Option ARMs: The Banking Backdrop of 2009

To follow up on the post that I scribble together at 3 am, undedited, the other day -A few grim thoughts for the New Year, as I reflect upon the past year, I want to refresh the memory of my readers, particularly in regards to why I was so bearish on many name brand banks last year. This may require some re-reading of the Asset Securitization series. So, before we get started on the major value drainers of 2009 (believe it or not, still mortgages, consumer and corporate loans) I want to provide a few links of interest that put things into perspective.

• The Asset Securitization Crisis Part 27: The Butterfly Effect: details leverage loan failure (ex-ibank risk), and The Butterfly is released!
• Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
• More on the banking backdrop, we've never had so many loans!
• As I see it, these 32 banks and thrifts are in deep doo-doo!
• A little more on HELOCs, 2nd lien loans and rose colored glasses
• Capital, Leverage and Loss in the Banking System
• Doo-Doo bank drill down, part 1 - Wells Fargo
• Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
• The Anatomy of a Sick Bank!
• Doo Doo Bank 32 Drill Down 1.5: Wells Fargo Bank

Yes, I know its a lot of reading, but that is why I have the confidence to short heavily into a rising market, and it is what has powered my returns thus far. it's confidence in the fact that I have performed more comprehensive, more diligent, and more accurate research than those that I am selling shares to.

Now that we have caught up on the happenings of last year, let's look forward to what we can expect this year.

Option ARMs: Next up in line

After the subprime saga the asset securitization crisis unfolds, another chapter up its sleeves with added melancholy, called the Option ARMs. With billions of Option ARMs due for recast in 2009 and 2010 another crisis is on the making. But this time problems are expected to be more pronounced than the subprime crisis since the economy is already nearing its trough, the consumer confidence has slumped to an all time recent history low and financial markets are in a gridlock. Making the matters worse is the unrelenting fall in the US housing market which is showing no signs of stabilization.

As seen in the tables below most of the subprime loans were scheduled to reset in 2007 and 2008 while most of Option ARMs are set to reset during 2009-2011. If Subprime loans are akin to "no documentation loans" then Option ARMs could be rightly fit as "ballooning loans". Lenders made Option ARMs with ‘teaser' features to borrowers, which included making lower minimum payments for initial years and then loan being reset to higher payment schedule thereafter. If that was not enough, these loans had another feature called "negative amortization". In plain vanilla language that would mean an actual increase in the principal of the loan itself, even after the borrower makes payments (due to the borrower opting to make a payment that doesn't cover full principal amortization). With US housing prices declining and the burgeoning loan-to-value skyrocketing, Option ARMs delinquencies are set to increase dramatically.

Click image to enlarge

Option ARM and its features: Unlike typical ARMs where the principal and interest or simple interest payment is calculated from an index (typically MTA) and margin, the Options ARM offers 4 payment options to choose from including - Minimum Monthly Payment, Interest-Only Payment, Fully Amortizing 30-Year Payment and Fully Amortizing 15-Year Payment.

Typically Option ARMs allow the borrower to make a low monthly minimum payment for five years after which loan is recast which causes increased mortgage payment. However under the minimum monthly payment scheme, the difference between the minimum payment and the interest payment is added to the mortgage balance which could cause negative amortization. The negative amortization cap when reached (the balance of the mortgage grows to 110%-125% of the original balance) will cause the loan to be recast earlier.

Growth of Option ARMs: According to LoanPerformance, option ARMs as a percentage of total ARM loan volume in non-subprime, non-agency securitizations increased from 12% in 2004 to 32% in 2005 and 42% in 2006 and was 40% in 2007. Some of the leading players issuing Option ARMs are BankUnited Financial (BKUNA), IndyMac, Wachovia (WB), Washington Mutual, Countrywide, Downey Savings, FirstFed Financial (FED) and Guaranty Financial Group (GFG). However most of these banks including Wachovia, Washington Mutual, Countrywide and Downey Savings have either failed or being acquired by relatively larger players.

Within the option ARM category, the 40 year Option ARM has witnessed a substantial increase reaching 38% of total Option ARMs in 2007 from 4% in 2004 since the longer term loans gained popularity because their lower initial payments and low-cost refinancing option. The 40-year Option ARMs not only have low teaser rates similar to 30 year ARMs but also have lower initial payments relative to the 30-year option ARMs due to the longer amortization term. This "double-teaser" feature of the 40-year option ARMs causes higher payment shock and could cause faster negative amortization than 30-year option ARMs.

In 2009 and 2010, loans with 2004 and 2005 vintages would be recast. Besides these vintages, loans with negative amortization are expected to recast early. With more than 65% of borrowers electing to make Minimum Monthly Payment (reaching a staggering 85% for 2006 and 2007 vintages), loans which recast on account of negative amortization caps are expected to increase drastically.

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The problem ahead: According to Fitch, of the nearly $200 bn of option ARMs outstanding, roughly $29 bn of loans are expected to recast by 2009. Of this $6.6 bn constitute 2004 vintage (that would be recast as a result of completion of the end of five-year term in 2009) and $23 bn constitute 2005 and 2006 vintage loans that would recast early due to the 110% balance cap limit.

Further an additional $67 bn is expected to recast in 2010, of which $37 bn belong to 2005 vintage (that would be recast as a result of completion of the end of five-year term in 2010) and the balance $30 bn consist of 2006 and 2007 vintage loans that would be recast early due to the 110% balance limit cap.

The potential average payment increase on the loans recast is 63%, representing an additional $1,053 due each month on top of the current average payment of $1,672. These large payment increases could cause delinquencies to increase, and increase dramatically, after the recast. The fact that only 65% of borrowers have elected (or are able) to make only minimum payments underscores the magnitude of the potential problem. The potential payment shock combined with the continuous deteriorating outlook for home prices and lack of refinancing opportunities could be a negative cause of concern for investors in Option ARM securities. Even more ominous, is pall cast upon the banks that hold these assets and are additionally exposed to other forms of consumer credit, ie. HELOCs, credit card debt and other unsecured loans (remember the links from the Asset Securitization Crisis above).

Comments

[rm:]

The problems with the Option ARMs that you've mentioned are compounded by a number of factors that seem to correlate with these products.

First, these loans were typically made to borrowers who were betting on appreciation. Second, they're often made to borrowers who are self-employed... many of whom are not very good personal money managers. Third, and most pernicious, is that these loans are nearly all 100% LTV, often with "generous" appraisals.

Not only would most of these borrowers need considerable payment relief on the TEASER rate in order to stay, they'll more than likely walk without substantial principal writeoffs... which most lenders are unwilling to offer.

Jan 04 09:00 AM

[Philip Gvinter:]

One last point that RM did not mention is that over 75% of these loans were originated using stated income or lower levels of income and asset documentation.

Jan 04 10:29 AM

[axelrod608:]

Excellent article - thanks. I've been saying that foreclosures would remain plentiful thru 2012 because the Opt-A's were made in large numbers thru most of 2007. I did not know about the balance cap limit, so surely many of these loans will reset before their 5 year expiration.

Other writers have confirmed that delinquency and default rates in Opt-A loans have been running close to 10% even at the low "teaser" rates. This is clearly an IED on the nation's road to recovery.

Most forecasters agree the nation will not recover until a foundation is found for the housing sector. Clearly, it will be YEARS, not months or quarters until that bottom occurs.

Jan 04 10:44 AM

[Ishortyou:]

the solution to the option ARM's is to REFINANCE the damn thing!!!!!11

Jan 04 11:47 AM

[Prof. Samue...:]

RE: 2nd Wave of Foreclosures, Small Business, Foreclosures, and Job Loss:

On December 14, 2008, CBS’s "60 Minutes" had a segment on the 2nd Wave of Foreclosures. They indicated that experts were expecting another wave of mortgage defaults on ALT-A and Option ARMs mortgages which will dwarf the Subprime Mortgage Crisis. CBS MISSED A VERY IMPORTANT FACT!

Many fail to realize that there are millions of self-employed smaller businesses, who employ from 1-10 employees, that are holding the mortgages that are going to reset in 2009 through 2012. These borrowers are Prime and Near-Prime borrowers who hold ALT-A, Option ARMs, Interest-Only mortgages. There are $1 Trillion ALT-As, and $500-600 Billion Option ARMs.

So, here we have a major problem… Not only will these small business owners lose their homes, but there will be the resulting JOB LOSSES on their business failure. Note, although President-Elect Obama is stressing the need to create 3 million new jobs, we must understand that “JOB RETENTION IS AS IMPORTANT AS JOB CREATION”.

I authored a survey which was conducted by the National Association for the Self-Employed (NASE) to its national membership. The NASE Survey disclosed disturbing facts. The NASE survey is at www.nase.org . See the NASE News for the Survey on Toxic Mortgages. Please read my Commentary.
According to this survey, it is estimated that 3,709,800 small business owners hold Alt-A and other toxic mortgages, and 1,279,800 are already delinquent as they have missed one to three or more monthly mortgage payments at mid-November, before the expected Resets that are scheduled to begin in 4th Quarter 2008 through 2012.
The solution lies in the hands of Congress as they meet in January to structure an economic stimulus package. Congress should take note of this survey and be “proactive” in addressing the situation, rather than “reactive” as the case has been in the Subprime Mortgage Crisis.
We can’t afford another shock to our economic system at this time. This 2nd Wave of Foreclosures which will be caused by the ALT-A and Option ARMs will not only result in Foreclosures, but also Job Loss.

Jan 04 12:06 PM

[Joe Friday:]

Unfortuately this investment theme appears to have been played out. With WM, DSL, FED and WB all gone or on life support there is no money left to be made shorting these names. (It was fun while it lasted). It is very clear that there will be many more foreclosures, the question is, how can we capitalize on that knowledge? Any ideas?

Jan 04 12:18 PM

[Ishortyou:]

Refinancing is one solution, it doesnt take a brainer to figure it out, although as professor said, the government could come with other alternatives to alleviate the tsunamy second wave on the housing market, obviously the simple supply and demand rule applies, then the key to how to get rid of excesive housing invetories needs more attention.

Jan 04 01:56 PM

[Reggie Midd...:]

It is not necessarily true that all have missed the shorting boat here. The two largest writers of option ARMs have been taken over by larger banks, both of which already had mortgage related and/or credit risk issues of their own. I have delved into this in detail on BoomBustBlog.com.

The issue is, do you believe the government has the ability to make everything better??? Or as Paulson has said several times in the past, the worst is behind us... boombustblog.com/compo.../

Jan 04 02:19 PM

[Ishortyou:]

God knows, but if I were the one having the ARM or resetting ALT-A loan, I would be worrying now on how to refinance those loans to more affordable ones with or without the governments help.

Jan 04 02:51 PM

[PainfullyAware:]

There is still a lot of Short Opportunity left in the market - Collateral Damage From Primary Collapse.

For a long term investment I would suggest looking into The Universal Opportunities Fund at Universal Equity Group. This Group is a Qualified bidder for the bank assets taken over by FDIC and their market core competency is in Distressed Real Estate. They are positioned to be the front side of the reset in Commercial and Residential Assets.

Universal Equity Group
www.universalequitygro.../

The Worst Is Yet To Come. We are about to leave the eye of the storm. What is coming, if allowed, will be unprecedented.

Chaos is dangerous, but is also ripe with opportunity.





On Jan 04 12:18 PM Joe Friday wrote:

> Unfortuately this investment theme appears to have been played out.
> With WM, DSL, FED and WB all gone or on life support there is no
> money left to be made shorting these names. (It was fun while it
> lasted). It is very clear that there will be many more foreclosures,
> the question is, how can we capitalize on that knowledge? Any ideas?

Jan 04 04:52 PM

[Mark in SF:]

the solution to the option ARM's is to REFINANCE the damn thing!!!!!11

@ishortyou:

you are *completely* missing the point. These loans will automatically refinance (recast) to a standard amoritizing 30 or 40 year loan. How is refinancing early going to help? I suppose it could for a lower rate. If they had enough equity, but... OOPS. That equity is gone.

Jan 05 04:13 AM

[Mark in SF:]

I don't see how we will pull out of a recession before 2011. Housing clearly will not bottom before then, and the gov't seems hell bent on keeping that correction from happening quickly.

Jan 05 04:31 AM

[Mr Mortgage:]

Hey Reg - First American's numbers are jacked. They 'track' $200 billion but there are more out there. Additionally, they have only been tracking POA's for about 2 years. But before that the methods of collecting the data did not include the markers needed to identify a POA from a 5/1 ARM for example. After two years of research on this, I have concluded that there were $750 billion originated since 2003 and $550 billion still in existence. Put it this way - we know WB has $122 billion on balance sheet. There is no way they hold 60% of all POA's in existence.

Jan 06 11:03 PM

[Reggie Midd...:]

I'm digging through Wells' Fargo ill-timed purchase next week. I've already busted JPM, they aren't being very forthcoming with their problems from the WAMU purchase not the Bear Stearns acquisition. Give me an email and let's compare notes.

Jan 07 09:50 AM

[HelluvaEngi...:]

They can't refinance if they are underwater, unless they're sitting on a pile of cash. If they are, its unlikely that they would have chosen such a bad mortgage. Nope, many of these people went for the lowest payment and then spent the difference on H2's and flat screen TVs.


On Jan 04 02:51 PM Ishortyou wrote:

> God knows, but if I were the one having the ARM or resetting ALT-A
> loan, I would be worrying now on how to refinance those loans to
> more affordable ones with or without the governments help.

Jan 07 01:56 PM

[Glenn Peters:]

I'm a life-long banker and economist and no, I don't live in the USA. From the inside, let me assure you this is going to be an economic catastrophe the likes of which we have never seen before. The senior bankers I know are terrified at what is about to be unleashed. By 2012, 2013 at the latest, the US will be utterly bankrupt, unable to pay foreign creditors, who themselves will wonder how their trillions in USD denominated securities became essentially worthless. The US govt won't be able to raise enough tax to pay interest on its bonds, as the US unemployed watch their 'safe' bond holdings evaporate. Ireland is a basket case and let's not talk about Iceland or Britain. No country will escape unscathed, best bets, Australia, France and Norway.

Jan 11 03:19 AM