More Option ARM Falsehoods: Interest Rates Are Not the Issue

 |  Includes: KBE, RKH, XLF
by: Karl Denninger

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."