Option ARMs: The Banking Backdrop of 2009

|
Includes: BKUNA, FED, GFG-OLD, WFC
by: Reggie Middleton

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.

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

optionarmreset.jpgClick 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 (NASDAQ:WB), Washington Mutual, Countrywide, Downey Savings, FirstFed Financial (FED) and Guaranty Financial Group (GFG-OLD). 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.

Click image to enlarge

recast.jpgClick to enlarge

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).