ACORN, the Association of Community Organizations for Reform Now, has just issued the results or a large scale study of the potential impact of upcoming adjustments to adjustable rate mortgages. ACORN bills itself as the nation's largest community organization of low and moderate-income families. It advocates for better housing, more investment by banks and government in lower-income communities, and better schools.

The study used a sample of 275 subsidiary lenders owned by 15 of the largest lenders in the country. These lenders represent 65.5 percent of all residential mortgages that were originated in 2005 and 55 percent of the sub-prime market. Each of the lenders was asked to provide the public version of data they collected as mandated by the Home Mortgage Disclosure Act (HMDA) which includes information on the race, gender, and census tract of each applicant and whether the applicants received high-cost loans (those with an Annual Percentage Rate or APR 3 percent or more above the rate on comparable U.S. Treasury securities) or a sub-prime loan.

The study examined only first lien conventional purchase and refinance mortgages; no government guaranteed (i.e. VA or FHA) loans. 130 metropolitan areas were examined to determine the disparities between borrowers of different race and income levels to identify those areas and groups that may pose the greatest risk of "rate shock."

ACORN noted that, while ARMs represent about 24 percent of all home loans nationally, in some communities and among some demographic groups they account for a much larger percentage of the mortgage pool. ARMS also make up about 75 percent of all sub-prime loans, a 50 percent increase since 1999.

The report stated that "until this year there has been little recognition of the prevalence of adjustable interest rates in sub-prime loans and the danger posed by these ARMS." The focus instead has been on predatory practices such as excessive fees, high interest rates, and balloon payments.

Sub-prime loans are generally tailored for a market where people cannot obtain a conventional loan at a standard rate but Freddie Mac and Fannie Mae have estimated that at least one-third of sub-prime borrowers could actually have qualified for a lower cost mortgage so, it would seem that a "large number of the borrowers who have received ARMS should not have been in the sub-prime market."

The ACORN study found 32 markets where at least one out of three loans given out was high cost and thus subject to rate reset shock. In ten of these markets high cost loans represented two-fifths of the home purchase and refinance mortgages. The ten were Detroit and Flint Michigan; Memphis, Tennessee; Jackson, Mississippi; McAllen, El Paso, Laredo, and Brownsville, Texas; Springfield, Illinois; and Birmingham, Alabama.

ACORN also found that minority neighborhoods are at a great risk of payment shock because of the extent of high cost loans. More than half of the high-cost refinance loans in 67 of the areas examined in the study were in minority communities and in 44 of these areas over 50 percent of the purchase loans were high cost.

And the risk was not limited to the low income in minority areas. Upper-income minority borrowers were found to be at greater risk than white borrowers of similar income. In 12 metropolitan areas upper-income African-Americans were at least three times more likely than their white counterparts to receive high-cost refinance loans and in 15 metropolitan areas upper-income African-Americans were at least five times more likely to receive a high-cost purchase loan than upper-income whites. These areas are mostly southern or east coast (Atlanta, Baltimore, Charleston, Durham, Jackson, NYC, Washington, DC; but Milwaukee and San Francisco were included in the mix.

The ACORN report cited the phenomenon of "layered risk" where high cost loans are layered with multiple features such as interest only requirements, prepayment penalties, option payments where the borrower can choose each month whether to make a payment that will amortize the loan, pay interest only or make a minimum amount that will add interest on to the principal due. Such layering has the potential of increasing rate shock. Lenders are also offering low initial "teaser" rates which adjust to higher rates after the initial "introductory" period. In the latter case payments are nearly guaranteed to increase even if interest rates in general do not.

Interest rates for sub-prime ARMs are usually tied to the London Inter-Bank Offer Rate (LIBOR) with a margin of about 5.5 percent added on. The LIBOR has increased from 1.21 percent in January 2004 to 5.64 percent in June 2006. While many ARMs have rate caps that limit the amount that a rate can adjust on each anniversary and over the life of the loan, many sub-prime loans do not - or else have caps that allow very large increases. Even a typical 2 percent cap on a $150,000 loan would allow an increase in the monthly payment of $212.

The study quoted a Federal Reserve report that found an estimated 35 percent of ARM borrowers did not understand the maximum amount their rate could rise at one time or even how to calculate what the maximum rate would be. Another survey by Public Opinion Strategies found that lower-income people did not think that traditional mortgages were an option for them and we also less informed about reset shock and the debt risks.

Borrowers with prepayment penalties and minimum equity may be unable to refinance out of a loan that, once it readjusts, they can no longer afford. The study quotes research by First American Real Estate Solutions that up to 1 million households are in danger of losing their homes through foreclosure aver the next five years because they will not be able to afford new payment levels and will owe more on their homes than they can recoup through a sale or refinance. The ACORN report indicates that the impact of rate reset shock may be concentrated in certain metropolitan areas, neighborhoods, and among certain demographic groups. This might possibly magnify the impact as forced sales and foreclosures flood the market and further drive down prices.