Hedge funds have been particularly active in the ARM mortgage trade, buying risky loans directly from banks and cutting out the middle men.
These hedge funds are willing to buy risky loans, as they can set their own terms that help insulate them from losses. And the banks make up the difference by taking more from the buyers, many of whom qualify for lower rates based on their credit histories.
Some $182 billion of the option ARMs written in 2004 and 2005 and an additional $83 billion this year have been sold to investors as mortgage-backed securities, says Bear, Stearns & Co.
To get the deals done, banks have turned increasingly to unregulated mortgage brokers such as hedge funds, who now account for 80% of all mortgage originations, double what it was 10 years ago,
Research forecasts total defaults of $300 billion across all types of loans, not just option ARMs, over the next five years, with lenders losing only $100 billion. Leaving the majority of the losses on the homeowners heads, as the less a borrower chooses to pay now, the more is tacked onto the balance, with steep penalties to prevent them from refinancing.
The ARM is an adjustable rate mortgage whose interest rate can go up or down. At first glance, an ARM looks like a good deal next to a fixed rate, as the average ARM rate nationwide is usually less than the average fixed-rate.
With an ARM the payments are lower for the first three or four years, and will stay low, provided interest rates in general don’t increase. If they do, the lender typically will adjust the ARM rate upward by a maximum of 2 percentage points a year, and a max of 6 percent over the entire loan period.
Stock and bond analysts estimate that as many as 1.3 million borrowers took out as much as $389 billion in option ARMs in 2004 and 2005. And it’s not letting up. Despite the housing slump, option ARMs totaling $77.2 billion were written in the second quarter of this year. So after prolonging the boom, these exotic mortgages could worsen the bust.
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