Saturday, June 7th, 2008 at 12:50 AM
Neg-Am Reset Update
Businessweek has a new article about neg-am loans that features an updated reset chart from Credit Suisse. We were just talking about getting an update, and here it is:
Blue bars on the chart represent the recast schedule if all the loans were to recast five years after origination date. Gray bars represent the expected schedule of option ARM resets, which show loans recasting sooner after hitting the principal cap. By Credit Suisse
Based on the reports of 70% to 80% of the neg-am borrowers only paying the minimum payment, the resets will be coming faster (the gray bars), because their loan balances are rising – reaching their 115% reset cap sooner than the other reset possibility, ‘after five years’. Washington Mutual and Countrywide imposed the 115% reset cap which is much lower than the more-traditional 125% cap that Great Western, Home Savings, and World Savings used, and now it’s time they paid the piper. If they would have left the resets at 125% or 10 years, like World Savings did, they wouldn’t be faced with nearly as big of a problem.
Let’s look at an example.
If you are only paying the minimum, and deferring the difference, once the new total balance grows to 15% over the original balance, then you lose the minimum payment option, and have to pay the full amount due each month.
When you receive your initial truth-in-lending statement, the lender is only required to disclose what happens based on the first day’s interest rate only – there is no illustration of what happens if rates go higher. But we can follow an example of a mortgage originated in July, 2005, and see how close they would be today to their reset point. Here is a typical Countrywide mortgage, and how it has performed since July, 2005:
$500,000 loan amount, neg-am with a 115% reset cap or five years, whichever is first.
1% initial teaser rate, with a 2.625% margin over the MTA index.
Initial minimum payment = $1,608.20
Actual payment due, 2nd month = $2,835.81
Deferred interest after 35 months = $55,419.38
Maximum deferred interest before reset = $75,000
Amount left to defer = $19,580.62
Approximate time left before reset = 19 months
Minimum payment in 19 months = $2,141.26
Mo. payment after reset = $3,599.02
Mo. payment shock in 19 months = $1,457.76
The fully amortized payment is calculated based on the MTA index at 3.29 + the margin of 2.625% and amortized over the remaining 315 months.
The borrowers got into this deal when the payment was only $1,608.20, and that minimum payment goes up every year – getting them used to a higher payment. If they’ve been able to handle an extra $120/month increase each year, then good for them. But will they be able to handle it when it goes up $1,457.76 in one month?
There is an easy way for the lenders to fix this problem – just suspend the reset, and/or push it back to the 10th year. World Savings (Wachovia) has been doing 10-year resets or 125% all along, so don’t believe the commentors when they say Wachovia is in the same boat as others – they’re not. It was when Countrywide and Washington Mutual got greedy and pushed down the reset caps to 115% and five years that these loans became super-toxic.
But you can’t keep deferring interest forever, can you? The technical difference in these loans is that the amount deferred gets smaller every year, and if you can catch rates dropping, the gap narrows quickly.
The difference between the minimum payment and the fully-amortized payment back in April, 2007 was $1,820.13. By July of this year it will be down to around $1,000/month. As that gap narrows, the reset date is pushed out further.
Back to the chart, and the 19 months. If the neg-am in this example will be facing a reset in 19 months, that puts it in the beginning of the year 2010 – which looks like the peak of the gray-bars chart. We remember that 2005 was the craziest part of the frenzy, so it looks like the gray-bar chart is the most accurate we’ve seen. It also brings into question the blue-bar chart that shows 2011 is the peak. It is based on five years after origination, and that would mean there were substantially more neg-am originated in 2006 than in 2005? That’s hard to believe, but either way, we’re just getting started!
Hat tip to GLG for mentioning the Businessweek article about neg-ams:
http://www.businessweek.com/lifestyle/content/jun2008/bw2008065_526168.htm?campaign_id=yhoo
Posted on Saturday, June 7th, 2008 at 12:50 AM in Neg-Am | 22 Comments » | 
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"It also brings into question the blue-bar chart that shows 2011 is the peak. It is based on five years after origination, and that would mean there were substantially more neg-am originated in 2006 than in 2005?"
This sort of makes sense to me. Subprime loans happened in the first place because lenders ran out of qualified borrowers for conventional loans, and as time passed the same degradation would have taken place in subprime, with lenders running out of "least high-risk" borrowers and then turning to "more high-risk" borrowers, who would get loans with more onerous terms. So the worst loans were the last ones made, to the least qualified borrowers.
GeneK | June 7th, 2008 at 6:54 amThe technical difference in these loans is that the amount deferred gets smaller every year, and if you can catch rates dropping, the gap narrows quickly.
—————-
Let me start out by stating that I was NOT a math major.
How does the deferred amount become smaller every year? From what I understand, there is a "teaser period" usually of 1-3 months where you pay a teaser/introductory interest rate of 1-2%. After that, you can still pay only 1-2% for the remainder of the year, but the "real" rate (index + margin) might be 5%+ (adjusts monthly?), and the difference is deferred, and added back onto the principal.
As the principal amount grows via deferred interest, interest is compounded and you end up owing interest on the interest.
In year two, you have a new minimum payment that is more closely aligned with the real rate (no 1% min pmt?), so your payment rises, no? Is this why the deferred payment gets smaller? Because you are paying off a higher rate (though it may still not cover the real rate)?
What determines the minimum payment after the first year?
CA renter | June 7th, 2008 at 7:30 amSecond question/comment:
IMHO, the lenders who cap negative amortization at a lower percentage are protecting themselves in the event the borrowers default. If they increase the cap from 110%-125%, they will end up having to write-off even greater amounts, no?
I’m going with the assumption that if a borrower is unable to pay the mortgage on a 110% LTV loan, that they will be even less able to pay the mortgage on a higher loan (125% LTV).
How would pushing out the reset date and/or increasing the cap make the borrowers less likely to default?
IOW, as a lender on a $100K loan, I’d rather someone defaulted on $110K sooner than $125K later. Maybe I’m just too conservative.
CA renter | June 7th, 2008 at 7:36 am110%-115%-125% of the original loan balance or home value whichever is lower.
Rob Dawg | June 7th, 2008 at 1:39 pmIt looks like neg-arms recasts will cause more trouble for the high-end market than say sub-prime recasts. Is this the end of CV?
guest | June 7th, 2008 at 1:42 pmCA renter,
The minimum payment increases by 7.5% of the previous year’s minimum, until it catches up with the fully-amortized payment. The 7.5% is purely mathematical, it has nothing to do with interest rates. Take the minimum payment, and multiply by 1.075 to find the minimum for the next year.
The neg-ams were pioneered in the 1980s by the big three; Great Western, Home, and World Savings. They were created with a couple of caveats:
1. The initial rate then was closer to the fully-indexed rate. Starting at 1% when the fully-indexed rate was 5% or higher creates a big gap, one that takes a longer time to catch up.
2. The interest rate environment was different – I doubt that they had any models where the 30-year fixed rates started, and stayed in the 5-7% range.
When the 30-year fixed was around 10% back in the late 1980s, and your neg-am start rate was around 7%, it didn’t take long for the minimum payment to catch up, plus there was room for the 30-year fixed to come down.
In the early 1990s as fixed rates came down, those who had a neg-am found that their minimum payment ended up much HIGHER than their fully-indexed rate.
The 7.5% increase is also the cap on the decrease – it is a +/- change of 7/5% of the previous minimum payment – and that’s where the 10-year reset comes in.
They figured that over a ten years period there would be enough fluctuations in the rates that there would be months/years of positive amortization, where the minimum payment would be high enough that the additional monies paid would reduce the balance that had built up with negative amortization.
The problem in this era is that when you start at 1%, you don’t have much room for the fully-indexed rates to eventually drop under the minimum payment.
Countrywide and Washington Mutual were stupid to not recognize how these work, and they should have left the resets at 125% and 10 years. If they can wave the magic wand and push back their resets, problem solved – for now.
Who was crazier was Deutsche Bank and HSBC for buying gobs of these without realizing the toxicity – I doubt they looked at them any harder than the borrowers.
What isn’t talked about is the lifetime cap – it has been 9.95% on all of the Countrywide/WaMu loans I’ve seen. It used to be 11.95% or 12.95%, and the lower life cap may have been what got borrowers comfortable enough to go ahead and sign – "heck the worst case is only 9.95%, that’s not bad, historically".
Jim the Realtor | June 7th, 2008 at 2:41 pmassuming 6 months of delinquency would result in a NOD filing.
assuming another 5 months to reach REO status (I’m adjusting the usual 4 months to 5 due to postponements).
that’s 11 months from delinquency to REO.
assuming once reset hits people automatically go delinquent, that means here in 2008 Q2 we are still digesting subprime resets from 2007 Q2.
the huge bolus of subprime reset doesn’t end until end of 2008. Which means thru out 2009 we’ll continue to be working on all of the resets from 2008.
then you move the bulk of the option arm resets to 2009 Q4 and thru out 2010. essentially the market doesn’t get a break at all. we march right from the subprime implosion directly into the option arm implosion as a continuous rolling bust.
last chance for CV folks to get out alive before they drown or face a 10 year lock down.
ocrenter | June 7th, 2008 at 2:53 pmRob,
My thought exactly. I think those resets will be moved way up….
"110%-115%-125% of the original loan balance or home value whichever is lower."
SMC | June 7th, 2008 at 4:35 pmI take umbrage to the idea that the loans became super toxic when Countrywide et al ",got greedy." The loan concept is itself toxic, whether the reset date is 5 or 10 years, 115% vs 125% isn’t even relevant. All that does is give the borrower more rope or less to hang themselves.
Long term liabilities financed with short term financing, which is what ARM loans really are, is a terrible idea in a society where the average person can barely calculate a tip.
Barnaby33 | June 7th, 2008 at 4:50 pmWell, nowadays it’s not that uncommon for people to move after a few years. Doesn’t the first time homebuyer stay for an average of 5 years or so? When you’re young, you could easily change jobs, move to be closer to family, or have a couple kids and need a larger place or different school district. Nothing wrong with that. In such cases an ARM can make a lot of sense if short term rates are much lower than long term rates. Of course, planning on selling in five years is a bad gamble if the market is in a bubble. But the market’s not always in a bubble.
Seems to me ARMs are more like futures. You can use them to limit your investment risk, which makes sense. Or you can use them to bet wildly, which has brought established investment houses to their knees.
Dwip | June 7th, 2008 at 5:06 pmI lived in the first home I bought for 15 years, the second for three years and the third for six years. I financed all of these homes with 30-yr fixed because at the time I bought them I intended to live in them until I retired. Life happens, and in retrospect if I had had a crystal ball I could have saved a few bucks interest on the house I sold after three years by going with an ARM. But I’d rather have it end up that I spent a little bit more that I could afford than find myself having to spend a lot more that I can’t. Every loan option has to be looked at with "what’s the worst that could happen?" in mind
GeneK | June 7th, 2008 at 6:00 pmIt’ll be a few more months but I can’t wait for the survival data, those $2b last month $4b next month and rising NegAm loans which actually start paying on the recast schedule. Remember my prediction of a few days ago that they were all TU.
Rob Dawg | June 7th, 2008 at 6:03 pmHow will the bleeding end? I just did a price check on Uhaul… To get a 24′ truck from San Diego to Salt Lake City costs $1238… To go from Salt Lake to San Diego the price is $724. Is there a mass exodus from San Diego or is it just that people leaving San Diego are broke (can only afford Uhaul) while people moving to San Diego are better off (can afford movers)? Is the population in San Diego going down? If the population is actually decreasing then that is a very bad sign for the housing market.
D Max | June 8th, 2008 at 6:33 amYour comments "It was when Countrywide and Washington Mutual got greedy and pushed down the reset caps to 115% and five years that these loans became super-toxic." entirely miss the mark.
these lenders are not greedy, but are in fact underwriting more conservatively than world savings and the others that allow 125% and 10-year recast. exactly where is the more conservative lender extracting larger economic rents than the more liberal ones?
the only reason world savings had such good performance on its option-arm book is the borrowers never had to prove they could perform. moreover, this asset dependent loan was mostly made in a period of extended and siginificant home price appreciation. thus, anyone that ran into difficulty could sell.
many of these lenders will likely mitigate these by allowing the neg-am to grow to 125% and delaying the recast. all this will do is delay the day of loss recognition as household income will not grow sufficiently over the next five years and home prices at best will be flat.
surferdude | June 8th, 2008 at 4:05 pmentirely miss the mark.
I guess I didn’t make it clear.
You think having loans reset in 2-5 years is more conservative than 10 years?
I explained further up that the way these loans are designed is to allow for the minimum payment to catch up and hopefully surpass the fully-indexed payment, allowing for positive amortization. There’s a chance for that to happen over 10 years, doubtful in 2-5, especially with 1% start rates.
Jim the Realtor | June 8th, 2008 at 4:16 pm…UHaul doesn’t need trucks in SLC…they need them in SD…therefore, they lower the price for moves to SD so they don’t have to pay someone to drive the truck to San Diego….
the current pool of peopple moving out of state has dramatically decreased, because (1) retirees don’t want to sell at the decreased price (2) selling your home is more difficult due to the tight credit standards (3) corporations are finding it harder to induce a person to transfer when the individual may only be able to sell his home at a loss…
Consequently, the Uhaul business is booming as forced to move homesellers use the least expensive form of transportation…this is in contrast to the boom times of the 70′s 80′s and 2004 when sellers made so much money on the sale of their house that they could easily afford a full service mover….
in addition, if you move from SoCal to LV or PHX it’s cheaper to move in a UHaul and return the truck to SoCal and pickup your car and drive to your new home….the rising price of gas may adversely affect this low cost option…..but, I haven’t seen a rise in the Pro Mover moves to AZ or NV
Beaver | June 8th, 2008 at 4:20 pmfrom the lenders perspective, it is more conservative to only allow a minimal amount of neg-am and to require the borrower to demonstrate the capcity to repay. collateral and capacity are 2 of the 3 C’s of lending, with the third being character. btw, we are seeing the character of these borrowers as they "walk away" when the home does not appreciate they way they dreamed.
this product was reportedly devloped for high income or net worth individuals that had alternative places to earn a higher return elsewhere. alomst all of the anecdotes of indivicuals defaulting do not and will never have the ability to make the full amortizing payment as they were relying on appreciation to make a fast buck.
this product was used by many to speculate on a much higher priced home than they could afford. this product contributed greatly to the price bubble. for realtors, this was like manna from heaven as the price run-up should have greatly reduced the demand for homes. foolishly, lenders drank the kool-aid and thought home prices only went up and that homedebtors would do anything to keep their homes.
surferdude | June 8th, 2008 at 5:57 pmThis what happens when people buy houses as "investments" rather than as "home." All of the houses I’ve owned have been "home," the place I plan on living at least until retiremet, and during periods of downturn and unemployment, I sure did "anything" to keep my home. But all along I’ve cashed out "investments" that maxed out their profits, and dumped ones that lost money. You would think that companies in the finance business would know the difference between "investment" and home;" the people walking away from their losing "investments" certainly seem to.
GeneK | June 8th, 2008 at 7:25 pmRob – as far as I know, no one ever wrote any of these providing for recast if the home value dropped. It’s always based on the original loan.
MaxedOutMama | June 8th, 2008 at 8:23 pmJim–
You know your neg am ARMs! Congrats–there’s more accurate and solid info in your article than in 10 typical articles on the subject!
A few additional points:
World Savings has traditionally been quick to modify neg am ARMs for borrowers who get in trouble. They often were more careful in their appraisals too.
Neg am ARMs were started by California lenders in the early 1970s, when they wanted a product that matched their cost of funds. That’s why early neg ams were based on the 11th District Cost of Funds, as calculated for S&Ls in California and some adjacent states. This history, and the dominance of the huge California-bsed thrifts, caused this Western-oriented index to become the standard across the entire country.
As you know, for years, federal lenders weren’t allowed to offer neg am ARMs, but California enacted legislation that allowed it for state S&Ls. (The old neg am language is still "in the statute books.") Eventually, under pressure from federally regulated banks/thrifts, the feds surrendered!
Another factor that made lenders prefer ARMs: As oldtimers will recall, the federal Garn-St Germain act also helped achieve a compromise to "misguided liberal" court rulings that prevented lenders from enforcing due-on-sale provisions in fixed-rate loans. This stuck lenders "upside down" as interest rates rose, their low-interest loans stayed on the books longer than expected. In addition, banks and thrifts suffered disintermediation and were unable to attract and retain deposits when their hands were tied by Regulation Q and they couldn’t offer interest rates that could compete with newly emerging money market mutual funds.
Neg am ARMs (aka Pay-Option or Pick-a-Payment ARMs) can be good products. They can be made toxic, however, when the teaser period is shortened (it went from 6 to 12 months down to 1), when the teaser rate is ridiculously low, when the margin is too high, when higher lifecaps are used, when lower neg am limits are used (e.g., 110% vs. 125%), when a faster moving index is used, when the recast is shortened, and when the underwriting is weakened (e.g., when lower FICOs, higher LTVs/CLTVs, reduced documentation, higher qualifying ratios, etc. are used). Also, when these loans are securitized, the servicer loses much of its ability to modify troubled loans. Combine this with a price bubble, and disaster is inevitable.
For a long while, mortgage bankers could not compete with neg ams offererd by depository lenders, but the introduction of super-short teasers allowerd mortgage bankers and brokers to compete and increasingly move the product "downmarket."
Many lenders (e.g., WaMu et al.) are taking the initiative and unilaterally modifying many of their neg am ARMs into more stable products, hoping (in part) that inflation defers or eliminates the day of reckoning. But it may be too little, too late! (And let’s not forget that neg am levels are considered an asset on the books of many lenders.)
Another factor: Voracious Wall Street firms got in the game and distorted pricing, abetted by conflicted and mercenary rating agencies. They didn’t know or even care if the loans were toxic as long as they could rake in the money through their slicing/dicing.
76s | June 9th, 2008 at 2:25 amThanks 76s.
Remember back in the 80s and 90s when the big three were doing a margin of 2.35 over the 11th District COFI? That was a decent loan, one that I doubt you could get today.
Jim the Realtor | June 9th, 2008 at 4:34 amI am not sure if this is correct..but my understanding with these neg ams is that making the lowest tier payment results in acceleration to the correct monthly payment. In other words, if you contine to make a payment that defers interest you will not make it to the 5 year mark, but instead have 3.5 years. Is this correct? I have 2 friends who have the MTA loans from Countrywide one bought in 05 another in 07..both have been making the lowest tier payment on a million dollar note and defering interest…Their payments are at around $3900 a month…
Annie | June 29th, 2008 at 10:51 pm