Pay Option ARMS: A Ticking Time-bomb?"

Article by Joe Chatham, President, Chatham Street Mortgage Services ( http://www.glgroup.com/Council-Member/Joseph-Chatham-138496.html )

Pay Option ARM’s: A Ticking Time-bomb?

As this article states, the past few months have seen a literal implosion of the sub-prime lending markets. New Century, Fremont, ResMAE, Ameriquest, OwnIt, Encore, and Option One are only a few of the well-known companies whose subprime lending divisions are either dead or on life support. If not for opportunistic investment firms acquiring some lenders or providing greatly needed infusions of cash, and if not for some lenders seriously curtailing their lending practices, we may have witnessed the death of the industry as we know it. It will take some time before we see it arise from it's own ashes, but it will. There is simply too much money to be made with good subprime loans. In the meantime, the originators on the street will tell you that despite ample subprime originations and despite lenders advertising subprime lending, there is nobody out there actually funding the loans...at least the ones that NEED to be funded. Higher underwriting standards, fear, and values may eliminate 10-15% of the buying/refinancing public from the mortgage markets. Until underwriting equilibrium is reached, regulatory bodies satisfied, public confidence restored and values stabilized we will witness a virtual halt in subprime lending. Despite the scary prospects of the aforementioned, there may be a larger problem looming in the background: Pay-Option ARM’s.
The Pay-Option ARM was formerly known as the “Neg Am” loan. Any first-year marketing executive on Madison Avenue can tell you that anything starting with “negative” is not positive. The industry threw some make-up on an old pig and renamed it the “Pay-Option ARM.” In the past five years one would have thought that a new product was invented which allowed a client to buy a million dollar home and have the payment of a $400,000.00 home! The Pay-Option solution was, and is, particularly attractive given the soaring housing prices, the need for flexibility, and consumers’ need to further charge-up their unsecured credit debt (tongue-in-cheek)! The Pay-Option allows many borrowers to do all the above and more! As long as homes are appreciating at a double-digit clip every year, the self-styled arbitrageurs are winning…as are developers, mortgage lenders, brokers, and the overall real estate markets.
The only catch is that you will owe up to 125% of your original balance. Wow! Option ARM's are Negative Amortization loans!
The risk of owing more than you borrowed is fine if the borrower understands the risk, is in an appreciating market, can afford the “re-cast” payment, and has the stomach to watch the negative amortization happen month-to-month.
Unfortunately, many of the aforementioned qualities of the ideal neg am borrower (oops, there I go again!), the Pay-Option borrower, are not present on the loans written in the past several years. Lenders, brokers, and Realtors were selling a panacea to the high priced real estate markets; buy a high priced home and have low payments! Unfortunately, there were many unqualified buyers.
The Pay-Option ARM actually offers great solutions for the appropriate borrowers: borrowers whose incomes vary month-to-month, borrowers with income properties, savvy investors, etc. The Pay-Option is actually one of the best loans on the market (I have it on all my properties!), but the way it has been marketed is wrong. Thus, the Pay-Option lenders may be sitting on a time-bomb that’s ready to blow if a number of variables line up: unqualified borrowers, high ( C)LTV loans, depreciating real estate values, and rapid or low re-casts (ie: FED’s 110%).
There is hope, however! Given that most re-casts are at about five years, many borrowers from Q3/Q4 of 2002 through Q2 of 2005 may have the appreciation to get refinance into another loan. The borrowers after Q2 of 2005 may be able to sit out the current real estate “correction”. After all, they should not re-cast until 2010 or 2011. Let us hope, for all of our sakes, that real estate values have bottomed-out (doubtful), that the MTA/LIBOR/COFI/CODI have seen their highs (maybe), that the non-sophisticated neg am borrowers (let’s call it what it is!) will start earning what they falsely claimed (hopefully), and that these same borrowers will start saving (not a chance in hell). Oh well, I guess we may be in this for a while. To be continued…