This was the year thousands of U.S. homeowners with option adjustable-rate mortgages were supposed to default as their payments spiked. Low interest rates and a surge of early delinquencies mean the numbers probably won’t be as bad as forecast, softening the blow to a housing market where prices have resumed falling.
Monthly payments on option ARMs reset after an initial low- rate period, usually five years, and researchers at CoreLogic Inc. in Santa Ana, California, estimated in 2009 that such recasts would peak at 54,000 a month in August of this year. In a 2006 cover story in BusinessWeek magazine titled “Nightmare Mortgages,” George McCarthy, a housing economist at the Ford Foundation in New York, compared the looming resets to a neutron bomb.
“It’s going to kill all the people but leave the houses standing,” he said at the time.
What he and other analysts didn’t anticipate was that so many option ARMs would go bad before resetting, and that interest rates would stay low enough to minimize the impact of the adjustments on borrowers who are making their payments. Still, a model developed by JPMorgan Chase & Co. analysts predicts that 70 percent of remaining option-ARM loans that were bundled into bonds will eventually default.
About $600 billion of the loans were made from 2005 through 2007, according to industry newsletter Inside Mortgage Finance. Of those packaged into bonds, some 20 percent have been liquidated at losses to investors, and almost half of the remaining ones are at least 30 days delinquent, in foreclosure or have been seized by lenders, according to data from JPMorgan.
“It’s not that option ARMs weren’t a bad way to finance homes, it’s just that the disaster already happened before the resets,” McCarthy said in a telephone interview last week.
The prospect of fewer defaults is a plus for the housing market, which was burdened by 2.2 million foreclosed homes as of Dec. 31, according to data from Lender Processing Services Inc. in Jacksonville, Florida. The S&P/Case-Shiller index of home values in 20 cities fell 1.6 percent in November from a year earlier, the biggest decrease since December 2009, the group said Jan. 25. The gauge remains 30 percent below its 2006 high.
Lenders and servicers are seeking to limit losses by modifying loans. Terms on about 20 percent of option ARMs have been revised, sometimes with a switch to a fixed rate, said Michael Fratantoni, vice president of research at the Mortgage Bankers Association, a Washington-based trade group. JPMorgan, Bank of America Corp. and Wells Fargo & Co. hold the biggest portfolios of option ARMs.
About half of the loans issued from 2003 to 2007 remain outstanding, he said.
For the remaining homeowners, payment increases will be limited to 30 percent to 40 percent, Barclays Capital Inc. estimated in a Jan. 7 report. Some borrowers are seeing their bills go down, lenders including Bank of America say. Analysts a few years ago were forecasting that payments for some borrowers could double.
“Of the borrowers who are still paying, the recast will not be a big deal,” Fratantoni said. “It’s not at all what people anticipated.”
I agree that many, if not most, Option ARMS defaulted before the recast – indeed, many of the properties in foreclosure that I track are in that category and have been on and off and now back on the NOD and NTS lists since 2009. Many of those early defaults probably occurred because many of the Option ARMs have annual step ups in the minimum payment required, so the noose has been slowly tightening each year.
I disagree with the analysis that looks at interest rates as a saving factor, because almost all the pain in the Option ARM recast comes from the reamortization that occurs, forcing principal repayment on folks who have been paying less than just the interest amount for the past 5 years. And that principal amount is usually hundreds of thousands more than the original loan amount because of the negative amortization over the initial period of the loan (5 years in most cases I have seen).
It is my hope that such recasts deliver the coup de grace to those already in default or living on the bubble, because there is alot of high end inventory that was financed with these products. Bring on the inventory!
Also, just FYI, alot of the stuff in the chart labelled alt-a can also be option arm.
I’ll admit, I was deeply alarmed when option arms became the norm in coastal california, and yes, that was probably the biggest factor in the housing bubble, at least for LA, Ventura, Orange County, and much of SD county. Inland areas were more affected by the unprecedented access to credit, so they had different factors which had the most weight; although one could not have existed in a vacuum without the other. The bubble, after all, was a psychological phenomenon, not financial.
However, I am genuinely surprised at prices still being paid. Even at what I paid. But, it it SoCal, and affordability has returned in some measure. Supply is still a major issue, as demand is quite strong that I have seen.
Many of us underestimated just how low interest rates would go. That saved so many; even recasts became nonevents because we have generational low rates. I had no idea we’d have sub 4% rates. No idea.
Now that the media and analysts are concluding that option arms will not create a problem going forward, they will probably explode.
Hi Chuck-I am confused that 2 of your statements seem to contradict another:
“…option arms became the norm”, “…unprecedented access to credit”, “The bubble, after all, was a psychological phenomenon, not financial.” The last statement seems to contradict the first two.
Sorry, it’s a complex theory when you look at the details. A bubble is a psychological phenomenon. Credit and access to credit are enabling factors.
Access to ever increasing amounts of credit doesn’t mean that you’ll have a bubble. Belief that prices will continue to rise in an unprecedented fashion being the accepted norm does. When both bankers (those granting credit), and home buyers (those receiving credit) believe that prices will rise faster than the cost of the borrowing, you have a bubble. If either side does not believe that, you’ll have caution creep in, which is the hemlock to a financial bubble.
Note, for example, that the stock bubble of 2000 did not involve as much credit to stock buyers, and therefore less financial ruin to them. Venture capital firms, on the other hand…
Ever since I first became a homeowner in the 80’s I’ve been told by countless lenders and brokers that I “qualified” for loan amounts that far exceeded what I would ever feel comfortable about taking on. I’m sure I wasn’t the only one being told that. The psychological component of the bubble was massive numbers of people allowing what they were told they “qualified” for to overcome their common sense about what they could really afford.
I’m with Kingside.
We’ll know as soon as the word “contained” shows up 😉
It was those pick-a-pay loans that eventually would recast into a fully amortizing loan after 5 years and in Wacovia (i.e. WFC) case 10 year pick-a-pay loans that were going to be the problem of 2011-2012 (the minimum payment was a negative amortization payment and if you went to a fully amortizing loan even at today’s interest rates the payment would go up 50-100%). The assumption is the people in these products have already defaulted. Of course we don’t really know with any certainty if that is indeed true.
A neg am on a $500K loan was about $1700 per month and I can’t imagine a loan mod or the decision to walk away and rent something similar would be cheaper than just continuing to pay the minimum payment. The begs the question is there a bunch of this stuff out there that we just haven’t seen yet. I don’t know, but it might be worth keeping an eye on NOD numbers. They’ve been declining but if the assumption that people already defaulted is wrong then those NOD numbers should ramp up quite a bit throughout 2011. It is a bit interesting that in 2009 we were really worried about this possible problem down the road and now that we’re here we don’t seem to worry about it anymore.
Doesn’t the problem lay within all ARM products, not just Option ARMS? I thought there were a ton of ARMS out there with 3 or 5 year fixed rates that then reset annually or biannually to the prevailing index rate plus a margin, with an IO period of 10 years. In our low interest rate environment, these borrowers are enjoying rate resets below their initial fixed rates – this is very good for them. But when the 10 year IO period runs and the loans recast to include principle, and the index rate has also risen, this is very bad for them. And this is what is looming in 2014-2016.
Maybe there are not enough of these loans out there to make a big splash, but I thought there were an awful lot of them being inked back in ’04-’06.
I don’t think there were that many 10-year interest-only mortgages written.
In 2001-2004 when Countrywide was pushing them hard, everyone was going for the lowest rate, taking the 3, 5 and 7-year versions (mostly 3s and 5s).
In thr 2004-2007 era the neg-am option-arms were the rage, and IOs didn’t get much of a look.
That’s what I remember from the peak when I knew about 10 people in the mortgage business and they’re all gone now. It was either neg am or pick a pay with the minimum payment being the neg am option. It I remember right there was an incentive to put people in these products because they paid more fees to the mortgages brokers (they knew they had to be refinanced down the road and could generate more fees). It was really the only way people could service these loans month to month. You had people where the neg am option was probably close 50% of gross income in some cases and in a fully amortizing loan it might have been their entire monthly earnings.
Neg Am could probably fall into 3 categories in the chart. Option ARM, Alt-A, and possibly Unsercuritized ARM, but I don’t know what unsecuritized ARMs are. Unsercuritized ARMS might be a good bucket for neg-am or pick-a-pay. It would be hard to traunch off pick-a-pay because you don’t know what payment you’re going to get each month. Maybe these are off balance sheet at the big banks and they were hoping refinancing activity on these loans would allow them to securitize them later.
The loan-rep compensation was commensurate with the loan’s toxicity – the higher the margin, the bigger the spiff.
If I am correct, Wachovia and several others had a 10 year recast on their neg-am products. They reset every year, but they didnt’ start full amortization until year 10.
These were originally “doctor’s loans” so their income could rise enough to cover the fully amortizing payment, or for salespeople whose sales commissions were paid out a few times per year yet had high incomes.
Unfortunately, they were mass marketed to strawberry pickers and garage attendants.
But, as many have pointed out, many neg-am loans already imploded or are in default right now (free rent). Until it’s “contained”.
World Savings was the only lender left doing the 10-year recasts.
When WaMu bought Great Western and Home Savings (who also helped pioneer the neg-am) they changed from 10-year to 5-year recasts, and Countrywide copied them. The yields look much more attractive to investors when they anticiapte a big bump in income after year five.
They didn’t understand that the 10 year recast was the most critical component – it allows the initial minimum payment to rise gradually each year so the recast payment shock is minimal.
When they imposed the recast after five years, there would have been great payment shock if the interest rates hadn’t have come down.
I think there were a bulk of the neg-am defaulters who bailed just because they were scared off by the thought of payment shock, and really didn’t stop to understand it. Today people who are recasting after their fifth year are feeling very minimal increases.
Here’s a hypothetical Option ARM Neg Am.
You borrow $500K in 2006 and the neg am teaser payment is $1700. This neg am payment probably rises over time based on LIBOR but LIBOR been consistently low for quite some time so let’s just say you’re payment gets up to $2000 after 5 years. In those 5 years let’s assume you’ve added $50K to the loan balance. So in year 6 your loan payment goes from right around $2000 per month to
550K @ 5% for 25 years fully amortizing = $3215 or about a 50% increase. You don’t have any equity so you can’t refinance into a 30 year fixed at this point.
Doesn’t mean these people didn’t already default and take the free rent but once you start not paying the clock on the free rent program starts. I’m personally in the boat that these people probably already defaulted but based on rent values, the math says they should pay the neg am amount until the recast hits and then they should default if they are going to. Of course I’m not servicing neg am loans so I just don’t know.
I really think you should start your own blog, and live life to the fullest in your hypothetical world.
Because I’m going to start deleting your comments here.
I’m the guy who knows what he’s talking about, I lay out how it works, and you ignore it, jump on the soap box again, and pontificate, which I don’t mind, I’m just tired of seeing it here. It’s like you are trying to take over.
I’ve looked at whats in some of these trust pools of mortgages that back the securitized certificates (RMBS) and they have plenty of pick a pay option ARMs in them. It was part of the ploy to hide the garbage amongst less risky loan types and pawn it off while making more fees on the underwriting and issuance and CDOS hedging.
I’ll add – the reason I don’t like it is because there are people who come here to gain insight, and when your hypotheticals are wrong, it gives them inaccurate data. I don’t want people to think the sky is falling because livinincali thinks the neg-ams are going up $1,000 per month at recasts. It’s not true.
I think you run a nice blog here and if you view my comments as fear mongering or doom and gloom than I apologize. I’ll refrain from commenting anything that might be questioning or negative. Like you said we haven’t seen any significant signs of increasing NODs or Foreclosure numbers recently so it’s probably a non issue.
Jim – love your site. Only wish I had known you 5 years ago. I have been lurking on this site for the past 9 months or so and this is my first comment. We bought our home at the height of the market (to the day I think) in October 2005 after selling our condo. We got one of these option ARM loans and thought the idea of a flexible payment was great since I am in sales and monthly income could vary quiet a bit. We had the loan for about 4 1/2 years and looking over the monthly statements our minimum payment varied from about $1950 per month to about $2600 while the interest only payment went from $2700 to $3600.
Thankfully we only had to pay the minimum a few times and actually paid down some of the principal in that time. I will say this, in that fourth year almost half of our minimum payment (which was now greater then the interest only option) was going towards principle.
For people who did not buy too much house and could afford the payments, this loan is not a terrible way to go. Now if you go into knowing that you can only afford the neg-am option then that is asking for trouble.
A big benefit of the neg-am, when rates go down you win. But agreed, they’re only good for those who can handle them though.
How did you find us; are you thinking of moving?