Round II: Coming to a Neighborhood Near You

Summary:

While a very general description of the Pay Option ARM disaster that is looming, the Reuters article is dead-on in two conclusions: many more homes will be hitting the market over the course of the next two and one-half years and that the mortgage plague that started with the subprime crisis will be moving from the lower income strata to the middle and higher income areas.
Analysis

Iowa AG Tom Miller is correct in his assessment of the Pay Option ARM crisis. The crisis is not looming; it is here. As I have written and consulted on numerous occasions in the past, we have entered a period of re-cast hell. The Pay Option ARM, a loan that offers the borrower the flexibility of up to four payment options, was the product du jour for the years 2004, 2005, and 2006. While I think the Pay Option ARM is a terrific product for the right borrower, it has been abused. I have heard varying numbers regarding the dollar amount of outstanding Pay Option ARM's written in those three years, but I think it is safe to say, in total, there was about $500,000,000,000 lent under this program. According to Fitch Ratings, 80% od Option Arm borrowers pay the negatively amortizing payment option! So, this means that approximately $400,000,000,000 worth of loans will negatively amortize (turn upside-down) up to 125% of the original loan amounts, or BACK to $500,000,000,000! The problem is, of course, that the underlying value of the security backing these loans (residential real estate) has dropped anywhere from 25-50%! Most of these loans were written at 80% LTV. Thus, taking into account the negative amortization and depreciation, borrowers will owe 133% LTV, conservatively. I know quoting "The Clash" is not professional for my esteemed readers, but I can't find a more appropriate line: "Should I stay or should I go now? If I go there will be trouble. If I stay it will be double".

The typical recast allows the borrower to go to 125% OR five years, whichever occurs first. Given the low rates over the past five years, and given that most of the Pay Option ARM's are based on either Libor or MTA, most of the loans are triggering the recast feature at five year benchmark. Despite the knowledge of many of the borrowers that they will not be able to afford their recasted payment, they are sitting in their properties as long as possible taking advantage of the minimum payment option, tax benefits, and keeping a roof over their heads. The Pay Option ARM, it appears, offers a fifth feature: delayed accountability for both the borrowers and the lenders! The problem is that time is running out over the next two and one-half years; both borrowers and lenders must finally ante up.

Recasts are now being triggered from 2004. The article states that $389,000,000,000 worth of loans was written in 2004 and 2005. While I cannot find the source to show the average loan size, let's divide that number a reasonable average home loan of about $260,000, or 1,496,000 homes, and we have a lot of homeowners facing some huge payment jumps between now and the end of 2010. While I have heard varying numbers regarding the default rate on these loans (it is a bit too early to have accurate info), but let's be real conservative and estimate that 25 percent default, or 374,000 foreclosures/short-sales added to an already bulging inventory (9-15 months, depending on the area). I have heard some claim default rates as high as 40%. Do I hear the sound of prices dropping more?!

Up until now, the lenders have not had to acknowledge these bad loans. In the past, lenders have taken advantage of accounting rules that allow them to claim the fully amortizing payments instead of the minimum payments. Only now, will they have to start showing the loans that are starting to default. It will be ugly. Perhaps acknowledgement of the problems will come in the form of active and real loss mitigation efforts: reducing loan amounts, extended terms, lower rates, etc.

I will not bore you with the reasons these loans were mostly given to middle and upper income borrowers except to say that underwriting did, in fact, require decent credit scores and, given the low payments this program afforded, these loans tended to be loaned on higher-valued properties. Thus, we will see the creep of defaulted loans from the economically challenged areas to the more affluent areas, resulting in lower prices, more foreclosures, lower prices, more foreclosures, etc., etc.

In my past writing and musings I have used different figures, but the figures are only starting to roll in. My doomsdaying is a work in progress and will be amended as I gather new info. Please keep in mind, I am not ordinarily bearish; it only hurts my business if I am correct. Indeed, I hope I am wrong. I can assure the readers, however, that I have remained relatively conservative.

Joe Chatham
President
Chatham Mortgage Partners Inc.
805-496-3000 x1