Step right up folks. You say you want to buy a home but have no money. You say monthly payments are unaffordable but you want to buy anyway. Well don’t worry about a thing. You’ve got a friend in the business. Let me introduce you to the option ARM, an affordability mortgage product that can get you into the home of your dreams….
Of all the mortgage ideas developed during the past few years, none tops the option ARM for sheer awfulness. And now the mortgage mess is about to get far worse as millions of option ARMs begin to recast. Not “reset” — but recast.
Fitch Ratings says in a just-issued report that option ARMs worth $200 billion are now outstanding. Among these loans, Fitch expects roughly $29 billion to recast by the end of 2009 and an additional $67 billion to recast in 2010 — that’s almost half of all the option loans now held by lenders. (See: “Option ARMs, It’s Later Than It Seems,” September 2008.)
The problem is what happens when required monthly payments change. According to Fitch “the potential average payment increase on this recasting population is 63 percent, representing on average an additional $1,053 due each month on top of the current average payment of $1,672.”
You don’t have to be a math major to figure out what will happen next: Huge numbers of option ARMs will fail in the next 24 to 30 months with results that will be devastating to borrowers, loan portfolios and local home values.
How They Work
Formally known as “payment option adjustable rate mortgages,” option ARMs are the most complex residential loan products ever offered. In brief terms, they work like this:
A borrower wants a $500,000 mortgage and gets an option ARM. Each month for the first five years of the loan the borrower can make one of four payment choices each month:
- Pay the loan on a 30-year self-amortizing basis just like a traditional mortgage. The monthly cost for principal and interest at 6.5 percent would be $3,160. Taxes and insurance are extra
- Pay the loan on a 15-year self-amortizing basis. While the mortgage would be repaid in half the time when compared with a 30-year loan, the monthly cost for principal and interest would rise to $4,356.
- Rather than amortizing the loan — reducing the debt with each payment — option ARMs allow borrowers to make interest-only payments during the start period. At 6.5 percent, the interest-only monthly payment falls to $2,708.
- Lastly, we have the real attraction of option ARMs, the option payment itself, a payment which is insufficient to even pay off the monthly interest cost. How much? About $1,325 a month when calculated on a 40-year basis. Huh? Why look at 40 years and not 30? Because Fitch says that a 40-year loan term represented 4 percent of all option ARMs in 2004 — but 38 percent by 2007.
A loan with four payment options may seem fairly understandable, but in the real world a lot of borrowers did not take out option ARMs because they wanted to make fully-amortizing payments. They took out such loans because they could borrow $500,000 at $1,325 a month instead of $3,160. The ability to afford a bigger mortgage also meant the ability to buy a bigger and better house. For option ARMs originated in 2006 and 2007 LoanPerformance says that 85 percent of all borrowers are paying no more than the minimum monthly payment (MMP), according to Fitch.
Not only are option ARMs highly affordable in terms of initial monthly payments, lenders made such loans enormously attractive. For instance, to reduce down payment requirements borrowers could buy with “piggyback” financing, deals with a first loan equal to 80 percent of the purchase price and a second loan equal to 10 percent, 15 percent and even 20 percent of the sale value. In other words, with an option-ARM and piggyback financing you could buy a home with little or nothing down and sharply discounted monthly costs.
And that’s not all. You could get your option ARM or your piggyback deal with a stated-income loan application, an application where you estimated your monthly income and the lender generally did not check your figures. A report by Credit Suisse showed that 49 percent of all ALT-A mortgages — the loan category that includes option ARMs — were made with stated income loan applications. (See: “Mortgage Liquidity du Jour: Underestimated No More,” March 2007.)
“Option ARMs only provide borrowers with these payment options for a finite timeframe,” explained Credit Suisse in its 2007 study, “which sets the stage for a significant payment shock when payments are recast to the fully amortizing rate at the current interest rate level. Depending on the amount and terms of the loan, monthly payments could increase in excess of 40% upon rate reset on these types of mortgages.”
But, as they say on late night television, there’s more.
Resetting Versus Recasting
As the expression goes, all good things must come to an end and so it is with option ARM low payments up front. But many borrowers — and many lenders — were not worried about higher future costs because they expected real estate prices to rise. With higher home values properties could be readily sold or refinanced with little risk.
The obvious flaw in this thinking is that commodity prices do not eternally go up — just look at oil pricing during the past six months.
Even if home prices flattened or fell, borrowers and lenders were not too worried — at least initially. The reason was that the market would have five years to appreciate before start periods ended and higher payments were likely. Surely in five years prices would increase enough to make option ARMs work out.
Unfortunately — and here’s where the big “whoops” is now emerging — it turns out that option ARM payments can rise in less than five years.
The rules for option ARMs often say that when the loan balance grows to 110 percent of the original debt the loan must then be recast. When a loan is “recast” annual payment caps — usually 7.5 percent per year — do no apply.
Combine minimum monthly payments with negative amortization and recasting when loan balances reach 110 percent and the result is that the monthly payment is increased immediately — not after five years. For a lot of borrowers recasting can mean a jump in monthly payments of $1,000 or more.
How soon? In the case of 40-year option ARMs issued in 2005, Fitch says such loans can recast after 28 months — a little more than two years if a borrower makes only minimum monthly payments.
“Option ARMs are really an odd form of mortgage roulette,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the largest U.S. source of foreclosure listings and data. “With real roulette when gamblers lose the house wins. With option ARMs when borrowers lose the lender is also in trouble.
“What’s most difficult about option ARMs is that they’re virtually impossible to refinance once home values fall. This is a problem for borrowers, but it’s also a problem for lenders and mortgage investors who want to avoid foreclosures. In the end, the most likely solution will be loan modifications, new deals between option ARM borrowers and investors to avoid foreclosure sales and massive losses.”
Why Option ARMs?
Given the inherent flaws and risks associated with option ARMs the question has to be asked: Why did lenders offer such financing?
The answer falls into two categories: money and regulation.
More people could qualify to buy a home with option ARMs. More people could get bigger loans. More loans and bigger loans meant more profits for loan officers, more volume was good for quarterly reports and good quarterly reports where good for share values and executive bonuses. As to negative amortization, accounting rules treat such increased borrower debt as lender “income” — even though it has not been collected and may never be collected.
There is also the matter of regulation. The Federal Reserve could have eliminated option ARM financing by simply declaring that such loans were “unfair” under section 129(1) of the Home Ownership and Equity Protection Act, legislation which has been in place since 1994. Instead, such loans were never banned or limited.
The result of option ARMs will be a huge number of foreclosures, a result which is not surprising, not unexpected and not unforeseen.
“In the next two to four years we’ll see elective payments end for many option loans,” I wrote in 2005. “Then we’ll find out who should not have bought and who should not have loaned. Don’t be surprised if a lot of cheap real estate floods the market — and don’t be shocked if the value of your home is impacted as a result. As to lender share prices and dividends, how attractive will such companies appear when huge numbers of loans are unpaid, especially if in many cases the size of the debt exceeds the value of the underlying properties?
“Alternatively, if we restrict option loans now by regulation or lender choice, the pool of buyers will shrink and home prices will be under far less pressure to go up. We will see less appreciation and even price declines in some local markets. Acting now we may face moderate and tolerable declines in market activity, an opportunity which should not be ignored in the face of the financial calamity which looms ahead.”