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Special section Mortgage reset

Adjustable mortgages with low introductory rates were the rage, but now the teaser rates are running out.

What is a reset?

Formula for foreclosure: resets, no equity

More than 1.1 million homeowners will lose their homes to foreclosures by 2014 because they can't afford the rising payments on their adjustable-rate mortgages, a researcher reports.

Whether you think that's a big deal depends on your perspective.

"This is not going to break the economy. It's better understood as a part of the business cycle," says Chris Cagan, the mathematician who wrote the foreclosures forecast. That's the big-picture, or macroeconomic, view.

The up-close, or microeconomic, perspective is more ominous: "The trouble is that it doesn't affect everybody equally," Cagan says. "Its impact will tend to fall on the subset of borrowers, lenders and investors who are most exposed."

$100 billion in foreclosures?
In other words, the biggest losers will be homeowners who lose their houses and lenders and investors who fronted them the money. Cagan, a researcher for First American CoreLogic, says the net losses from these foreclosures will total about $100 billion over the next six or seven years. Depending on whether house prices go up or down in the meantime, the financial impact could be lighter or heavier than that, he says.

Cagan says the problem stems from "the double whammy of reset and no equity." There's a lot of meaning stuffed into that sentence.

Let's unpack it:

  • Reset refers to the rising rate on an adjustable-rate mortgage, or ARM. In most cases, the introductory rate on an ARM can rise a maximum of 6 percentage points. That means someone who gets an ARM with a starting rate of 6 percent could end up with a rate of 12 percent someday.
  • No equity refers to the squeeze borrowers find themselves in when they owe more than the house is worth (being "upside down" on the house). Cagan expects this to happen to millions of homeowners. When they owe more than the house is worth, but can no longer afford the payments after ARM reset, they won't be able to refinance. The most likely outcome is foreclosures.
  • When Cagan makes his prediction of 1.1 million foreclosures over the next six or seven years, he's talking only about people caught in the vise between rising ARM rates and declining home equity. These reset-related foreclosures will be in addition to millions of foreclosures resulting from the usual reasons: job loss, divorce, death, illness and fraud.

Home values dropping
People become upside down on their houses in two ways: The house loses value, or the loan balance rises, or both.

Property values in 20 markets
Property values are falling overall in the United States, but the change is anything but evenly spread.
This interactive map shows changes in house prices in 20 large markets in 2006-2007, and in recent months.
Click to enlarge.

Houses are losing value in some markets. The S&P/Case-Shiller home price index reports that the average house in Detroit lost a whopping 11 percent of its value in the 12 months ending in June. Over the same period, houses lost 3.6 percent of their value in Cleveland, 7 percent in the District of Columbia, 3.7 percent in Boston, and also dropped in Denver, Las Vegas, Los Angeles, Minneapolis, New York, Phoenix, San Diego, San Francisco and Tampa, Fla. In the nation's 20 biggest metro areas, house values fell an average of 2.2 percent.

-- Updated: Oct.1, 2007
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