Friday, January 30, 2009

Option Arms Defaulting

A very important update regarding the rising default rates for option arms from the Wall Street Journal via Calculated Risk. Since the article is behind a subscription wall we will look at CR's report -

Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance ... Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders.

As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics ... An additional 7% involve properties that have already been taken back by the lenders. ... Just over half of subprime loans were delinquent, in foreclosure, or related to bank-owned properties as of December. The nearly $750 billion of option ARMs issued from 2004 to 2007 compares with roughly $1.9 trillion each of subprime and jumbo mortgages in that period.

Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs ...

If 61% of the $750 billion in Option ARMs default, and with a 50% loss severity, the losses to lenders will be about $225 billion - far less than for subprime, but still a huge problem.

The key problem with Option ARMs is that they were used as affordability products, mostly in California and Florida, because buyers couldn't qualify for fixed rate mortgages or even regular ARMs. It should have been no surprise that most borrowers chose the negatively amortizing option; it was the only one they could afford!

The Goldman Sachs analysis is that 61% will default - we suspect it will be higher. The current data shows that before massive layoffs started 80% of option arm holders could only pay the minimum. We have to agree with an earlier Barclays prediction that it will be at least 80% defaults.

Since as the value of an option arm's holder property is declining the the value owed on their mortgage is rising - in some cases to 125% of the original purchase price. We gave this
example last June
but it is worth looking at again since it puts the option arm issue in black and white numbers so the problem can be easily understood with some clarifications -

A Merced, CA house that was purchased at $400,000 may have a mortgage that has grown to $500,000 with a real current market value of $200,000, add in the $50,000 for foreclosure costs and the lender loses at least $350,000 from the original mortgage terms plus another $100,000 in lost accumulated interest . The owner could not afford the payments on a $400,000 property when the economy was strong and gas was affordable. It will be impossible to pay a $500,000 with a weak economy and a property now valued at $200,000. How long can the lenders and our economy sustain losses on these levels?

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