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Option-ARMs: File under, "It sounded good at the time."
These exotic mortgages allowed homebuyers to come to closing with little cash and choose, monthly, how much to pay: interest and principal, interest only, or a minimum amount less than the interest due.
Of course, the last option is the one 93% of option-ARM buyers selected, according to a new report released this week by Standard & Poors.
But eventually, everyone has to pay the piper.
Nearly all of the 350,000 option-ARM borrowers owe more than when they first bought their homes thanks to the unpaid interest accumulating. And many loans written during the first big wave, which started in 2004, are getting ready for their five-year reset, when they become standard amortizing loans. Additionally, some newer loans will reset early if the accumulated interest has pushed the loan-to-value ratio above 110% to 125%.
That means borrowers are about to start paying very hefty prices for their homes. In one scenario outlined in the S&P report, the payment on a $400,000 mortgage jumps from $1,287 to $2,593.
25% default rate
But that doesn't just spell bad news for borrowers. Some industry pessimists say the looming default problem could have the power to derail the nascent housing market recovery. "The crux of the matter is that as soon as these mortgages recast, the history is that they will default," said Brian Grow, one of the S&P report's coauthors.
And the newer the loans, the worse they will perform, the report said. The last year that any option-ARMs were issued was 2007. In the first 20 months after issuance, this vintage of option-ARMs had an average default rate of just over 22%.
That includes all option-ARMs issued in 2007. But if you calculate default rates for only 2007 option-ARM borrowers who are now underwater, the default rate jumps to 25% after just 20 months, according to S&P.
So, while there may not be an awful lot of these loans out there, their high default rates will have an outsized influence on housing markets, adding to already bloated foreclosure inventories and driving prices down further.
Bubble markets
And the markets where they'll produce the most foreclosures are still among the most vulnerable in the nation.
Option ARMs were most popular in bubble markets -- California, Nevada, Florida and Arizona -- where double digit home annual price increases put the cost of buying a home out of reach.
In fact, 60% of these loans went to residents of California and other Western states, places where prices have fallen the most, according to report coauthor Diane Westerback. "The geography is negative for these products," she said.
Many borrowers in these places could only afford a home if they chose the option ARM. Many counted on continued hot market conditions to add value to their homes. The extra equity could then be tapped to pay their bills.
We all know how that worked out.
Home prices in many of the markets where option ARMs are most concentrated have fallen 30%, 40% or more. When the loans recast, most borrowers will find themselves severely underwater.
"Because borrowers of [options ARMs] are in a much worse position," said Westerback. "You'll see defaults rising very rapidly."
And most option ARM borrowers will not be good candidates for refinancing or mortgage modifications because their loan-to-value ratios will be far too high. Under the administration's Making Home Affordable program, for example, mortgages with balances that exceed 125% of the home's value are not eligible for help.
Not so white lies
There is another little problem that many option-ARM borrowers seeking refinancing would face: "Upwards of 80% of were stated-income loans," said Westerback.
These are the so-called "liar loans" in which lenders did not verify that borrowers earned as much money as they said they did. Lenders may not be able to modify mortgages because many of the borrowers' income could not stand up to the scrutiny. Borrowers may also not want to go through underwriting again because they could be held legally liable for deliberate inaccuracies on their original applications.
Add to those conditions the still fragile economy and high unemployment rates, and you have a recipe for disaster.
The health care bill that passed a crucial test vote in the Senate on Saturday is proof that getting reform passed and getting it right are two very different things.
Both are hard. But the pursuit of votes has weakened key elements with the most promise of reducing overall health spending.
Exhibit A: The eleventh-hour introduction of a Medicare tax hike as a way to help pay for reform.
Health care reform, to succeed, must not only help more people get coverage but also slow the growth in health costs and spending.
The latest balancing act has been led by Senate Majority Leader Harry Reid, D-Nev.
Reid crafted a Senate bill that blends elements from bills passed by two Senate committees and adds some new measures. The hybrid bill must garner support not only in the Senate, but also in the House, which passed a different version earlier this month.
To that end, Reid included an increase in the Medicare tax on high-income workers to help pay for the cost of reform. Under the bill, individuals making more than $200,000 ($250,000 for joint filers) would pay a 1.95% Medicare tax on their wages, up from the current 1.45%.
The tax certainly would raise revenue. The Congressional Budget Office estimates $54 billion over 10 years. But experts say it would not curtail spending as the tax proposal approved in October by the Senate Finance Committee.
The problem is the Senate Finance proposal, known as the Cadillac tax, has drawn political opposition.
Under the Senate Finance bill, a 40% excise tax would be imposed on insurers that offer benefits in employer health plans for which the cost of individual coverage exceeds $8,000 and the cost of family coverage exceeds $21,000.
Opponents say the excise tax would effectively get passed down to workers.
But supporters say it holds the promise of reducing the growth in health spending over time. Why? As more and more plans become subject to the tax, employers will instead opt for lower-cost options to avoid the tax.
A hike in the Medicare tax, on the other hand, holds no such promise, experts said.
"A higher Medicare payroll tax rate for upper-income people would provide no incentive at all to reduce costs or spending on health care," said Stuart Butler, vice president of economic policy at the conservative Heritage Foundation.
Nor for that matter would a surtax on the wealthy - which is a major revenue raiser in the House-passed reform bill.
Reid didn't get rid of the Cadillac tax altogether. But he raised the thresholds that determine whether a plan is subject to the tax to $8,500 for individual coverage and $23,000 for family coverage. That means the tax would not reduce health spending as quickly because fewer employers would be subject to it initially.
"It sort of just delays things a little bit," said Paul Fronstin, director of the health research program of the Employee Benefit Research Institute.
Excise tax a shadow of original proposal
Of course, as with most elements of the health reform effort, there's plenty of uncertainty about how well the excise tax would work in reducing health spending over time.
0:00 /3:59A new and improved Medicare
But what is certain is that the excise tax is a far weaker version of what health policy experts and some lawmakers originally proposed: To eliminate or at least limit the tax-free nature of the health care subsidies that workers get from their companies.
Currently, the portion of premiums paid by employers is treated as tax-free compensation, and there is no limit on how much employers may contribute.
A cap would mean workers might have to pay income tax on some portion of their employer's contribution to their health care.
And when that happens, the thinking goes, workers would instead choose lower-cost plans to escape the added tax.
That idea never took flight for the same reason that the excise tax isn't winning popularity contests: Workers would pay.
Hence its more contorted cousin: the excise tax on high-cost health plans.
And even the excise tax was watered down before it hit Reid's desk. Critics complained the original thresholds were too low, and thereby would catch too many plans. So the thresholds were raised before the Finance Committee voted through its health reform bill.
Of course, the reshuffling and tweaking of proposals to pay for reform is far from over. The bill still needs to move through the Senate and then, if it passes, into conference with the House.
But it's a fair bet that the end result will be a hodgepodge of pay-fors designed more to secure votes and keep the bill deficit neutral than to reduce spending.
"Finding the revenue to pay for health reform was always going to be a huge challenge," wrote tax expert Howard Gleckman, editor of the TaxVox blog. "It still is, but we are beginning to see the outlines of a deal - a little income tax surcharge here, a dollop of insurance premium excise tax there, and more than a few cats and dogs."
Stocks fell in late trading Thursday, halting a six-day rally as investors questioned the runup in the face of an unclear recovery.
The Dow Jones industrial average (INDU) fell 56 points, or 0.5%, with about 1-1/2 hours left in the session.
The S&P 500 (SPX) slipped 7 points, or 0.6%, and the Nasdaq composite (COMP) dropped 10 points, or 0.5%.
The blue-chip Dow hit its third consecutive 13-month high Wednesday, but with little in the way of economic news to sway markets, gains were modest. On Thursday stocks opened lower before reversing course several times.
Mark Luschini, chief investment strategist for Jamey Montgomery Scott, said the pause was unsurprising given the consecutive gains in stocks so far this month.
Dave Shepherd, president of Retirement Financial Services, agreed, saying that underlying weakness in the labor and housing markets are leaving consumers cash-strapped.
"For this rally to be sustainable, the consumer has to bounce back," Shepherd said. "The market is acting so contrary to some of the data."
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The recent runup is a "relief rally, because we realize the economy isn't going to collapse," Shepherd said, and the market seems to be questioning whether the increases are based on true fundamentals.
The Dow has ended higher for the past six sessions. During that streak, the Dow has soared more than 500 points, or 5.3%, to a series of 13-month highs.
"We've had this unprecedented rally off the lows we saw in March, so a pause today [is] normal," Shepherd said. "I would tend to think a correction will come soon, but there's been so much momentum."
Shepherd said the rapid rise is cause for concern, as stocks took three years to come off a similar fall seen in 2002.
"There's a lot of money floating around, we haven't had the data to back it up," Shepherd said. "Either the data have to get better or stocks are going to retreat as the market worries it got ahead of itself."
Currencies in focus. The dollar was slightly higher against major international currencies late Thursday, and overnight gains in the greenback triggered some selloff in foreign markets -- spilling over into U.S. stocks, said D.A. Davidson & Co. analyst Fred Dickson.
"It wasn't a tidal wave of selling," Dickson said. "But with the stock market and the dollar so closely tied lately, it did have an effect."
A softer dollar encourages investors to move into higher-yielding assets like stocks; a firmer greenback tends to send the stock market lower.
With the Federal Reserve holding the key interest rate near zero and pumping money into the economy, the dollar has hovered near 15-month lows, Dickson noted. Stocks may have been more susceptible to the dollar's small rise Thursday because of the relative lull in economic news this week and the recent rally that occurred despite fragile signs of recovery, he said.
Companies: Wal-Mart (WMT, Fortune 500) announced on Thursday that it beat third-quarter earnings estimates.
The world's biggest retailer said earnings were 84 cents per share on sales of $98.7 billion. Analysts surveyed by Thomson Reuters expected 81 cents per share.
Intel (INTC, Fortune 500) and Advanced Micro Devices (AMD, Fortune 500) announced an agreement to end all legal arguments between the companies, including antitrust litigation and patent disputes. Among other provisions, the agreement stipulates that Intel will pay AMD $1.25 billion and AMD will drop all pending litigation worldwide.
HP (HPQ, Fortune 500) said late Wednesday that it was buying networking company 3Com (COMS) for $2.7 billion.
Economy: The Labor Department released its weekly report on initial jobless claims, which said there were 502,000 new filers last week. That's the lowest level since Jan. 3. Economists were expecting 510,000 claims.
The Treasury Department said the federal deficit hit $176.4 billion in October -- the 13th monthly deficit in a row and the first one of the fiscal year.
President Obama said Thursday he will hold a jobs forum at the White House in December, as the country faces a 10.2% unemployment rate.
Other markets: Stocks in Japan and Hong Kong finished the session lower. Major European indexes ended mixed.
Oil prices dropped 3% after a report from the Energy Information Administration showed crude supplies jumped more than expected.
Gold prices slipped, halting a runup that has driven the metal almost 6% higher this month. December gold fell $8 to settle at to $1,106.60 an ounce.
Stroller maker Maclaren announced a recall on Monday that affects about 1 million umbrella strollers that can reportedly amputate or lacerate children's fingertips.
So far, the company said there have been 12 amputations across the country. This happens when children get their fingers stuck in between the stroller's side hinges while it is being opened or closed.
The South Norwalk, Conn.-based company announced the voluntary recall in cooperation with the U.S. Consumer Product Safety Commission and advises customers to stop using the products manufactured in China sold since 1999 at stores including Babies R Us and Target.
Consumers can contact Maclaren at 877-688-2326 or visit www.maclaren.us/recall to receive a free repair kit.
Maclaren said the kit includes hinge covers designed to fit all Maclaren strollers.
The recall affects the following models, which range in price from $100 to $400: Volo, Triumph, Quest Sport, Quest Mod, Techno XT, TechnoXLR, Twin Triumph, Twin Techno, and Easy Traveller. To top of page
Warren Buffett's Berkshire Hathaway said Tuesday it will buy railroad operator Burlington Northern Santa Fe for $44 billion.
Berkshire (BRKA, Fortune 500), which already has major stake in the company, said it would acquire the remaining 77.4% of the company in a cash-and-stock offer worth $100 per share.
Widely regarded as both one of the world's richest men and the investment community's more brilliant minds, Buffett called his firm's investment an "all-in wager on the economic future of the United States."
"Our country's future prosperity depends on its having an efficient and well-maintained rail system," Buffett said in a statement.
Burlington Northern (BNI, Fortune 500) shares soared 29% in pre-market trading on the news.
Separately, Berkshire said it was announcing a 50-for-1 split of its Class B common stock. The majority of stock issued by the company in its purchase of Burlington Northern will be its pricier Class A shares, the company said.
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The deal, which would rank as the largest acquisition in Berkshire Hathaway's history, would also include $10 billion of Burlington Northern debt.
It would also expand the already massive portfolio of companies Berkshire already owns. Brand-name businesses such as auto insurer Geico, See's Candy and Fruit of the Loom are all subsidiaries of the Omaha, Neb.-based firm.
The deal is expected to close sometime in early 2010, pending approval by Burlington Northern shareholders and following a review by the Justice Department.
