Recasts and Foreclosures

Over at Calculated Risk there is a great post regarding the upcoming wave of foreclosure due to option arm recasts. Just the posts title is shocking - Option ARMs: Paying $98 a month on a $350 Thousand Mortgage! Lets take a look at the post -

From Bloomberg: Option ARMs Threaten U.S. Housing Rebound as 2011 Resets Peak

Shirley Breitmaier took out a $315,000 option ARM to refinance a previous loan on her house.

Her payments started at 3/8 of 1 percent, or less than $100 a month ... The 73-year-old widow may see it jump to $3,500 a month in two years ... She’ll be required to start paying principal and interest to amortize the debt when the loan reaches 145 percent of the original amount borrowed.

[CR Note: the 145% recast level is much higher than normal. This is now a GMAC loan]
...
About 1 million option ARMs are estimated to reset higher in the next four years, according to real estate data firm First American CoreLogic of Santa Ana, California. About three quarters of those loans will adjust next year and in 2011, with the peak coming in August 2011 when about 54,000 loans recast, the data show.

[CR Note: recast, not reset. This article uses the two terms interchangeably]
...
“The option ARM recasts will drive up the foreclosure supply, undermining the recovery in the housing market,” [Susan Wachter, a professor of real estate finance at the University of Pennsylvania’s Wharton School in Philadelphia] said in an interview. “The option ARMs will be part of the reason that the path to recovery will be long and slow.”

And compare these two comments:

“This loan is a perfect example front to back, bottom to top, of everything that has gone wrong over the last five to seven years,” [Cameron Pannabecker, the owner of Cal-Pro Mortgage] said. “The consumer had a product pushed on them that they had no hope of understanding.”
...
“The problem is, real estate values went down,” [Peter Paul of Paul Financial, the loan orginator] said.

We always compare these to reverse mortgages. They are both complex and new financial instruments where the vast majority of owners will not understand the details and get in trouble down the road. This is going to be a big mess since in the meantime the mortgages are increasing the property values are plummeting. We will see a wave of walkaways and foreclosures in the next few years.

National Foreclosures Rise - NJ Foreclosures Dip

Perhaps this is a sign that the foreclosure mediation program is working. Or perhaps we are just behind the curve. Either way it gives us a glimmer of light at the end of the recession. From The Record we get an article titled April foreclosure filings dip in N.J. Let's take a look -

Nationally, foreclosures rose 32 percent from a year ago, as one in every 374 households received a foreclosure filing in April.

...

After several states and mortgage companies put moratoriums on foreclosure actions several months ago, activity has begun to pick up again, said James J. Saccacio, chief executive officer of RealtyTrac, a California company that follows the foreclosure market.

In New Jersey, foreclosure filings were down 3.5 percent from April 2008. One in every 695 households received some sort of foreclosure filing last month — ranging from a notice that the homeowner is late on a mortgage payment all the way up to sale at sheriff's auction.

Passaic County had the state's highest rate of foreclosure, with one of every 461 households receiving a foreclosure filing during the month.

Bergen was 15th in the state, with one of every 892 households receiving a filing; Hudson County was 18th (one in 1,023) and Morris County was 20th (one in 1,215).

The article notes that the expiration of teaser rates are one huge reason for the new wave of foreclosures. We know that option arms will be a big problem in the next few years. Remember these loans were given at the peak. And many homeowners could not afford to pay more than the teaser rate. Now their loans have increased but the value of the properties are lower. Either we will see a huge wave of short sales (ha ha) or a huge wave of foreclosures.

Equity and the Small Business Owner

We knew that many business owners were using home equity to raise capital during the boom years. What we did not know was that often the capital was raised through the use of an Option ARM. Now the recasting ARMs that are severely underwater may cause the small businesses to fold while the homeowner/business owner potentially loses their property as well.

While it would be nice to blame this all on the bad decisions of bosses using your HELOC for everything became the advice of many financial planners and advisers during the bubble. Unfortunately many workers will be paying the price. First we will take a look at an article from the Sacramento Bee titled Exotic home loans could hurt business owners to see how bad things may get. Lets take a look -

Nearly 35 percent of the [California's] small-business owners used Option ARMs or other exotic home loans to finance their companies during the housing boom, according to a study released Thursday.

As those mortgages reset and monthly payments rise, scores of small businesses will be at risk along with the homes, the study concluded. The study was conducted by MerchantCircle, a Los Altos company that helps small businesses with Internet Marketing.

...

Samuel Bornstein, an accountant and business professor in New Jersey who analyzed the MerchantCircle results, said the use of exotic home loans will haunt business owners for several years. Bornstein, a professor at Kean University in Union, N.J., predicted a wave of foreclosures "that will dwarf the subprime crisis."

From the Map of Misery we know that California was the capital of the Option Arms. However the were taken throughout the country and the percent used by small business owners is unknown.


Following this up is another article about how much the small business owners are really hurting. The crutch is gone and may can not stand on their own. This article from the Wall Street Journal article titled Entrepreneurs Cut Own Pay To Stay Alive illustrates how bad things are getting. Let's take a look -

It's impossible to know just how many owners are affected. But in a sign of the breadth of the trend, 30% of 727 small-business owners and managers surveyed by American Express Co.'s small-business services division said recently that they were no longer taking a salary. That's a troubling sign for small businesses, which have created a significant share of the new U.S. jobs in recent years.

During past downturns, business owners might have turned to a home-equity line of credit, a personal loan or credit cards to shore up finances. But this time, real-estate values have plummeted, leaving many with less equity to tap, and bank credit is virtually nonexistent.

It's not uncommon for owners to give up salaries from time to time to give their companies a temporary lifeline, but business advisers and owners say the prevalence of salary cuts now is unusual even for a recession.

With the equity gone and credit avenues drying up things are getting tighter and tighter for many small business owners. The affects of the housing bubble and subsequent bust onto small businesses will have long-lasting compounding affects.

Option ARM Foreclosures Delayed

The upcoming issues with the Option Arms look like problems will be delayed due to low interest rates (see here and here). Remember that the recasts are set at 110% to 125% of the principal on the loan. So properties purchased at market peak will have a huge gap between the new loan recast value and the present market value. Also, many of the owners are only paying the interest - either the teaser rate or interest only which is stemming off the recast but not lowering the principal.

The fact that these recasts have been pushed back does not mean that the foreclosures will not take place. It just means that for many homedebtors (only appropriate word for the context) the foreclosures will just be delayed. In the big picture it is probably hoped that the foreclosures will be delayed long enough for the markets to stabilize. However that does not mean that there will still be big losses coming for the lenders between the 125% recast rate and the current value.

BusinessWeek has an interesting article titled Good News: Option ARMs resets delayed. Let's take a look -

Option ARMs typically reset after five years, at which point the monthly bill increases 65% or more. About 37.5% of option ARMs originated in 2005 are still outstanding, 63% of the 2006 vintage are outstanding, and 82% of the 2007 loans remain, according to Barclays Capital (BCS). And about a third of the outstanding loans in these years are deeply delinquent.

...

The Mortgage Bankers Assn. is also estimating that the lower interest rates will delay the resets. But the group also expects that lenders will help borrowers move out of the option ARM products before they reset. Many of the investors who can't easily qualify for modifications and the borrowers beyond help have already lost their homes, says Michael Fratantoni, vice-president of single family research and policy development for the Mortgage Bankers Assn.

And the homeowners who are holding option ARMs when the wave of resets hits won't face as big a shock because interest rates have fallen, adds Fratantoni. "Interest rates have come down to the point where the resets that are going to occur are going to be a bit of a non-event," he says. "Very few borrowers will experience the recast." But Nicholas Chavarela, managing attorney for Orange (Calif.)-based America's Law Group, which represents borrowers negotiating modifications, says banks remain reluctant to reduce principal for underwater borrowers.

...

Under the plan, taxpayers and participating lenders would share the cost of cutting borrowers' debt-to-income ratio to 31%. Loans terms could be extended to 40 years and interest rates dropped to as low as 2%. But option ARM borrowers would likely have to pay more each month, even with a modification, because they'd suddenly be required to pay both interest and principal. "The Obama plan needs to be built upon," Chavarela said.

But even if they can refinance many borrowers can't afford the higher payments. Philip Tirone, president of the Mortgage Equity Group in Los Angeles, said he reached out to borrowers with option ARMs, offering to help them refinance into a fixed-rate mortgage with a low interest rate. "For them, it's all about the payments," Tirone said.

...

Keith Gumbinger, vice-president of HSH.com, a publisher of loan information in Pompton Plains, N.J., said the lower interest rates have helped to diminish the option ARM problem. But it remains unclear how many option ARMs are left to reset and how many borrowers will be able to get out of the loans before it's too late. Moreover, by the time they do reset it is unclear whether the economy will be better off. If home values and unemployment continue to weaken, it will become even harder to refinance. But the delay in resets gives some motivated borrowers time to work with lenders and negotiate a solution.

It is all about payments that they can barely afford on a loan they can not. If the homedebtors can not afford more than the teaser rate how are they going to afford interest with principal. And since lenders are not willing to take such huge losses - what will happen to what these properties that are have principals that are up to 25% more than their peak prices? If there ever was a group that was perfect candidates for walking away, these are them. They own nothing. They can not afford their property. And they are too deep in debt to probably ever make it worth while.

And here is a graph depicting the recasts, notice how it tapers off 5 years after the housing industry imploded in 2007 -

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Here is an example we gave of the problem last year to understand the numbers -

For example 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 $350,000. The owner could not afford the payments on a $400,000 property when the economy was strong and gas was affordable.

Mortgage Industry Implosion

One favorite response regarding the mortgage industry implosion is the who could have known attitude. Everything was working perfectly. The industry started giving loans on assets not for what could be repaid. The industry started giving loans where people could have several options, one being to pay only a portion of the interest. The industry stopped requiring people to prove the money they had or they made - a good credit score was enough. Why would anyone ever envision anything wrong with these business models?

The Feb. 15th episode of 60 Minutes provides a great story about the fact that people did know in their story titled World Of Trouble. People did know that there was something wrong with the bubble business practices but they were dismissed or ignored. The money coming in was more important than using good business practices. From the video below it shows that the better the business practice the less money one would make. The story focused on World Savings that was bought by Wachovia (Wachovia now folded into Wells Fargo). Lets take a look at the story -

Watch CBS Videos Online

For those that can not watch here are some snippets from the accompanying article -

But Paul Bishop says he watched the bank famous for quality begin to emphasize quantity. World relied on outside mortgage brokers to bring in 60 percent of its customers. The more loans that were approved, the more the brokers, and World Savings, made in fees.

...
By 2005, 38% of World's clients had subprime credit scores. And customers were shown fliers that told them their income would not be checked by the bank.

"So I don't really need to know what you make. I don't need proof. You tell me you make $200,000 a year? You make $200,000 a year," Bishop said.

...
"When one lender dropped standards, another lender felt that they had to do the same," [Bob Simpson, whose company, IMARC, investigates failed mortgages] told Pelley.

Simpson says World and other lenders were in a ruinous competition for customers. "There are people inside of every institution that have been screaming for years about these terrible loans. Don't fund these. These are horrible loans. And they were routinely ignored inside of their own institutions."

Asked why they were ignored, Simpson said, "Because there's no money in common sense. There's no money in stopping a loan. There's only a payday when that loan closes."

The short term closing was the only part of the loan that mattered during the bubble. Whether the loan was viable was of least importance. As long as housing prices continued to have double digit gains year after year no one would get stuck with over priced houses or bad loans. But values did not only stop increasing, they went down. Business practices that made no sense but were highly profitable brought giant companies and industry leaders down in one fell swoop.

As in many cases the best line of the story is left for last -

"We have talked to some former executives of the bank who tell us that they listened to your complaints, they investigated your complaints, and they found that there was nothing to them," Pelley told Bishop.

"Are they employed today?" Bishop asked.

"No," Pelley said.

"Surprise. They lost their job. The bank went bust. They took down the fourth largest bank in the country with them. But there was no problem," Bishop replied.

Classic. Hopefully some governmental agency hires Bishop to help sort out the issues. He has the background and the insight to help straighten some of the issues out.

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?

Option ARM Intervention in Ohio

We are not fans of the Option ARMs or Pick-A-Payment mortgages. Not even mention the tidal wave of foreclosures coming as they reset, it is a loan that most people can not afford nor understand. We know that many people can not afford the full payments (see here). We also wonder how many fully understand the financial consequences they are when when they picked this loan. And from this article in the Columbus Dispatch titled Mortgage plan could keep 8000 in homes - we are not the only ones. Lets take a look -

Countrywide was accused of misrepresenting "the true nature of escalating payment obligations inherent in (adjustable-rate mortgages), the diminished home equity resulting from its Payment Option ARMs, and its borrowers' financial ability to afford their loans and/or refinance their mortgages."

About 400,000 of the company's 9 million mortgages fit into these categories, Countrywide spokeswoman Jumana Bauwens said.

In some payment-option mortgages, Bauwens said, borrowers paid only the interest on their loan. Others paid even less than that, which meant their principal increased every month.

"These borrowers are eligible for the opportunity to write down the principal to 95 percent of the current market value," she said.

...
"There are two groups," [Columbus bankruptcy lawyer Scott Needleman] said, "the very intelligent who knew what they were getting into and thought they'd be selling their house for a profit in five years -- and the other half who had no idea what they were getting into, which is fraud through and through by Countrywide."

...
"Loans will be modified based on what people can afford," Bauwens said, adding that the mortgage will be no more than 34 percent of a homeowner's income.

While we agree with Mr. Needleman that there are two groups getting the Option ARMs - we do not think they are split evenly in half. We think a just a very small percentage really understood the full consequences of the loan.


Ohio is also going to make significant write-downs. Changing many from probably over 50% of income to only 34%. Are these going to be adjusted of current income figures? How will they take the newly unemployed into account?

We believe the Ohio program is only for Countrywide customers - so those unlucky Wachovia customers may still owe 125% of the original purchase value while their Countrywide neighbor gets a huge reduction. That is going to go over well.

Mortgage Meltdown

How did we miss this? Found it over at Irvine. Well worth the watch -



Watch CBS Videos Online


Here is the description of the video "Scott Pelley reports on the mortgage crisis that's far from over, with a second wave of expected defaults on the way that could deepen the bottom of the U.S. recession."

Reducing Foreclosure Rates

It is wonderful to see a business look at the long-term stability rather than just to the next quarterly report. And when the long-term stability of a company is intertwined with their customer's stability it is even better. Few business decisions have as huge of an impact as keeping people in their homes, and reducing foreclosures, as load modifications do. Especially when the loan modification is in the best interest of all the parties involved.

This brings us to an article in the Wall Street Journal titled Massive Effort to Save Mortgages. It is about a loan modification program that JP Morgan is implementing to reduce foreclosure levels. Lets take a look -

J.P. Morgan Chase & Co. launched an ambitious plan Friday to modify the terms of $70 billion in mortgages for borrowers who are behind on their payments or soon could be.

The move by the New York bank will cover as many as 400,000 borrowers. They'll be moved into loans carrying lower interest rates, smaller principal amounts or other more-affordable terms.

...
The move also suggests that banks are realizing they can improve the value of their loan portfolios through mass modifications rather than foreclosures, which tend to produce larger losses. Until now, mortgage holders have been reluctant to renegotiate loans or have been doing so one-by-one, a time-consuming process. The bundling of loans into securities that are then sold to investors further complicates matters.

...
J.P. Morgan's push is especially aimed at so-called option adjustable-rate mortgages, or options ARMs. These allow borrowers to make a minimum payment that may not even cover the interest due -- resulting in a higher loan balance.

Under the plan, option ARMs that are accumulating interest will be replaced with fixed-rate loans that are more stable for borrowers and seen as far less likely to default. J.P. Morgan said it wouldn't begin the foreclosure process on borrowers during the next 90 days, as it opens loan-counseling centers and takes other steps to launch the program.

This is a very good business decisions. These Option ARMs are toxic. Once the recasts start there would be a massive wave of foreclosures. While it is letting people stay in homes they could never afford. Many people may not be able to even be able to make a fixed rate mortgage payment at the new, lower value. However it will definitely slow the bleed, and possibly long enough for prices to stabilize.

Another interesting morsel in the article is the following -

Nationwide, 7.3 million American homeowners are expected to default on their mortgages between 2008 and 2010, about triple the usual rate, according to Moody's Economy.com, a research firm. Some 4.3 million of those are expected to lose their homes.

As we note over and over, things will get worse before they get better.

Wachovia and Option ARMs

As expected Wachovia is no more. Thanks in a big part to the Option ARMs that are to be shortly exploding and spiking up the foreclosure numbers to all time highs. We are working on an Option ARM post for later today, but first lets take a look at the Wachovia issue. Here is a Bloomberg article titled Wachovia Option-ARM Mortgage Losses May Force Merger. Lets take a look -

Wachovia's plight stems from the $24 billion acquisition of Golden West Financial Corp., a California lender that specialized in payment-option adjustable-rate mortgages. Former CEO Ken Thompson told shareholders in May 2007 the loans would help propel earnings to new highs. Instead, Wachovia now expects losses on 12 percent, or $14 billion, of the $122 billion option-ARM portfolio. Analysts at Fitch Ratings predict default rates on such loans packaged as securities may reach 45 percent.

``I don't see why Wells Fargo would take on $122 billion of option ARMs to work out after they've eschewed doing those kinds of loans over the past five years,'' said Nancy Bush, an independent bank analyst in Annandale, New Jersey. ``Citigroup isn't in a better position to bid than Wells. They've got their own problems.''

...
Wachovia is the largest holder of option ARMs, ahead of Washington Mutual Inc., the Seattle-based lender that collapsed last week. The mortgages, which the bank calls ``pick-a-pay,'' represent 73 percent of Wachovia's loan portfolio, according to its Web site.

...
Option ARMs allow borrowers to skip part of their payment and add that sum to their principal. Monthly payments increase after five years or once the loan balance reaches a predetermined limit, usually 110 percent to 125 percent. Introductory interest rates can be as low as 1 percent.

...
For the average option ARM borrower, payments will rise 63 percent, or by an additional $1,053 per month, when their rates reset, according to a Sept. 2 report by New York-based Fitch.

Think about those numbers - Wachovia had $122 billion in Option ARMs. The article does not state if that was at the original loan price or reflects the additional 10 to 25 percent increases that are allowed prior to the recast taking place. Either way that number is over 17% of the total bailout number. And most of these Option ARMs are heading one place - foreclosure.

Will Wachovia make it until Monday?

Another bank that has been hit by the financial crisis seems to be teetering. With the loud thud of WaMu still reverberating there are reports surfacing that Wachovia is actively looking for a buyer. Here is an article form the New York Times titled Wachovia, Looking for Help, Turns to Citigroup. Lets take a look -

As concern spread Friday that more banks might run into trouble even with a $700 billion rescue for the financial system, Wachovia, one of those hardest hit by the housing crisis, became the latest to reach for a lifeline.

Weighed down by a huge portfolio of troubled mortgage loans, the nation’s fourth-largest bank by assets entered into preliminary deal talks with Citigroup, and extended feelers to Wells Fargo and Banco Santander of Spain, people briefed on the matter said. The talks are early, and no deal may emerge from them. But it appeared Wachovia was seeking potential alternatives should the bailout plan being debated in Washington not pass quickly, or fail to provide enough help.

Wachovia has a $120 billion portfolio of mortgages loaded with adjustable interest-rate loans that allow borrowers to skip part of their monthly payments, much of which it inherited from its ill-timed acquisition of Golden West, the big California lender, at the end of the housing boom in 2006.

...
“Wachovia has a real problem,” said Len Blum of the investment bank Westwood Capital. “Option ARMs are probably the worst mortgage products out there and Wachovia has a lot more of them than it has in tangible equity.”

...
“The Treasury Department plan will not prevent more bank failures,” said Chip MacDonald, a lawyer who advises banks at the law firm Jones Day. “The plan proposes to make purchases based on market prices, which are likely to be at a loss to the sellers. Such losses will deplete the sellers’ capital, which only strongly capitalized institutions can absorb without raising additional capital or a merging with a stronger bank.”

Option Arms are bad for everyone. Those that took them and those that lent them. The trouble is caused by the option arms are barreling down the hill looking to take everything in their path - and Wachovia will be one of the first casualties. Practically every homeowner that took one of these loans will also find themselves to be a casualty. Dangerous times ahead - be on the lookout.

Another Record -

9% mortgages behind in payments. Today must be bad news day. This is really bad. Wave after wave of problematic housing issues. This article from Yahoo titled Home loan troubles break records again: Delinquencies, foreclosures rise to more than 9 percent of US home loans in second quarter says it all. Lets take a look -

A record 9 percent of American homeowners with a mortgage were either behind on their payments or in foreclosure at the end of June, as damage from the housing crisis continues to mount, the Mortgage Bankers Association said Friday.

...
New foreclosures were concentrated in eight states: Nevada, Florida, California, Arizona, Michigan, Rhode Island, Indiana and Ohio.

...
What's driving the delinquency rate up now is the number of homeowners with risky, adjustable-rate prime loans made with little or no proof of the borrowers' income or assets.

Many of these loans allowed the borrower to pay only the interest on the loan for a fixed period of time. Others gave borrower the option to "pick-a-payment," adding any unpaid interest to the principal balance.

More than one out of 10 borrowers with a prime adjustable-rate loan is now delinquent or in foreclosure. That portion, 11.3 percent, was up from 9.7 percent in the first quarter and is expected to continue to rise as more homeowners see their monthly payments spike.

Option ARMs and Liar Loans are going to drag everyone down. Just wait until the ride down hill really starts. We are in for a bumpy ride - downhill.

Option Arm Trouble Ahead - Proceed with Caution

The trouble surrounding Option ARMs or pick-a-payments are coming. Unlike regular ARMs where holding down the interest rates to very low levels can post-pone the troubles that luxury is not available to Option ARMs. With huge numbers not even able to make a full ARM payment and routinely having negative amortizing loans things will get very ugly. And no quick fixes are really available to resolve the upcoming issues. This article from CNBC titled ARM Resets: Tsunami Ahead gives the same warning that we have here and here. Lets take a look at the article -

Last year, everyone was worried that the resets on subprime loans would force borrowers into higher interest rates and payments. This element of the housing slide and credit crunch has subsided a bit. Akiva Dickstein, Managing Director of Fixed Income Research at Merrill Lynch explained, "Subprime and ARMs have become less of a problem recently because short rates have come down so much. If the Fed decides to raise rates the issue will return. However, even without reset difficulties, subprime and Alt-A loans are slipping into default at very high rates. The concern about future resets has given way to concern about borrowers equity erosion."

However, the Option ARMs and Interest Only (IOs) loans scheduled to reset in the next few years will add more trouble. These loans represent about 15% of securitized loans and some have negatively amortized, increasing the payments and making refinancing more difficult. According to data from Barclay's, about $300 billion in option ARMs and $820 billion in IO's are set to recast. The results could be payment shocks over 80% for option ARMs and over 60% for IOs according to Barclay's.

So when things are "moderating", it appears to only be for the time being. Does this mean that the home builders like Toll Brothers, Pulte Homes or Centex will fall more? Not according to Jim Cramer. Cramer projects a housing bottom by June, and recommended the Housing Index as a way to play the sector. Either way, over the coming quarters, pay attention to news from these builders as well as the Financials including banks like Citigroup and the GSE's, Freddie and Fannie.

While the positive spin at the end tries to down-play some of the forthcoming problems, the graph that is included in the article does nor present the same optimistic outlook.

Option ARM Recast and Payment Shock Forecast

This will be a huge problem that will be difficult to address. And the problems created with the recasts will reverberate throughout the country.

Are we there yet?

In the housing bill that was signed into law last week, there was the GSE bailout bill. The bill includes the government to use unlimited funds to save Fannie Mae and Freddie Mac. But once the market bottoms and the housing industry stabilizes the need for a bailout will no longer exist. That brings us to a Bloomberg piece on Fannie Mae, Freddie Mac to Report Losses Through 2008. The article discusses the second quarter losses here -

Fannie Mae and Freddie Mac, the biggest U.S. mortgage-finance companies, may report net losses through the first quarter of 2009 as home-loan delinquencies rise to the highest on record, analysts' estimates show.

Freddie, based in McLean, Virginia, probably will say tomorrow when it releases second-quarter results that it had $1.9 billion in credit-related costs, while Washington-based Fannie will report $2.4 billion, according to Credit Suisse analyst Moshe Orenbuch in New York. The companies' regulator said July 22 that they may need to write down the value of $217 billion in securities.

Then a bit further down the article we get these two nuggets of important info -

Fannie will lose an additional $45 billion and Freddie $30 billion on mortgage defaults over the next two to three years, and each may need to raise $15 billion in capital, Miller said.

There are few signs that the housing market has bottomed. The S&P/Case-Shiller home-price index dropped 15.8 percent in May from a year earlier, the biggest decline since records began seven years ago. Some 6.35 percent of home loans had at least one payment overdue as of the end of March, up from 4.84 percent a year earlier and the highest since at least 1979, the Washington- based Mortgage Bankers Association said June 5.

...
Freddie has yet to write down the value of $150 billion in privately issued subprime, Alt-A, option adjustable-rate mortgages and home-equity loan securities because the company considers those losses ``temporary'' and expects to recover the full investment when the debt matures, according to Orenbuch. That could lead to potential losses of $24 billion more, he said. Non-agency, or private-label, mortgage securities, lack guarantees from Fannie and Freddie or U.S. agency Ginnie Mae.

The first interesting claim is that the housing markets has bottomed - due to the already steep declines and the high numbers of late payments. Are we certain that neither of these numbers can get any higher? This seems like a short sighted and premature reason to claim a bottom.

This is followed by the statement additional writedowns that may be "temporary." Does Orenbuch really believe that option arms will fully recover? Perhaps Orenbuch has a different data set from the rest of us, because we just see further losses still to come.

Watching out for those Option Arms

There are obvious signs that things will get worse before they get better. The option arms or pick-a-payment loans have to work themselves through. There is a huge group of homeowners who can not afford regular arms, can not afford to pay any principal and are already underwater. So know the truth and some will find out the hard way.

The upcoming wave of option arm recasts will be huge. Just looking at the upcoming tidal wave of option arms that are due to recast in the graph below. The comparison in numbers to the subprime levels are significant. The economy is already in tatters and this wave is still to come.

The second graph illustrates the recasts will come even sooner than expected due to the negative amortization feature of the loans. The negative feature is based on the value of the house when purchased not the current values - so it is easy to assess that these negatives are actually skewed upward. If real property valuations were used the number of negative house values or properties underwater would be substantially higher.

The fact remains that between 70-80% of the option arm customers can only pay the minimum payment. Therefore the negative recasts will hit well before the scheduled recasts. When this occurs the lenders and the homeowners will be in a world of hurt (most in both categories already are whether they admit it or not). Mr. Mortgage provides a list of the top option arm lenders -

• American Home Loans
• Bank United
• Countrywide
• Downey Savings
• First Federal
• IndyMac
• Wachovia
• Wamu

These recasts will not happen within a vacuum - there will be strong reverberations throughout the world. This will be stronger than the subprime breakdown - since the system is already very weak.

As Mish aptly uses a hurricane analogy. The option arms are the back of the hurricane - when the most damage is done. The front of the hurricane weakens the structures but the back demolishes and devastates things. Mish is right - now is the time to batten down the hatches.

You ain't seen nothing yet...

We know that foreclosures rates are reaching peaks in various areas throughout the country. We know that housing pricing declines are reminiscent of the Great Depression. We also know people are routinely stating that the worst is over and the we have turned a corner. And everything was just contained to the subprime issues. The Washington Post must have missed the memo - for some reason they have an article that the worst is yet to come in an article called Resets Peaking on Subprime Loans.

First the article discusses the adjustable rate mortgages (ARMs) that helped bring about high foreclosure rates and mortgage problems we have seen so far.

Nationally, the number of subprime adjustable-rate loans resetting peaked at 7.61 percent of the loans outstanding last month, according to data from CoreLogic. More than 300,000 such loans will adjust this summer. CoreLogic's data covers about 80 percent of the mortgage market.

...
Lenders, federal officials and housing counselors have worried that borrowers will not be able to afford the higher payments after the reset and will quickly fall into foreclosure. Declining home prices have made it impossible for many of these homeowners to refinance.

...
But analysts and housing counselors have noted that while the interest rate decreases have helped some borrowers, others still face a rate shock because they had an artificially low introductory rate, known as a teaser rate, or other types of loans. Some homeowners face an 8 to 10 percent increase in their payments, said Bruce Marks, executive director of the Neighborhood Assistance Corporation of America.

Then we get to the real problems yet to come a the very end of the article -

Borrowers may face another significant problem when option ARM loans, which allowed them to make less than full payments, face increases, said John Taylor, president of the National Community Reinvestment Coalition. Those are not classified as subprime loans, but the borrowers will begin to see their payments spike in the next few years as they are forced to start paying the principal of their loans as well as the interest, he said.

"There is this second wave behind" subprime loans, Taylor said, "that is going to complete the tsunami."

This looks like a good time to revisit our Monthly Mortgage Rate Resets chart to get a good visual of just has happened and the "tsunami" that has yet to hit.

Remember one huge aspect of the option arms is that people can not even make the full ARM payment and 70% to 80% of borrowers can only pay the minimum. Paying the minimum required increases the principal every month. Therefor these properties have loans that are now bigger than they were when purchased at the peak of the Great Housing Bubble. So many of these properties are already underwater - that is just how the loans work. That is why they are termed negative amortization - one is not paying down the mortgage but adding to it.

From a review of the above chart waves certainly is a fitting description of the mortgage resets/recasts crisis. The first wave has hit and we survived - but the second wave is coming and what we will face may be nothing compared to what is coming. Or as the song goes "you ain't seen nothing yet."

The Harvard Report

During the Great Housing Bubble things were wonderful. There was easy access to money - even those with bad credit could access it. It was easy to buy a house - the better the credit the easier to buy. No money for a down payment? No problem there was 100% financing. Wanted a bigger house than you could possibly afford? No problem there were pick-a-payment mortgages that let you pay a fraction of a normal mortgage payment. Had an unreliable income? No problem just use a stated income loan - no reason to show you really had money coming in lenders would just take your word for it.

Times were good. Unrealistic? Yes. Unsustainable? Yes. But things everyone was making money and we felt wealthy. Hopefully those feelings and memories can carry us through the on-going slump. Marketwatch has a summary of the Harvard University annual report on housing. Here are some of the findings -

The housing slump, already shaping up to be the worst in a generation, still hasn't run its full course, according to Harvard University's annual report on housing, released on Monday.

...

Other key points in the report:

• Last year marked an acceleration of home-sale declines, propelled by falling home prices and the credit crunch. The pain in the housing market spread to the rest of the economy by the beginning of this year, as the drop in home building, turmoil in the credit and stock markets and the effect of falling home prices on borrowing and consumer spending contributed to the slowdown.

• Real home equity (adjusted for inflation) fell 6.5% to $9.6 trillion in 2007. And home-price declines as well as a slowdown in home-equity withdrawals conspired to trim one-half of a percentage point from real consumer spending and more than one-third of a percentage point from total economic growth.

• During 2003 to 2005, housing prices surged so far ahead of incomes that by 2006, the number of households (both renters and owners) paying more than half their income on housing rose to 17.7 million, or 15.8% of all households. Today, lenders are requiring larger down payments and higher credit scores, squeezing many would-be buyers out of owning a home -- even though prices have fallen.

• More proof of the changing lending landscape: Subprime loans fell to 3.1% of originations in the fourth quarter of 2007, from 20% in 2005 and 2006. Interest-only and payment-option loans fell to 10.7% of originations in 2007, from 19.3% in 2006.

Some unsettling findings in the report is while prices are being lowered the pool of potential pools is shrinking drastically. Another group removed from the housing buying market are former owners who are now in or have just gone through foreclosure. The damage to this group's credit scores will prevent them from buying homes for years.

Another unsettling part is that more than 10% of new loans are option arms. We know that these are unsustainable. They are really only suitable for a small portion of borrowers - much less than 10%. Numbers are 70-80% of option arm borrowers can only afford the minimal payment. So if these current numbers are still applicable we know that 7-8% of all current home purchasers can not really afford the property. That just means more hurt down the road. Borrowers are still adding more debt on top of falling equity - something shown to be a dangerous combination.

Slow Motion Implosion

The option arms are coming. Pick a payment will soon be replaced with pick a foreclosure date. These loans are non sustainable for the current housing market. Home values are decreasing while the money owed on most option arms is increasing. While in theory it sounds great thinking that people are choosing to pay the lowest amount and socking the difference away in a higher paying account. But lets be realistic, the difference of a full payment, full interest and teaser rate level that 70% of Wachovia customers are paying is being used just to get by.

The difference in the value of what the house is worth and what is owed is becoming a larger and larger gap everyday. Yet Wachovia is aggressively notifying customers about what their pick-a-payment loan really means. A few phone calls will stop the coming implosion? Not likely, but Bloomberg news has an article regarding Wachovia Moves to Assure Borrowers Understand Loans. Lets take a look -

Wachovia is contacting people who apply through independent mortgage brokers to ensure ``the customer understands the key features of the Pick-A-Payment loan product,'' according to a June 11 memo from Tim Wilson, head of loan origination at the Charlotte, North Carolina-based company. The loans let borrowers defer part of their monthly bills.

...
Golden West was the market leader in option-ARM mortgages, with about $120 billion of the loans when it was acquired by Wachovia. The loans, termed Pick-a-Payment by Wachovia, allow borrowers to make lower initial payments that don't even cover the accrued interest. Almost 70 percent of Wachovia's borrowers choose to pay as little as possible.

...
The unpaid portion gets added to the principal of the loan. That can backfire on the bank if a borrower defaults while home prices are falling, leaving the lender unable to recover the full amount owed. U.S. single-family home prices fell at a 6.7 percent annualized rate in the first quarter, Waltham, Massachusetts- based research firm Global Insight Inc. said June 2.

...
Wachovia's new policy ``is far too little and far too late and indicative of how bad it is,'' said William Purdy, a Soquel, California, lawyer who concentrates on home refinancing. ``These loans are ticking time bombs and probably the worst thing the bank can say it has ever done to its customers.''

The new policy of calling borrowers applies to loans initiated by brokers, which make up 30 percent of the bank's mortgage lending, said Vecchiarello, the Wachovia spokesman. The bank began contacting would-be borrowers to verify information and improve customer service.

Do the homeowners really understand the loans? Are they pretending to realize they are getting deeper and deeper in debt everymonth hoping that by the time they reach their cap there will be some kind of program so they will not face foreclosure? Wachovia should realize that a large portion of the loans are already in trouble. People can not refinance - the debt is more than the value of the property. The only sales will be short sales.

The implosion is coming for the Option Arms - the only real question is when. The problems have been documented here and here and here. The map of misery post also shows where the fallout will be the highest.

The Option ARMs Are Coming

Over and over this blog has warned about the upcoming hurt following the Option ARM recasts. When predictions are made that the worse is behind us, the housing crisis has bottomed out and the financial crisis has been averted we realize people do not see the elephant in the room. The upcoming pain from the widespread option arm recasts looks like it will dwarf the sub-prime and ARM problems we are currently experiencing.

Business Week are the Paul Revere's of the upcoming problem. They have been the only warning "The Option ARMs are coming! The Option ARMs are coming!" Over and over again with few others hearing the warnings. Today they are at it again with an article titled The Next Real Estate Crisis. Here are some important snippets -

With the subprime mortgage crisis already crippling the U.S. economy, some experts are warning that the next wave of foreclosures will begin accelerating in April, 2009. What that means is that hundreds of thousands of borrowers who took out so-called option adjustable-rate mortgages (ARMs) will begin to see their monthly payments skyrocket as they reset. About a million borrowers have option ARMs, but only a fraction have already fallen due.

...
Many home buyers thought they could resell their homes before their payments increased. But instead, many of them got trapped.

...
William Purdy, a lawyer at Simmons & Purdy in Soquel, Calif., a firm that specializes in home refinance issues, said some borrowers with option ARMs are defaulting before the loans recast because they couldn't afford even marginal increases in the minimum payments.

"It's a ticking time bomb inside your house that you can't get rid of," Purdy said. "They can try to slow down the inevitable, but sooner or later their loan is going to cap. …This year is going to be a blood bath. Next year, we'll start out just about the same."

Remember a huge difference with the Option ARMs and regular ARMS is the money owed on the mortgage. Many of the Option ARM home buyers owe 110-125% of the original purchase price and now the houses are worth (depending on location) between 50-90% of hte original purchase prices.

For example 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 $350,000. 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. How long can the lenders and our economy sustain losses on these levels?

"Pick a Payment" or Pick a Foreclosure

One good sign in the Option ARM issues are that analysts everywhere are aware of the future problems. The subprime and ARM issues have been very re-actionary. The huge spikes in resetting of the regular ARM were able to be taken care of through lowering interest rates. Many of these people can afford to pay their full interest with a but of principle so long as the interest rates remain low. The traditional ARMs are not increasing their debts every month - getting them further in the hole. Those who took out the Option ARMs are not so lucky. Every month they pick a lower option they are not paying any principal and are increasing the amount of interest due. Most of the loans are taking on negative amortization every month. Combined with falling home prices and Option ARMs are deeper underwater every day.

In this article from the Wall Street Journal, a look at the rising defaults from the Pick-A-Payment loans. These loans have numerous problems - they are very new and very complex. They are adjustable like regular ARMs but have negative amortization. People who qualified for a $200,000 mortgage and are paying only the minimum may not be able to payback the loan when it reaches the predetermined recasting level of 125% or $250,000. Lets take a look at the article, it summarizes many of the issues very concisely.

These mortgages, which are sometimes known as "pick-a-pay" or payment-option mortgages but are generically called option adjustable-rate mortgages, are turning out, in some cases, to be even more caustic than subprime loans, in part because the loan balance and the monthly payments on some loans is growing even as home prices are falling.

... Losses on option ARMs could be "in some cases close to subprime" mortgage levels, according to a recent report by Citigroup.

Unlike subprime loans, which went to people with weak credit, option ARMs were generally given to borrowers considered to be lower-risk. But lending standards weakened in recent years and many borrowers now have little or no equity. Many lenders reduced the teaser rates on these loans as home prices climbed, making them appealing to borrowers looking to make the lowest monthly payment possible.

Now, with home prices dropping in California, Florida and other markets where option ARMs were popular, a growing number of borrowers with these loans now owe more than their homes are worth, one reason delinquencies are climbing, lenders say.

... Most other lenders won't see large numbers of resets until at least 2009 or 2010.

Many borrowers now say they didn't understand the features of the loan. For example, borrowers who make the minimum payment on a regular basis can see their loan balance grow and their monthly payment more than double when they begin making payments of principal and full interest. This typically happens after five years, but can occur earlier if the amount owed reaches a predetermined level -- typically 110% to 125% of the original loan balance.

"My sense is that many option ARM borrowers are in a worse position than subprime borrowers," says Kevin Stein, associate director of the California Reinvestment Coaliton, which combats predatory lending. "They wind up owing more and the resets are more significant."

People were given complex loans at a time it was assumed house prices would keep increasing. I wonder how many people thought they could actually ever be at any advantage with this type of loan. People gambled that house prices would have to continually rise substantially year-over year. The real appraisal price would not only need to be above the negative amortization accumulation rate but for any resells that number plus a 6% realtor fee. Both the buyers and the lenders bought into this gamble.