Option ARM Time Bomb About To Explode

by: Michael Shedlock September 03, 2008    
Michael Shedlock

Michael Shedlock

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HousingWire is reporting Fitch Warns on Option ARMs; “High Defaults Await”:

Fitch Ratings on Tuesday released a wide-ranging look at option ARMs that paints a decidedly negative picture for the mortgage markets over the next 36 months. In fact, the picture is a downright scary one: the bottom line is that most outstanding neg-am mortgages won’t get out of 2011 alive, thanks to forced recasts.

Fitch analysts said they now expect roughly $29 billion in option ARMs to recast to higher monthly payments by the end of 2009, and an additional $67 billion to recast in 2010; of this, approximately $53 billion is attributed to early recasts.

“Though recent declines in the 12-month Treasury average rates have mitigated some risks, the majority of option ARM borrowers have elected to make the monthly minimum payment over the past 24 months,” Fitch said in the report. “As a result, a large number of these loans, especially those with 40-year amortization and 110% principal caps are expected to reach their recasts before the end of the five-year mark.”

My Comment

Declining treasury yields will bail out some subprime borrowers, but not Alt-A Pay Option Arms. 80 percent of pay option arm holders make only the minimum payment. That is all they can afford (if they can even afford that). The time bomb is negative amortization, and that time bomb goes off when negative amortization hits contract levels (typically 110% percent but as high as 125%).

The result? Fitch said it expects 90-day plus delinquencies — already ranging from 10 percent to 24 percent, depending on vintage — to more than double after recast for 2004-2007 vintage loans. It gets worse: Fitch also estimated that the potential average payment increase on the re-casting loans to be 63 percent, representing on average an additional $1,053 due each month.

California Will Be Hit Hard

California will be the state hit the hardest by Pay Option Arms. Florida and Las Vegas also had significant pay option arms usage. Pay option arms were least used in the Midwest where home price appreciation was more subdued than the biggest bubble areas.

For some additional thoughts on California housing, please see When Will Southern California Home Prices Bottom?

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This article has 24 comments:

  •  
    Sep 03 08:10 AM
    Looks like we are not out of the woods yet with yet another piece of negative news.
    Reply | Link to Comment
  •  
    Sep 03 08:26 AM
    You are about 18 months late on this predicition. American Home Mortgage (AHM) was taken down by the Option ARM filing bankruptcy in August of 2007. Wachovia has been hammered by the ill-timed purchase of Golden West / World Savings who was primarily an Option ARM wholesale lender. Wachovia attempted to force by manipulation of compensation their loan origination staff to push this product over everything else and it has landed them in court.

    Option ARM's were a cancer in the mortgage industry from the day the product was launched and are potentially more dangerous than 2 year subprime ARM's with 3 year pre-payment penalties. Most lenders removed the product from their offerings in 2007.
    Reply | Link to Comment
  •  
    Sep 03 08:35 AM
    Heis not late-he is talking about another wave.....
    Reply | Link to Comment
  •  
    Sep 03 08:46 AM
    Agreed. This is another wave - after the traders like tcorn think its "over." Whether this is the fundamental story that propels the market lower or not, the market IS headed lower. Yesterday (Tuesday 9/2) exemplifies "ugly reversal."
    Reply | Link to Comment
  •  
    Sep 03 09:27 AM
    WaMu, Countrywide, Wachovia, Indy Mac, Downey, and Bear Stearns were/are among the largest Option ARM lenders. Option ARMs are literally worthless with no bids found for many months for these assets. Bank of America is now stuck with the loan portfolio previously originated and held by Countrywide. A great deal of these B of A loans are in California, Nevada, and Florida, states that have been hit hard by the housing crisis. WaMu “specialized” in Option ARMs starting in 2000; that was their biggest and primary product. Their entire sales force was addicted to this product because of the “easy sell” and higher commissions. The sales force turned many builders and real estate agents into Option ARM junkies.

    Even though there was great pressure put on senior management from the sales force at Wells Fargo Home Mortgage to do these loans, Wells Fargo elected not to do them. They said it was not a product that was good for their customers or good for the company. They did NO Option ARMS, NONE. Turns out they were right.
    Reply | Link to Comment
  •  
    Sep 03 09:48 AM
    The market is reacting like my hormonal teenager... Every instant message brings a new mood swing. She can't see tomorrow because she is so REACTIVE she can't play the chess game of life 10 moves into the future.
    The message is very, very clear. The economy is in major trouble any way you slice it. Invest accordingly and you will come out of it, 10 moves from now. That is what you need to bank on right now.
    Reply | Link to Comment
  •  
    Sep 03 11:38 AM
    One thing that's not mentioned here is that the banks that made those Option ARMs have been reporting ALL the interest income--even the neg am portion--as current revenue--even though people are paying only the minimum payments.

    When those loans start to go into default, the banks will have to take additional writedowns for foregone interest that was reported in previous years.

    WaMu, IndyMac and Wachovia are most at risk for these writedowns. Something like 35% of interest income resulted from interest on Option ARMs. (You have to check the footnotes of the financials to see the percentages).

    Another bloodbath in banking is coming soon to a lender near you!
    Reply | Link to Comment
  •  
    Sep 03 11:50 AM
    Great comment Kelly Lieberman.

    The dead horse of option ARMs has been beaten to death. This is old news.
    Reply | Link to Comment
  •  
    Sep 03 12:34 PM
    This is very significant. My loan resets in 2010. Although I can easily afford my payments, I cannot refinance my mortgage because all they are offering are those FHA backed mortgages. These loans have strict lending requirements that I can't qualify for. Therein lies the problem, even if people wanted to keep their homes, they can't because they can't qualify for a mortgage refinance. Another round of guaranteed foreclosures is coming soon. I wouldn't load up on bank stocks just yet.
    Reply | Link to Comment
  •  
    Sep 03 12:35 PM
    This is only "old news" in some of the financial press. The business sections of the popular press and mainstream media still hasn't caught on.

    When reading most of them, it seems like the housing market will hit its bottom some time in early 2009 and everything will start getting better after that. They're living in a fool's paradise when they really should be printing articles like this.

    One of the best ways to make money in the next 3 years will be shorting bank stocks or buying put options on them.
    Reply | Link to Comment
  •  
    Sep 03 01:53 PM
    The Canadian Guy has it figured out. Currently the financials are held up by the IB's and the U.S. Government and that won't last. The truth will prevail in the end. Creating the largest debt the world has ever known. The only one's that I listen to are Professor Nouriel Roubini and Wall Street analyst Meredith Whitney. They are the most reliable at providing information at this time.

    Please vote this is an election year! Any politician who voted for allowing the Investment banks access to the Fed window after creating this disaster is no friend of the U.S Taxpayer.
    Reply | Link to Comment
  •  
    Sep 03 02:11 PM
    @Tom Lindmark and Kelly Lieberman,

    How does this being "old news" (to the 1% of the population who read financial blogs) in any way invalidate its truthfulness or blunt the impact of the housing tsnumai that's headed our way from 2010-2012? Or do you believe that our perfect Free Market of Rational Actors already "priced in" all the bad news ahead?
    Reply | Link to Comment
  •  
    Sep 03 06:15 PM
    Kelly Lieberman referred (above) to "...the chess game of life 10 moves into the future." I don't know that anyone can see ten moves ahead, right now, but I think I can see clearly for about five moves, and what I see is a radically changed landscape, financially, for the middle class. This group is ALREADY in much deeper trouble than the optimists predicted would occur, only 18 months ago. There's going to be an entirely new class of renters, for one thing. Many, many families who now live in "owned" houses will never buy another house, after their foreclosure, because Mom and Dad will never be willing to go into big debt, again, even if they can somehow qualify for a mortgage, in their late fifties and early sixties. And their kids will find getting a mortgage extremely more difficult that in their parents' day. The "everybody-can-af... bubble was a cruel hoax, and I, for one, was mystified at the time it began, as to why so many people literally bought into the hoax.
    Reply | Link to Comment
  •  
    Sep 03 06:21 PM
    To correct a technoglitch, on my comment, above: "The 'everybody-can-afford-... bubble was a cruel hoax, and I, for one, was mystified from the time it began, as to why so many people literally bought into the hoax."
    Reply | Link to Comment
  •  
    Sep 03 06:22 PM
    I give up. Maybe the glitch can't be corrected.
    Reply | Link to Comment
  •  
    Sep 03 09:12 PM
    in terms of the whole financial mess, this is not big money. but i guess when you are weakened, it will just take one more straw to break the camel's back.
    Reply | Link to Comment
  •  
    Sep 03 09:41 PM
    I think the Fed was in collusion with the banks and mortgage lenders. Greenspan was advocating the use of adjustable rate mortgages. I cannot believe that fool. I had advised my younger brother to get a fixed rate mortgage but he said that Fed chaiman advocated variable rates and he is now walking away from his home on the rate reset. It seems like this was all a set-up for the redistribution of wealth to the super-rich. Happens every 8 to 10 years. We have not seen the last of these fiascos.
    Reply | Link to Comment
  •  
    Sep 03 09:52 PM
    I think some might have misinderstood my comment. I believe that the dance the market is playing is just that. When taking a look at the FUNDAMENTALS we are in deep trouble. No amount of short term "fake good news" can buffer this market for very long.
    When I say look 10 moves forward, for you that might mean 10 days or 10 weeks. For me, it means I was out of most stocks in February (it would have been earlier but my husband was not convinced....), and selling more last week so I could buy more Gold and Silver at what I think are amazing bargains given the state of this economy...
    Reply | Link to Comment
  •  
    Sep 04 02:25 AM
    cash is the only bargain in a deflationary depression. Nothing has `intrinsic value`. If people don`t have extra money to buy gold and silver, then gold and silver will continue to go down until they do. Gold and silver getting cheaper won`t help because (mainly) people buy stuff because other people are buying it. And people not buying gold and silver (and everything else) will lead others to not buy things like gold and silver and everyting else. The markets are all psychological, as Elliott said. Because Prechter had trouble `picking the top` does not diminish the validity of Elliott`s insight.

    we`ll have another leg down this December, then a honeymoon rally next year. Then these resets start in 2010 and we start heading for the real bottom.

    Elliott-wise, I believe we have entered wave 2 of THE BIG ONE. In other words we are going to test the bottom of the entire runup of stocks for the history of the US. May take some time to get there, but new highs are out of the picture until the bottom is tested.
    Reply | Link to Comment
  •  
    Sep 04 02:44 AM
    In my opinion, it all started with the Clinton vision of "The American Dream" - everybody deserves to own a home. His administration pushed for looser oversight of loan applications and challenged the financial industry to come up with creative solutions so that low-credit-score buyers could get mortgages.

    As time progressed, oversight and restrictions on federally-insured home loans were relaxed. The fed cut interest rates to banks, to free up money for mortgages. Regulators were told to just wink at lenders not checking the truthfulness of loan applications, lenders using phony accounting to look like they met their mandatory loan-loss requirements, and companies who's only product was generating loan applications to be sold to investors.

    The bankers and real loan companies knew full well that so-called sub prime borrowers were a huge risk. People with a family income of $40,000 cannot afford a $400,000 house, no matter how you package it. That's why they all unloaded the toxic stuff as quickly as possible.

    The problem was that the housing boom lasted too long. Banks couldn't stop making ever more risky loans because they had to keep showing rising quarterly profits, to stay up with the competition. Loan packagers were making huge salaries and bonuses, and they wanted to keep the money flowing as long as possible. Real estate agents were making double their normal commissions, because house prices were twice as high as normal. Everybody wins, nobody loses, until the bubble bursts - so I'm getting mine now while I still can.

    Then the first failures. The auditors that had blessed all those CDO's and other bogus derivitive schemes got sued along with the banks and brokers who had lied about them being "safe" investments. Once the accountants got burned, they finally toughened up. That's when "mark-to-market&q... got mandated - and that nailed the coffin lid down on the financial industry.

    Previously, banks could hide toxic debt off-balance sheet. Now the accountants/auditors were making them confess the amount of liability, and to price it at what they could sell it for (market). When nobody will buy it, it's market value is $0. Mark-to-market means you have to write off almost all of it. Add in the leveraged iterations - one $100 bad loan repackaged and sold ten times becomes $1000 worth of mark-to-market write downs.

    So my take is, good intentions purposely mismanaged over decades (likely more for political reasons than altruistism), using a financial system designed to increase the insiders' personal wealth at the expense of anybody not in the clique, and resulting in a gauranteed continuation of the socio-economic status quo.
    Reply | Link to Comment
  •  
    Sep 04 07:37 AM
    This piece dovetails with Steve Waldmans "Inequality and the Credit Crisis", SA 9/1. Also interesting to consider the ramifications of the Jefferson and Hamilton polemics as they have played out in the American economy.
    Reply | Link to Comment
  •  
    Sep 05 01:27 PM
    I think my name says where I stand on this. As usual, Mish did a great job. When I tell my friends I will probably be buying around 2012 or 2013, they are dumbfounded. They also get all their news off the MSM. ;)
    Reply | Link to Comment
  •  
    Sep 05 01:31 PM
    I used to work at Wamu. I see them as the equivalent of a boxer that is on his knees, trying desperately to get back up ofter an "almost knockout" punch. I predict that just as they do get off that last knee, an upper cut from the Option ARM is gonna do it, decisively and finally.
    Reply | Link to Comment
  •  
    Oct 06 10:27 AM
    I love how this topic has been completely left out of the news. I remember reading an article in time magazine I think, 1 year back or so, mentioned that 70% of West Virginia alone has option arms. That 70 billion default number is greatly understated. As a former mortgage broker, those option arms were paying 5 points commission to brokers who got borrowers into them. So lets do some math, average home price of 72,800 multiplied by 1,818,417 people from 2006 population survey and we get $132,380,757,600.....m... by 70 percent.....$92.66 billion dollars of defaults alone in West Virginia. Who is kidding who? That's one state with 92 billion in defaults over the next 3 years. Goodbye America, welcome Marshal Law, NAFTA and the Amero. We just got fleeced and American's aren't going to do a damned thing about it.
    Reply | Link to Comment
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