Friday, October 26, 2007
the next housing disaster: pay-option arms
These loans are known as option adjustable-rate mortgages, or option ARMs. They typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow -- a phenomenon known as "negative amortization."
An analysis prepared for The Wall Street Journal by UBS AG shows that 3.55% of option ARMs originated by Countrywide in 2006 and packaged into securities sold to investors are at least 60 days past due. That compares with an average option-ARM delinquency rate of 2.56% for the industry as a whole and is the highest of six companies analyzed by UBS.
The increase in overdue payments partly reflects a decline in home prices in much of the U.S., which has made it more difficult for borrowers to refinance or sell their homes. In addition, at Countrywide, "they were giving these loans to riskier and riskier borrowers," says UBS analyst Shumin Li.
Among option ARMs held in its own portfolio, 5.7% were at least 30 days past due as of June 30, the measure Countrywide uses. That's up from 1.6% a year earlier. Countrywide held $27.8 billion of option ARMs as of June 30, accounting for about 41% of the loans held as investments by its savings bank. An additional $122 billion have been packaged into securities sold to investors, according to UBS.
The deteriorating performance of option ARMs is evidence that lax underwriting that led to problems in subprime loans is showing up in the prime market, where defaults typically are minimal. Challenges could grow, as from 2009 to 2011, monthly payments on some $229 billion of option ARMs will be adjusted to include market-rate interest and principal, according to Moody's Economy.com.
It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS.
read that again: $230bn in option arms, with 4 in 5 negatively amortizing -- meaning the $230bn figure is actually growing as the months go by -- with rate resets beginning in 2009 and hitting hard by 2010. here's the new rate reset chart being circulated by credit suisse, showing option arms explicitly.
and it is further worth noting that these loans are already defaulting at record rates -- well prior to any rate resets. once resets start, the effect is likely to be devastating.
more at housing wire as well.
first thought: it would seem to me that a lull in foreclosure pressure is likely as the subprime 2/28 resets roll off in 2009, and that the market may experience a revival of sorts in and just after that period. but 2010 and 2011 will see another, perhaps more vicious wave of housing supply. that may extend the cyclical forecast i made here, adding inventory and supply out into 2011, meaning the market may not clear and prices bottom until 2012 or 2013. mish thinks it could be longer still.
UPDATE: again via mish, there are many millions of currently vacant homes that will be entering the supply chain in coming months. this is evidence of fairly severe overbuilding, and if much of it is in fact reo then the effect on pricing is going to be dramatic.
second thought: countrywide, a major purveyor of pay-option arms, is on its way to bankruptcy by 2010, if it can stave it off even half that long.
UPDATE: russ winter notes that, while the chart above notes the rate resets in time correctly, there is a second condition that can trigger negatively-amortizing (that is, 4 in 5) option arms (or OA's) to reset to a normal amortization schedule.
Finally comes what I feel is the flaw in the analysis of pay option mortgages. There are two conditions that cause the neutron bomb recasts to regular amortization. One is the term, and CR mentions this. Most pay option ARMs have 3 and 5 year reset periods, only a few are less.Less than 10% of Alt-A ARMs in 2005-2006 had an initial fixed period of less than 3 years.
So this gives the appearance that the problem is deferred to 2009-2011. I don’t follow the logic behind the pay option part of this chart at all, as both 3 years and 110% clauses are due to recast in the immediate period ahead.
However there is another condition that triggers the neutron bomb. That happens when the negative amortization caused by paying only 3-4% interest rates against the fully indexed and margined rate of 7-8% hits either 110% or 115% of the initial loan amount. The big data point I’m seeking and have searched for a year, is the percentage of Option Arms that uses 110%. In the case of 110% clauses, an aggressive neg am debtor will neutron bomb him or herself well before 3 years into the loan period.
so some -- probably a significant percentage -- of these negatively-amortizing option arms are going to jump forward on the reset chart to fill the 2009 gap i noted above.