We've had a ton of people writing to us to ask about how the new Bush Plan (Hope Now) will affect Pay Option ARMs. It would appear based on the eligibility requirements that Option ARMs ARE included in Hope Now (despite initial reports that they were NOT included). It is unclear on how to freeze rates on these loans due to the negative amortization aspect. Hope Now loans must meet the following tests:
Many initial reports interpreted "SubPrime" as separate and distinct from the actual Option ARM product because Option ARMs were generally considered A or Alt-A paper. Option ARMs are even more risky as they generally involve all categories of borrowers and home values. Option ARMs were especially popular in California (A big state for CountryWide loans). Almost all the big lenders hold and originated a large amount of these loans - Wamu, Wachovia, IndyMac, Downey and Bear Stearns all hold inventory in Option ARMs.
These loans are now impossible to transfer on the back end. The loan was oversold to borrowers because of the extradorinary commissions attached to the loan during the boom. Almost all of these loans are currently in Negative Amortization as 80% of Option ARM borrowers make the minimum monthly payment. Even worse, another 80% were no documentation or minimal documentation loans. With home prices dropping, the average combined loan-to-value on these loans is 90% or greater.
These loans have even more Payment Shock than the 2/28s and 3/27s that are at the core of the Subprime Crisis. These loans offer small PAYMENTS, but the actual RATES are often higher thus increasing the actual loan balance over time. The crux of the matter is that each loan has a MAXIMUM NEGAGIVE BALANCE built in that is specified in the Note as a percentage of the original loan balance. Usually, this amount is 110%, 115% or 125%.
These loans literally explode when they hit that threshold (called a "recast" or "recasting"). When they hit, the payments become fully amortizing at the higher-than-market -ate over a shorter loan term! It's not uncommon for payments to double under this scenario. Thus, borrowers have no choice but foreclosure. They cannot refinance, because comparable programs no longer even exist and - with appraisals dropping so much - borrowers cannot qualify for conventional financing.
Don’t expect lenders to freeze rates at the crazy low introductory rates and lose money. The best plan we’ve seen put forward for these loans is:
If the borrower can’t make payments at 5.25% on their current loan balance (sorry – going back to the original loan balance and forgiving the interest simply isn’t going to happen).
Clearly, the greatest risk to the economy is the Pay Option ARM. The question is whether the HOPE NOW plan will be enough to accomodate these borrowers. Unfortunately, most of the data indicates that these loans will start exploding in July 2008 and continue for at least 18 months. Let's hope the word gets out and these people find help fast!
...or there will be a lot of vacant homes in California.
(for those who asked)
Now that the rock has been kicked over on the mortgage market, many people are questioning the accounting aspects of Option ARMs. Here’s the skinny:
Lenders can recognize the deferred interest on these loans as immediate income. This means that Joe Borrower who makes a minimum payment of let’s say, “$2400” but his Interest Only Payment (due to the crazy indices on these loans) is $4200. Even though the lender only gets a check for $2400 in the mail, they record the entire $4200 as income. WHOA! Yes, it’s true. Check this snippet from Bloomberg:
To see why even $1.3 billion in provisions looks light, consider Washington Mutual's $57.86 billion of so-called option- ARM loans, which make up 24 percent of Washington Mutual's loan portfolio. These adjustable-rate mortgages were popular during the housing bubble, because they give customers the option of postponing interest payments, which the lender then adds to their principal balances.
As of Sept. 30, the unpaid principal balance on Washington Mutual's option ARMs exceeded the loans' original principal amount by $1.5 billion, meaning the customers owed $1.5 billion more in principal than what they originally borrowed. By comparison, that figure was $681 million a year earlier, when Washington Mutual had $67.14 billion, or 16 percent more, option ARMs on its books.
Look to the end of 2005, and the trend becomes even starker. Back then, Washington Mutual had even more option ARMs on its balance sheet, at $71.2 billion. Yet the unpaid principal balance exceeded the original principal amount by only $160 million -- and that was up from a mere $11 million at the end of 2004.
Deferring Pain
The deferred interest from option ARMs also boosts Washington Mutual's earnings, part of a process known as negative amortization, or ``neg-am.'' That's because option-ARM lenders recognize interest income when customers postpone their interest payments, even though the lenders got no cash.
For the nine months ended Sept. 30, Washington Mutual recognized $1.05 billion in earnings as a result of neg-am within its option-ARM portfolio. That represented 7.2 percent of Washington Mutual's $14.61 billion of total interest income year-to-date. By comparison, neg-am contributed 1.8 percent of Washington Mutual's interest income for all of 2005 and just 0.2 percent for 2004.
What's going on here? Either the borrowers postponing their interest payments are doing so as a matter of choice, by and large, or they can't afford to pay them. Common sense suggests it's the latter -- and that there's serious doubt Washington Mutual ever will collect the $1.5 billion of postponed interest that its option-ARM customers have added to their original principal balances.