More Option ARM Falsehoods: Interest Rates Are Not the Issue

Dig this load of garbage:

The Mortgage Bankers Assn. is also estimating that the lower interest rates will delay the resets. But the group also expects that lenders will help borrowers move out of the option ARM products before they reset. Many of the investors who can't easily qualify for modifications and the borrowers beyond help have already lost their homes, says Michael Fratantoni, vice-president of single family research and policy development for the Mortgage Bankers Assn.

And the homeowners who are holding option ARMs when the wave of resets hits won't face as big a shock because interest rates have fallen, adds Fratantoni. "Interest rates have come down to the point where the resets that are going to occur are going to be a bit of a non-event," he says. "Very few borrowers will experience the recast." But Nicholas Chavarela, managing attorney for Orange (Calif.)-based America's Law Group, which represents borrowers negotiating modifications, says banks remain reluctant to reduce principal for underwater borrowers.

What a load of bilge.

The issue is not interest rates or "resets".

It is RECASTS, which typically happen when you either reach 125% of the original loan balance on a negative amortization basis OR five years pass, whichever comes first.

These loans were sold as "affordability" products to people who could not afford to buy the house they wanted, often due to rampant speculation.

The lenders expected that the borrower would either take out a new OptionARM or sell the house before the recast happened, thereby "rescuing" them, or in the worst case, the house would appreciate faster than the loan balance, allowing them to pay it off.

Neither happened.

Virtually all of these loans are severely underwater, precluding refinance. Not only are the borrowers adding to the principal every month but home prices are declining, hitting the borrower's loan-to-value ratio twice.

Lower interest rates do exactly nothing for these people because the original "option" period typically had rates as low as 2% on simple interest, and thus payments could be under $1,000/month on a $600,000 loan during the "option" period. But if you took the "option" the amortizing amount at 5.5% is $3,391.19.

Wachovia, Washington Mutual, IndyMac, First Federal and Downey were some of the prime offenders in this market, pushing these things hard. Wachovia was even selling these up until last year, calling their particular version "Pick-A-Pay".

They all forgot to include in their commercials that if you elected anything less than a fully-amortizing payment on any sort of consistent basis you were walking around shaking a container of nitroglycerin with your financial future - and theirs.

California and South Florida were the worst offenders in terms of markets for these "products." They allowed people making $40,000/year, the median California household income, to "buy" $500,000 houses, and allowed speculators to run what looked like a great business - buy one of these homes, rent it for $2,000/month, pocket the extra grand.

Essentially everyone who took one of these loans couldn't qualify on a fully-indexed amortizing payment and did nothing to improve their savings and cash reserves, instead spending all they made (and sometimes more.) Often times these same people refinanced into new OptionARMs several times during the bubble years, pulling out the extra cash and spending it on boats, Hummers and other expensive toys and tribbles. This stupidity is what funded the "prosperity" of the 2003-2007 years both in private business and government budgeting; none of the "value" that was extracted, spent and taxed away was REAL!

Worse, all of the banks that wrote this bilge were booking the additional interest and principal that was "capitalized" back into your principal as earnings and reported it! This was what I screamed about back in the first part of 2007 when I caught Washington Mutual trying to pay a dividend out of "capitalized interest", as they lacked sufficient cash earnings to do so. Regulators willfully ignored this little bit of accounting gimmickry, including The Fed, OTS, OCC and The FDIC.

This is why Washington Mutual, IndyMac and Downey all blew up, and it is the reason that Wachovia had the shotgun put in their face and was forced to "marry" Wells.

The truly bad news is that most of those recasts haven't happened yet - the destruction of these institutions happened over only a very small percentage of these loans blowing up - so far.

When the loan recasts five years after origination (assuming that comes first) even if you can get a 4% interest rate based on current low "adjustable" rates you are now financing $750,000 and must amortize the 4% over the remaining 25 years. Your home is only worth $400,000 in today's market, so the possibility of a refinance into a conventional (or any other) product is in fact zero unless you happen to have an extra $350,000 laying around to pay the bank back, which you do not.

Your payment goes from under $1,000 a month to $3,945.62, a near-quadrupling, overnight.

"I don't think this is going to be the tsunami that was forecasted a few years ago," Gumbinger said. "But it's probably bigger than a ripple in a pond."

Comments

[BostonObserver:]

The question now is how long will this next wave take to flow through the system? Will these recasts happen quickly - over the next twelve months? Or will they drag on for several (many?) years? I have looked at the famous/infamous CSFB reset chart, but it's hard to know from that how things will shake out. Curious to hear what the author thinks... housing bottom in 2010? In 2012? Or later??

Jun 22 07:14 AM

[D_Virginia:]

Just as a data point, I got a 7-year interest-only ARM in 2005, w/ a 20% down payment. Seemed reasonable enough, "5 years to break even" and all that, plus all my bankers and now-fired financial advisors said it was actually pretty conservative. Heh, eff them.

Today, I am now 40% underwater and am looking at anywhere from a 20% to a 80% increase in monthly payment in 2012, depending on interest rates.

Luckily, I can afford that, though it becomes far more than what I feel the place is worth paying for, which is why I did the ARM in the first place.

What frustrates me most is being stuck. Can't refinance. Can't sell. I'm current on my payments and can afford them, so the lender won't even talk to me about a short sale.

I've had to turn down some pretty good job offers recently just because I can't move. And while I have a good career, it's not of the sort where a company would pay off my mortgage as a signing bonus -- a Wall Street banker I am not.

Several lawyers have basically told me there's no walking away, either -- the banks can and will pursue a deficiency judgment since I'm not a deadbeat. Sucks to be responsible, I guess.

Anyway, if I get laid off or have any semblance of a financial hardship, you can bet I'll be mailing on those keys will a big picture of my one-finger salute to a lender that helped break the market.

Jun 22 08:07 AM

[Iconoclast421:]

So the Fed just buys up all these mortgages. Green shoot.

Jun 22 09:34 AM

[Trane250:]

I really feel sorry for all the people who were suckered into buying a home that they couldn't afford. I don't feel sorry for those folks who took out home equity loans on the inflated value of their homes and then had a fling on the borrowed money then refinanced with a "pick-a-pay." Where were the regulators and the politicians when this nonsense was happening?

Jun 22 09:56 AM

[Leftfield:]

D_Virginia is just one of countless stories that negates the green shooters. The only bigger jerks I see besides the financial kamikazis who have left us holding the bag is the politicians. They're the only green shoot here as Iconoclast421 points out. We've had middle-class income decline, masked it with government spending, bubbles and now the last one, putting it all on the taxpayer tab. The smart ones on Wall St. and DC are quietly leaving the Titanic for the Caymen Islands. The dumb ones continue to run things, with a total time horizen of, next election.

Jun 22 10:02 AM

[Leftfield:]

Oh, and do the reduced values of homes now translate into lower property taxes?

Jun 22 10:04 AM

[Lies and Da...:]

What a nightmare but this scenario seems to only take place if the borrower's mortgage is a negative amortizing option ARM. Those who have amortizing payments don't seem to be of much concern.

Is there any data out there showing us how many option ARMs are in the negative amortizing class?
If possible this sounds like horrible news for the banks and not so great news for those entering the housing market.
Really hard to get a good deal on a house when the loan on it is double or triple the value of the home.

Jun 22 11:00 AM

[HardwoodFlo...:]

Good Points. The troubling thing is that people can't qualify out of the ARM program to get into a fixed. The other problem is that JUMBOs aren't available and banks don't want to write them because they are only going to sell FHA loans that they no they can then sell to the Government. It's still a mess.

Jun 22 12:39 PM

[Mad Hedge F...:]

This has been undetstated. Since I have been pelted daily with predictions that residential real estate has bottomed for the last 18 months, I feel a public duty to tell that is just not the case. Now that the state and federal moratoriums are off, foreclosures are accelerating. There are over a million Alt-A loan resets about to hit the fan. Since many owners will not see positive equity in their homes in their lifetimes, banks are seeing more walk always. The run up in mortgage rates from 4.5% to 5.5% has yet to hit the market. Some 18 million homeowners divert 50% of their incomes to pay for housing, double the 25% that is considered healthy, and many of them are losing jobs. While the volume of units sold has rebounded, the action is dominated by speculators, flippers, and bottom feeders bidding for properties at 10-40 cents on the dollar, not exactly a sign of health. Call me when Ozzie & Harriet Nelson come back to the market. I listen to industry insiders call the bottom of the Japanese real estate market for 15 years, until they finally died, and the market is still a fraction of its 1990 high. I thing we are closer to the bottom than the top in terms of price, but closer to the top than the bottom in terms of time. You can take that to the bank.

Jun 22 02:14 PM

[Bill Zielinski:]

Karl,
Great article. From the perspective of a first hand observer of the option arm financing fiasco, I can tell you that your assertions are exactly right. Virtually all of the option arm borrowers took this product based on the artificially low payment, virtually all of the borrowers paid only the minimum payment and virtually all of the borrowers have already or will default.

Jun 22 03:38 PM

[PainfullyAware:]

Sub-Prime was the "Fuse" for the first "Financial Bomb" - The Second Fuse Has Just Started To Burn.

Until The Underbrush Is Cleared By "Maturity or Remedy" There Will Be No "Recovery".

Summer 2011 is the last of the "Stupid Loan" resets. Beginning of 2012 would have started to look semi-normal if it weren't for the AMAZING DEBT that will need to be Inflated Away.

It is too bad that Fannie and Freddie are planning on continuing their Stupid Loan Practices even though they have been shown to be a detriment to all.

Jun 22 08:10 PM

[Donald Ingram:]

Bottom line in that story "banks remain reluctant to reduce principal for underwater borrowers". In other words - 'you're screwed pal! Pay up!"
Don't you just love bankers? Aren't they right up there with lawyers?
My bumper sticker did read 'First We Hang All The Lawyers..."
Guess I'm going to have to get a new one now or add to the old one.

Jun 22 11:50 PM

[Andrew Butter:]

Re: "Worse, all of the banks that wrote this bilge were booking the additional interest and principal that was "capitalized" back into your principal as earnings and reported it! This was what I screamed about back in the first part of 2007 when I caught Washington Mutual trying to pay a dividend out of "capitalized interest", as they lacked sufficient cash earnings to do so. Regulators willfully ignored this little bit of accounting gimmickry, including The Fed, OTS, OCC and The FDIC."

Exactly Right !

What basically happened over the past five years was that a lot of "earnings" declared by banks (and used to pay bonuses, dividends, and taxes), were fake.

So in fact the banks were making a loss not a profit.

But the books were audited and every year by a Big Four auditor who puffed himself up and signed a piece of paper to certify the books were prepared strictly in accordance with US GAAP.

So much for US GAAP and the SEC. Looks like those auditors were not much more use than Madoff's auditors.

This whole thing is nothing more than an Enron repeat, just this time everyone got away Scott free.

Jun 23 08:33 AM