An interesting article for investors about the current forclosure market.

Foreclosures.com - The Foreclosure Experts: "March 2006
Volume 9, Edition 3

Foreclosures: How Serious the Situation is
by Alan Smith
During the final two years of the feeding frenzy in the hot bi-coastal housing markets, we saw the increased use of unconventional loan products as eager buyers sought to qualify for ever pricier homes. As we discussed earlier these new loans included interest only financing, as well as 'option' ARMs with initial interest rates as low as 1% and negative amortization resulting from the unpaid portion of market rate interest being added to the loan's principal balance.

We've known for some time that these loans were dangerous, and would likely lead to an increase in mortgage defaults in the near and intermediate future. We did not know, however, just how many defaults could be expected as these loans reset to full amortization.

Now, thanks to a recently published paper entitled 'Mortgage Payment Reset by Dr. Christopher Cagan, an analyst with First American Real Estate Solutions,"

Cagan studied the loan/equity relationship for 26 million residential mortgages (or about 60% of the homes in the U.S.) and isolated those with the greatest risk of being forced into default either because of negative equity (i.e. the borrower owes more than the property is worth) or because of payment shock when the loans reset, or both.

Cagan estimates that, nationwide, homeowners and lenders face $110 billion in losses over the next five years. He did add however, that the effect on the U.S economy would be slight because these losses will be spread over time. While that's a staggering number, it represents a small percentage of the $1.8 trillion in ARMs sold in 2004 and 2005.

To evaluate the risk level, or level of "reset sensitivity" of these adjustable rate loans, Cagan uses a color code. "Red" loans with initial rates of less than 4% are at the highest risk. "Yellow" loans with near market initial rates are at low risk. While "Orange" loans with above market initial rates are at intermediate risk of reset sensitivity.

There is an overwhelming preponderance of red loans with start rates of 2% or less. Red loans issued in 2004 and 2005 number 1,418,612 nationwide. Cagan says 100% of the red loans are at risk, while 10% of 3,024,485 yellow loans, and 40% of 3,264,253 orange loans may be headed for trouble.

Equity is key for investors.

The red loan category is divided into two broad sectors -- Homeowners with equity and those without. According to Cagan's data, 17.8% of owners have zero equity or are upside down in their mortgages. Again, the great majority of these loans was made with start rates of 2% or less, and will be subject to severe payment shock when the loans reset. (That also means that 82.2% of these owners have equity to save. See below for more ideas.)

In other words, Cagan says if a homeowner is paying $800 per month on an option ARM, when the loan resets, his payment could jump to $3000 per month. The situation will be made worse because negative amortization will have increased the principal balance due, possibly beyond the actual value of the property.

Those with no equity will find themselves in a "can't pay, can't refinance, can't sell" bind. They will be forced into default and foreclosure, and the lender will wind up with the property as a REO (real estate owned). At that time, lenders will find themselves overwhelmed with REOs and will finally need investors to save them. They will begin to liquidate these inventories at deep discounts rather than sell for full market value as they are doing now.

That's not happening yet, but it will. At that time, we'll discuss how to make profits with these new opportunities. (Read "What's the to Find Deals in Your Market? Part 3 of 3: The Cold Market Buying Season" for more on this topic now.

What about now?

While Cagan's study deals with adjustable rate loans issued in 2004 and 2005, bear in mind that these loans were being offered in 2003 as well. The chickens being hatched in the fine print of the loan documents are now maturing and coming home to roost.

The 2003 buyers now have equity because of the continuing run-up in prices over the last two years. Interest rates, however, have increased a bit and are continuing to creep up. When payment shock hits, these troubled owners will find the refinance window closed. Their situation will be "can't pay, can't keep, must sell."

Additionally, some of the early 2004 buyers that used interest only loans or option ARMs, may find themselves facing big payment increases in 2006.

One does not have to be the proverbial rocket scientist to see the investment opportunities that lie ahead. While sales volume across the country may drop 6-8% this year, that's merely a return to a more normal market from the wild party that's been going on for the last five years. The housing markets will, if anything, be healthier than they've been in recent years.

In this case, seeing red is a good thing.

Using Cagan's color code, we expect to start seeing more 2003-2004 loans showing up on our foreclosures.com lists this year. Do look for the 82% of the loans who have 30% or more equity, because of the double-digit price buildup in the last few years. (Read more about "How to Weed your Leads for Equity."

There isn't much we can do for the zero equity folks (Read more about "Why Short Sales Dont Work" but we'll be able to help their lenders out later on (Read more about "Weeding Your REO Leads for Profit!"

Now you can see why we are going to be extremely busy buying discounted properties this year. I expect 2006 foreclosure investment opportunities to equal what we saw in 1998. Don't miss your second bite at the apple!

And remember... don't speculate, calculate! Read this month's Marketing Mania for more on this subject.