Option ARMs: The New Foreclosure Menace

It used to be that few people had ever heard of something called “mortgage recasting,” but now this term is likely to become very well known, and not in a good way.

Fitch Ratings said that during the next two years option ARMs worth $134 billion will be recast. If a typical option ARM had an original balance of $200,000 then we’re talking about 670,000 property owners who are likely to face serious trouble. Many, if not most, will be foreclosed. Large numbers of lost homes will be added to the inventory of bank-owned properties, an inventory which holds down local real estate values in most communities.

The odd thing is that recasting was originally a consumer protection designed to prevent balloon payments. Unfortunately, like much else associated with recent “affordability” loan products, this is a case where something which made sense originally has been twisted beyond recognition.

When borrowers sought ARMs in the past they generally paid little or no attention to the subject of recasting. No lender advertised their great recasting deals and few mortgage commentators have had much to say about the subject because with traditional ARMs recasting was rarely a problem.

Okay, so what’s recasting and why should borrowers care?

With traditional ARMs borrowers obtained financing where the monthly payment could change, depending on whether an “index” such as U.S. Treasury securities moved up or down. To make sure that the loan would be repaid in 30 years and that there would be no balloon payment, most traditional ARMs recast every five years.

Let’s say that your payment in year five is $1,000 per month. Let’s also say that after year five the loan will have 25 remaining years and that to repay the loan at the then-current interest rate you’ll have to make payments of $1,200 per month. At the start of year six the loan payments will go to $1,200 regardless of the interest rate or payment caps because recasting supersedes all loan caps.

Recasting also works the other way. If you’ve been prepaying your loan, then at the start of year six your required payment might be only $900. Again, regardless of interest rate or payment caps your monthly cost would be based on recasting.

Because interest rates have largely been declining since the 1990s, few borrowers with traditional ARMs faced higher costs as a result of recasting. Many, in fact, saw monthly costs drop.

During the past few years, starting perhaps in 2002 and 2003, a new form of financing slowly entered the marketplace.

Option ARMs allowed borrowers to get mortgages and make initial monthly payments which were less than even the cost of interest. The interest not paid was added to the loan balance — a process called negative amortization. Such start rates often lasted for three, five, seven or even ten years.

Lenders also changed the interest rate cap system. Instead of annual and lifetime caps, say 2 percent annually and as much as 6 percent over the life of the loan — 2/6 caps — lenders now went to a system with three caps for “nontraditional” loan products.

Under the new system there was an annual cap (say 2 percent), a lifetime cap (6 percent) and a re-set cap (also 6 percent). Now the caps were described as 2/6/6, meaning that borrowers with a 4-percent start rate could instantly go to 10 percent once the up-front teaser period ended and the loan re-set.

If you combine negative amortization with a huge re-set cap then you can see what happens when start periods end: The debt owed to the lender increases, the time remaining to repay the loan is shorter and the monthly payment can rise significantly as soon as the start period ends.

How much? Speaking in 2005, Comptroller of the Currency John C. Dugan said typical option-ARM mortgage borrowers could see payments rise 50 percent. In some cases, said Dugan, required payments could double.

Fitch Ratings reported in September 2008 that “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.”
A lot of households don’t happen to have an extra $1,000 a month for mortgage payments. In such situations the usual solution would be to sell the property, but with negative amortization the loan balance has grown while in today’s market most home values have shrunk. Unable to stay, unable to sell, many option ARM borrowers face a bleak financial future.

Speedy Recasting
To make matters worse, newly-minted option ARMs had other features which made them especially toxic.

     • They routinely required little or nothing down.

     • Borrowers could often apply for such financing with stated-income loan applications where their income would not be checked by lenders.

     • Many option ARMs had 40-year loan terms rather than 30-year terms.

     • Option ARMs had two forms of recasting — recasting every five years and recasting when the loan amount increased to 110 percent, 115 percent or 125 percent of the original mortgage balance as a result of negative amortization.

If you combine a longer loan term with negative amortization and recasting once the debt reaches 110 percent of the original loan balance, then a borrower who makes only minimal monthly payments could face recasting and far higher monthly payments in just 28 months according to Fitch.

When was 28 months ago? That was in 2007, just before many local markets saw substantial price declines.

And how many option ARM borrowers have been making only minimum payments? According to Fitch, 94 percent of them.

“More homes will be lost to option ARMs than were lost to Hurricane Katrina and the destruction of New Orleans,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the nation’s largest source of foreclosure listings and data. “We’re now looking at a surge of option ARM resets which will drive large numbers of families from their homes and impact home values in many local markets.”

No Surprises
Option ARMs were destined to be a full-blown disaster from day one. As I wrote in 2005, “in the next two to four years we’ll see elective payments end for many option loans. 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?”

So why did lenders market such woeful products? As Business Week explained in 2006, few borrowers knew “that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan’s interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they’ll soon be confronted with the choice of coughing up higher payments or coughing up their home.”

Despite claims that the recession is over, for today’s distressed-asset buyers and investors the result of the option ARM mess is that home prices in many markets will be forced lower and the inventory of foreclosed homes will grow. Only after the inventory of distressed homes is cleared out in individual markets can we begin to think in terms of stabilizing local home values and perhaps even rising prices. Until then, depressed values will remain.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com

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