A Look at Option ARM Issues

A few interesting pieces in today regarding Option ARMS - first the terminology. ARMs reset, Option ARMs Recast. On the Federal Reserve Boards website there is a post about the dangers of Option ARMs - unfortunately none of our figure heads were verbally spreading the warnings. It may have made consumers and bankers wake up for a moment and realize the potential problems. Here is a snip -

• Rising monthly payments and payment shock. It is risky to focus only on your ability to make I-O or minimum payments, because you will eventually have to pay all of the interest and some of the principal each month. When that happens, the payment could increase a lot, leading to payment shock. In the worksheet example, the monthly minimum payment on the option-ARM payment rises from $630 in the first year to $1,308 in year 6, assuming the interest rate stays at 6.4%. The monthly payment could go up to $2,419 if interest rates reach the overall interest rate cap.

• Falling housing prices. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have negative amortization, you may owe more on your mortgage than you could get from selling your home. Also, you may find it difficult to refinance. And if you decide to sell, you may owe the lender more than the amount you receive from the buyer.

And remember regarding the upcoming Option ARM problems, that it is estimated 80% people with Option ARMs can only the minimum payment we are already in a world of hurt. Just wait for the recasts. Marketwatch has a great description of the coming problems -

After about 40 months your 2% b.s. payment would make the loan grow to about 115% of the original amount and then — WHAMMO — your loan would recast to a 27-year fully amortizing mortgage. Your payments would go from $1,000 a month to over $3,000 and you would be walking around wondering, like “What is happening?” A good analogy is the three-year no-payment, no-interest Circuit City TV loan. The catch is that in month 37 you owe ALL back interest — usually about double the original charge.

The guys talking about resets are trying to confuse the situation. The option arm loan was very popular through 1Q07 - so take 40 months from that date, plus 3 months for them to go 90 days late and then and only will you see foreclosures start to level off.

We have not started the huge levels of recasts yet - lets take another look at the reset/recast chart and note that the recasts do not really start showing up until 2009. Then they rise in huge numbers in 2010 through 2011. With the combination of falling house prices and negative amortizations these will result in huge, huge numbers of defaults.




At least some lenders realize what is coming and are trying to solve some of the issues before the crisis occurs. Here is a quote from Thomas W. Casey, Chief Financial Officer & Executive Vice President, during a Washington Mutual Q1 Earnings Call -

Option ARMs represent roughly half of the prime balances but approximately 70% of our prime non-performing loans. Option ARMs tend to have higher expected losses in all environments. Losses tend to be driven by the same attributes: leverage and FICO that drive losses in other loan types, current evidence does not support the conclusion that negative amortization or payment shock from loan recast are contributing to the recent deterioration in the performance. Further, expected recast dates have been pushed further in to the future as a result of the decline in treasury yield which comprise the NPA index used for option ARMs. Although the bulk of our option ARMs are not expected to recast until 2009/2010 we are already working with option ARM borrowers in a variety ways such as expanding recast figures to avoid foreclosure. Included in our NPAs are $669 million of troubled debt restructurings resulting from our work with customers to keep them in their homes through work out plans or modifications. Approximately 54% or $363 million in non-accrual CDRs were current with revised loan terms at quarter end. We expect the level of work out plans or modifications to continue to rise in 2008 as we continue our proactive practice of working with borrowers to keep them in their homes.

But current evidence also illustrates that loans are not recasting in record numbers yet. It would be great to see the data of Option ARM - 100% financing loans. These are already bank-owned, they are just showing up on the wrong side of the balance sheet. With house prices still in free-fall in some areas, especially the Super Bubble States, this will probably require numerous revisions to the original contract to try to stave off foreclosures and walk-aways.