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Wednesday, October 15, 2008

The Looming Option ARM Nightmare

If you thought you couldn't be depressed about the economy any more than you already are, let me give you a hint about a new looming nightmare on the horizon. It is the looming option arm nightmare. The option arm is a somewhat obscure loan that began to first generate excitement in 2003 and really took off in 2004-2006. This is a loan that few mortgage brokers understood and even fewer borrowers understood. Yet, that didn't stop many brokers from selling it and just as many borrowers from taking it on.

First, here is a quick run down of the nuts and bolts of the loan. The loan essentially allows a borrower to temporarily make an obscenely low payment. What happens is that borrowers that borrowers are given a payment option as though based on an a thirty year amortization at a rate that is very low, the standard being 1.95%. In other words, the borrower is allowed to make a payment based on receiving a rate of 1.95% over 30 years. So, let's say, a borrower has a mortgage balance of $300,000. Their temporary payment would be $1,107 monthly. Now, here is where it gets tricky. That is the PAYMENT not the RATE of the mortgage. The rate is actually based on something separate. As such, anyone making this payment is almost certainly creating something called negative amortization.

Now, this loan had many variations and it also went through all sorts of metamorpases. For instance, in its original form, this minimum payment would be fixed for one year and then it would adjust. That said, the adjustments were usually fairly minimal limited to no more than a 7.5% increase of the original minimum payment. Eventually, these loans were modified and the minimum payments would increase but they were fixed for five years. The most important thing to understand is that the gimmick of minimum payments would only be available for five years. Then, the loan would adjust and turn into payment based on normal amortization of CURRENT rates based on the time remaining, normally 25 years. Let's look at the first example again. Let's say they still owe $300,000 which they wouldn't. They would likely owe much more since they were making the minimum payment the whole time. Still, let's say their current rate would be 7%. Their new payment based on this new 25 year amortization would be $2100 a month. I took very liberal inferences about both loan amounts and interest rates and the payment still jumped by a thousand dollars monthly.

This loan is not meant to be kept for more than five years. Yet, we now have an environment of dropping property values. Meanwhile, most of the borrowers of this loan have been creating negative amortization in these loans for years. In other words, most of these borrowers likely owe more than the property is worth. As such, getting out of this loan will be quite a task. As I said, these loans first gained popularity in 2003. In fact, they are a major reason for the failures of Indymac, Washington Mutual, and Countrywide which all carried a lot of them on the books. The loans are now toxic, but starting soon most of the borrowers will become toxic as well. It is estimated that there are still about a half a trillion Dollars worth of option arms that still need to adjust.
While this number is a relatively small portion of the overall mortgage portfolio, the number of defaults we will see once these loans adjust will simply be astronomical. I would estimate that three quarters of all borrowers in option arms that end up adjusting will in fact default on that loan. The number has to be that high because almost no one can afford to double and triple their payment.
In fact, the situation is so dire that more than one of the banks that still have a lot of these on their books have had to resort to something called loan modification. In this event, banks are contacting many of their current borrowers in these loans and they are attempting to refinance them into other loans, not based on qualification for said new loan, but based on figuring out a way to get them into a loan they can afford and out of their option arm loan. That's because any remaining bank that continues to have any sort of significant portfolio of option arms when they adjust WILL FAIL. The first of the stampede of option arms have started to adjust and it will be 2010 and especially 2011 when the really heavy load of adjustment will occur.
As such, if the market continues in free fall, that free fall will contribute to an avalanche of defaults on option arms, and that in turn, will perpetuate the free falling real estate values. The real estate market has about nine months to steady and even begin to creep upward. If it doesn't the rash of option arms that will adjust will make us in 2011 wish it were as "good" as it was in 2009.

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