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Monday, August 08, 2005 4:42 PM

Unlock Shock and Libor Creep

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I received the following question from a poster on the Motley Fool.
Mish, why do you think a few more hikes will "break" housing? I mean, I think housing will break for a plethora of reasons, but so far these hikes have only affected the ARM rate trend and have had little or no effect on 30 year fixed mortgage rates. What seems to be the result of the divergent trends of the 30 year rates and the ARM rates is that houses are sitting longer on the market, but not selling significantly lower. If 10 rate hikes have had so little effect on the 30 year rates, why should a few more matter?

Smufty, housing will break regardless of what the FED does at this point. The global economy is slowing and housing is in decline big time in places like Australia and the UK. It would eventually die of exhaustion here as well, regardless of what rates were set at.

As for why a "few more matters" is because there are a lot of people out there that got a 1 or 2 yr adjustable rate ARMs and those are about to reset big time. Adjustable rate mortgages have been averaging well over 30% and in some places like California “creative alternatives” have averaged over 50% of the loan totals. Some of the people that got in near the absolute lows in interest rates might go from 3% to 5% overnight. I think the range might be something like a 33-65% overnight increase in interest payments. That will be one hell of an "Unlock Shock".

Others on interest only libor based loans are slowly getting whacked to death. For 350K borrowed on an interest only libor product, I estimate payments to have gone up from about 1000 a month to 1600 a month and two more hikes are likely coming. Someone who stretched on one of those loans to make the monthly payment "affordable" is now finding it increasingly "not affordable". Let's call this affect "Libor Creep".

Every passing month there are more and more people whose initial lock period is about to come into "Unlock Shock" and there are more and more people slowly getting whacked by "Libor Creep". When Greenspan raises the FED Fund rate tomorrow, the latter group will immediately see another 25 bps hike.

What I do not know is how many people had 1-yr ARMs vs 2-yr ARMs vs 3-Yr ARMS etc and what the initial rates were. What we do know for sure is that anyone who got loans near the bottom in rates or got a "teaser rate" good for one or two years might be in for a rude awakening on that first adjustment. Those that were not 100% prepared for hikes are going to come under huge pressures. Heaven help those that have to sell but can't because home prices have dropped in the meantime.

Here is a final thought. Even for those that were prepared for it, that jump in interest payments is going to take away from discretionary spending or savings. "Unlock Shock" and "Libor Creep" are increasingly likely to have a noticeable affect on the economy but I do not know how to measure it.

Mike Shedlock / Mish

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