May 31

Option ARM Defaults Looming On the Horizon

Posted by Kristjan Velbri | Posted in Finance, Personal Finance | Posted on 31-05-2009

The financial media would have us believe that the economy is about to recover and things will sooner, rather than later, return to normal. Aided with billions of taxpayers’ money, the banks seem to be doing fine, that is, of course, if you consider a profit made by changing accounting rules ‘doing fine’. The markets have recovered some 35% since the lows reached in March this year. The politicians assure us that now that the stimulus money is entering the economy, things will return to normal and the happy days are back. But they are not telling the whole story.

Even though the leading indicators have turned up and there is talk about a recovery, there are mortgages worth billions of dollars that will be reset in the coming years. Remember the subprime crisis? Well, this thing is even bigger than that. I am talking about option ARMs (Adjustable Rate Mortgage). First, in the name of clarity, here is an explanation of the term:

The loan carries and adjustable interest rate, and this rate can adjust as often as every month. If the borrower is paying only the minimum payment, then he or she isn’t even paying enough to cover that month’s interest on the loan. What happens then? The unpaid interest that has accrued is added to the loan principal. The principal can actually grow larger, and as interest due is calculated on the loan principal, the interest due will increase, as well. Interest rates are currently near all-time lows and are sure to increase. A buyer who continues to make minimum payments on an option ARM will find that the principal on the loan is actually increasing over time! This is known as negative amortization.

In a negative amortization situation, only bad things can happen. The lender can require refinancing under certain conditions stated in the loan agreement. The buyer may find himself unable to pay the loan and may have to default. And the lender could find himself holding a note that is worth far more than the house that it represents.

The option ARM is a loan that is best suited to investors and homeowners who only intend to keep the home for a short time. It is not a good choice for anyone who may be using it to buy more home than he or she can afford. Unfortunately, that describes a lot of buyers who are taking out this type of loan. Anyone who is considering a home purchase should be very careful if this type of loan is offered, as it could leave you both bankrupt and homeless.[source]

Resets and defaults:

All of these loans are scheduled to reset over the next few years if they are still outstanding (ie – have not defaulted). Unfortunately, most of these homeowners cannot qualify for traditional 15 or 30 year mortgages. That’s too bad since today’s mortgage rates are below 5% in some parts of the country. The bottom line is that many of these option ARMs are going to default, especially given that home prices continue to slump – down a record 19% in the 1Q alone.[source]

For these loans, resetting will mean a sudden, large increase in montly mortgage payments. Given ever-rising unemployment, wage cuts and a drop in consumer spending, it’s difficult to see why many of those mortgages will go into foreclosure. The problem with option ARMs is that these were not only written out to people with no income or to finance houses that were on the other side of the road, so to speak. These mortgages were written out to ninjas (people with No Income No Job and no Assets) and middle-class people alike. Here is a good example of a typical option ARM mortgage from California (visit the Dr. Housing Bubble link below to get the full story). Below is a chart of option ARM resets.

Massive option ARM defaults on the way

  1. Defaults will start picking up pace in the second half of 2009. Resets at $2 to $4 B a month.
  2. More defaults as resets near $8 billion a month throughout 2010.
  3. Resets over $10 billion a month! Street riots in 2011?
  4. Resets fall but there is still a lot of pain as even more houses come on the market. Resets at around $6 to $8 billion per month throughout first half of 2012.

In March, the home mortgage foreclosure rate surged to 46% from a year ago, hitting a record high. Home prices dropped a record 19% in the first quarter of 2009, while 5.4 million Americans are delinquent on their mortgages or already in foreclosure. All in all, 20 million American households are now underwater, as their their mortgage loans are larger than the price of their homes.

The current recession started when the housing bubble burst. Lehman went under, many were bought and many received a bailout from the taxpayers. But the preceding crisis was mostly focused on subprime mortgages. This is way bigger than that! Actually, if you consider not only option ARMs, but also Alt-A mortgages and unsecuritized ARMs, the situation is much, much worse. (Alt-As are loans to the folks who are a small step up from subprime. Unsecuritized loans are a 50-50 proposition; either the borrowers were good enough that they weren’t thrown into the CDS pool, or they were so risky no one would insure them. (source)

Mortgages - Credit Suisse

Take a few minutes to figure this chart out, as it will determine the policy of the White House, the FED, the Treasrury and foreign debt holders for years to come. This will also have major implications for the stock markets as the green shoots will turn out to be nothing but an illusion.

If you would like to read a more detailed article about the mother of all bombs that is the continuing mortgages crisis, here is an article by Doctor Housing Bubble. You might also want to read what a foreclosure actually looks like. You’ve probably heard about foreclosures happening all over America, but these stories don’t get told in detail. This one did.

In addition to that, old-fashioned loans are going bad as well: Troubled Bank Loans Hit a Record High

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Comments (5)

[...] the previous post, Option ARM Defaults Looming On the Horizon, I gave a summarized overview of why the mortgage market will witness another crash, even more [...]

This is a great article. I have to keep the following in mind going forward during my trading

1. Defaults will start picking up pace in the second half of 2009. Resets at $2 to $4 B a month.
2. More defaults as resets near $8 billion a month throughout 2010.
3. Resets over $10 billion a month! Street riots in 2011?
4. Resets fall but there is still a lot of pain as even more houses come on the market. Resets at around $6 to $8 billion per month throughout first half of 2012.

You know what, in order to grasp the severity of the option ARM situation you should visit Dr Housing Bubble’s website. He is really a specialist on the topic.

[...] Waiting in line to be foreclosed are the Alt-A and Option ARM mortgages, which will hit the market so hard that they will send the ‘all-is-fine-and-we’re-gonna-have-a-real-estate-recovery-soon’ guys down the drain with their already tarnished reputations. Of course, the politicians have yet again tried to outsmart the housing market with a new law, the California Foreclosure Prevention Act. The new law, which is already in effect, puts a 90-day moratorium on all new foreclosures. This is insanity! But it’s also one of the things that’s keeping the housing market from further descent, as there are already 4 million homes on the market, with another million waiting on the sidelines. Make no mistake, there is nothing good about it – the moratorium might put a floor under the housing market for some time, but it will be a failure in the long term (since it’s an artificial floor), as those houses will eventually find their way on the market, further suppressing prices. For a more in depth look at the new law, see Dr. Housing Bubble. As of right now, the option ARM reset schedule looks like this: [...]

[...] imply that these people have gotten their houses back or purchased new homes. If you figure in the massive Alt-A mortgages that are about to be reset in the coming quarters then the picture turns really, really bleak. Recovery? No [...]