the first adjustment period, with more upward adjustments in the near future,” he says. “One of my registered rep referral partners is recommending that his clients bite the bullet and refinance their adjustable-rate mortgages into fixed-rate mortgages if they plan to stay in their homes more than a few years.”

In some cases, says a banker with Wells Fargo in New York, payments on 2004, 2005 and 2006 loans are tripling from the introductory rate. “You're seeing cases where the teaser rate was 2 percent, but is being reset at 6 percent and higher. A perfect storm is developing,” he says.

These days, depending upon where you live, refinancing may not even be an option, the mortgage broker says. “If you own a condo in a high rise in Miami, no banker will refinance because no one knows what the condo is worth.”


The banker also says that the days of 100 percent financing are history. These people are taking a risk (one that has paid off handsomely in many parts of the country) that their property will (continue to) rise in value. In fact, they are counting on this rise since they will need some cash at time of sale (about 7 percent of the selling price) to cover commissions and other costs. They may also be anticipating this rise in value to provide them with tax-free cash at time of sale.

A Merrill Lynch rep who recently moved from Northern Virginia to Jacksonville, Fla., is very concerned about the impact of ARM adjustments on her retiree clients. She said, “I strongly discourage clients on fixed incomes from considering adjustable-rate mortgages. I can't see the adjustments being anything but upward for the foreseeable future.” She also doesn't consider ARMs a good idea for dual-income families. “I am very concerned that if one person loses a job, the family will also lose the house. The same concern is there if the payment rises, and they maxed out to get the house in the first place.”

Remember that the mortgage industry is largely unregulated. If your client deals with a bank, savings and loan, or credit union rather than an independent mortgage broker, he may be in better hands — that is, the lender may be more careful in giving a loan he can actually pay back. Independent mortgage loan originators are experts at creative financing, catering to the wishes of people who want to buy far more house than they can really afford. As financial advisors, you might try to be like Mark, and help clients avoid financial plans built on unrealistic dreams.


Residential real estate doesn't always go up. According to research by Yale economist Robert Shiller, median residential real-estate prices, adjusted for inflation, increased by just 2 percent a year from 1940 to 2000. The recent years have been anything but normal.

Housing Price Increases/Decreases in Real Terms, 1980-2004
1980-1982 (7.2) percent
1982-1989 16.2 percent
1989-1995 (8) percent
1995-2004 40 percent
Actual relative increases/decreases vary by geographic market.
Source: Federal Reserve Bank of New York, Staff Report 218, September 2005.


Got clients still interested in adjustable-rate mortgages? Show them this. In a rising interest-rate environment, mortgage costs can escalate — in this case by $1,000, or almost 73 percent — in just two-and-a-half years. While conventional 15- to 30-year mortgages are tied to long-term interest rates, ARMs are tied to much shorter-term indexes.

How Payments Can Rise with ARMs For a $250,000 Mortgage-Five Year ARM
Interest Rate Payment (Principal and Interest) (Estimated)
Initial Interest Rate 5% $1,380
Possible rate year 5 6% $1,500
Possible rate year 5 + 6 months 7% $1,663
Possible rate year 6 8% $1,835
Possible rate year 6 + six months 9% $2,000
Possible rate year 7 10% $2,185
Possible rate year 7 + six months 11% $2,380
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