WEST PALM BEACH, Fla. - Credit unions like most mortgage lenders have been keeping a watchful eye on rising interest rates, realizing that any continuing increase will likely slow the pace of their originations. But what about the effect of rate increases on adjustable rate mortgages that have been so popular with lenders and borrowers and allowed many consumers to become homeowners or upgrade their home ownership? An article in the Wall Street Journal painted a bleak picture of the prospect. The March 11th article stated that "millions of Americans who stretched themselves financially to buy homes face a painful adjustment - some could even lose their houses - as monthly payments on adjustable-rate mortgages are reset higher." Moody's Economy.com estimates more than $2 trillion of U.S. mortgage debt, or about a quarter of all mortgage loans outstanding, comes up for interest-rate resets in 2006 and 2007. WesCorp's Dwight Johnston, vice president economic and market research, for one, agrees that rising rates will cause trouble for ARM holders, adding that WesCorp has been talking about the issue of rising rates and ARMs for a while. "The issue isn't how home prices have increased in value which is often talked about, but that we've gotten there through questionable lending practices," says Johnston. "Historically subprime loans have been about 5% of total originations, but in the last two years they've accounted for about 28%," he notes. According to Johnston, looking back on 2004 and 2005, the mortgage industry has already begun seeing a "sharp increase" nationally in delinquencies and foreclosures. Still, he said, "We're coming off a low base, so that's not so bad yet. However, it's not the kind of trend we want to see." Indeed, in New Hampshire alone, officials recently reported the number of foreclosure filings in the state jumped from 188 in February 2006 to 263 in March. ForeclosureNH, a business that acts as an intermediary between investors looking to buy foreclosed homes and sellers whose homes are being foreclosed, said 52% of February's foreclosure notices went to homeowners who purchased or refinanced their homes in the past two years. With homes sitting on the market longer before they're sold, Johnston said, "The debt structure under the recent price increases is what worries us." CUNA Economist Mike Schenk isn't as concerned. He said CUNA expects Fed funds to average 4.5% over the forecast horizon to the end of 2007. The rate will probably go up one more time to 4.75 and then come down later this year. That would mean the average for 2006 would be in the neighborhood of 4.65 in the 12 months through the end of 2006, and 4.35 average 2007. While "people with ARMs who are facing adjustments in their monthly payments because of rate increases won't be facing huge additional increases," Schenk admitted that "it's difficult to say how much pain and suffering there may be." The bigger question though is what effect future rate increases will have on credit unions' loan portfolios and delinquency and foreclosure rates. According to Callahan & Associates' Peer-to-Peer survey, for the third quarter 2005, ARMs of one-year or less accounted for 4.5% of CUs' first mortgage dollars, and 12.7% of those greater than one year. Balloon/hybrid loans less than five years made up 7.8% of the dollar volume for the period, and 16.9% of those greater than five years. Both Schenk and Johnston are relatively confident credit unions will fare well in the rising rate environment and won't get hit as hard as other lenders with delinquencies and foreclosures because, said the CUNA economist, "credit unions in general have a reputation of being very conservative." In addition, he said it's important to remember that credit unions have relatively high earnings - even though they've decreased a bit over the last few years - and a record amount of those earnings are coming from noninterest sources such as fee income. Moreover, CUs' capital ratios are close to all-time highs. "The vast majority of credit unions are well-capitalized and have significant buffers to weather a rising rate environment," says Schenk. Johnston agrees, saying that while the effect of the changing rate environment on credit unions "will be wildly variable across the country, still most credit unions have done a very good job qualifying borrowers and educating them on the pluses and minuses of the types of mortgages out there." But he still emphasizes that, "We can't put on rose colored classes. If the real estate market and home prices go down considerably, credit unions will feel the effects." Johnston also advises credit unions "to exercise their capacity to evaluate their loan portfolios and identify which loans are potentially at risk where members are already late on their payments. Credit unions should take preemptive steps to work with those members if they're already showing signs of stress. "The teasers on a lot of these loans have expired and the loans are playing catch up now on rates. So the rates don't have to go much higher than they are now for them to cause pain to borrowers. There will be a lot of upward adjustments on rates as ARMs hit their trigger point. Even if rates stay flat many borrowers will see a significant increase in their mortgage payments." Johnston also expects to see a "sharp increase" in the number of foreclosures nationwide, especially in the lower home price ranges bought by first-time home buyers, many of whom bought their homes with zero down payment or interest-only loans. Schenk says the housing market has already been through a year-and-a-half of price increases. Many consumers who took out one-year ARMs did so before the rates stared to rise and have already experienced monthly payment increases. "The Fed funds rate has gone from 1 to 4.5 in the last year-and-a-half, so many variable rate borrowers have already felt the 350 basis point increase. Any adjustment process in the coming months won't be as stark as they've been before," he says, adding, "When you take that into context with the asset quality of credit unions, the real story is that while we've had the huge rate adjustment, credit unions haven't had more fallout. It will take some time for it to become obvious if variable rate borrowers can't handle the adjustment. But based on what we've seen so far, credit unions and the economy as a whole will weather the rate increases fairly well." NAFCU Economist Jeff Taylor also expects credit unions to come through the interest rate rise "relatively unscathed." NAFCU, he said, estimates credit unions did about 15% in ARM originations in 2005, "so they don't have as much risk exposure as banks and the Countrywides." He forecast that unless rates go very high, the housing market won't see too many foreclosures, "although there will certainly be pressure on the balance sheets of some households, and there will be situations where borrowers will have to refinance or sell their homes. The biggest effect of ARMs will be in the higher cost markets." To see a "huge default" rate in loans, Taylor estimates a rise of 160-200 basis points would start to put pressure on some homeowners, and a 300-400 basis points rise would be very hard for most to handle. Taylor says credit unions will have to "prudently" tighten their lending standards and revise them with the upward movement of interest rates. The last half of 2006 and into 2007 will be the tell-tale time, he predicts, as the housing market slows and rates level off. "We have to remember the housing market set record levels the last three or four years, and now the ride is over. But the landing will be soft," he says. Taylor also emphasizes that the latest housing boom was the first of its kind in recent history, especially with the length of time it lasted, "so there's really no track record to look back on and make comparisons to. Now we'll see how resilient consumers are so the next time there's a housing boom we'll have some loss patterns to compare to." -

[email protected]