Mortgage Resets: Subprime May Be Ending, Option ARMs Have Just Begun

by: Herb Greenberg

I was a guest on CNBC’s Kudlow & Co. on Wednesday night. It’s always fun to be on the other side of Larry, who for some reason actually agreed with me and the other realist,’s John Browne, on a number of points.

Usually I have an idea about the night’s topics so I can do a little research ahead of time. This night was no different, with one exception: I wasn’t expecting Larry to do a chart that showed how mortgage resets were about to fall off a cliff, suggesting happy days will soon be here again.

Had I known about it, I would’ve brushed up. Instead, I shut up and (novelty of novelties) listened — and was totally puzzled.

I wasn’t alone. “When they start talking about mortgage RESETS,” emailed Paul Jaber, a portfolio manager at the Perpetual Value Fund, “can you correct them and tell them the problem is RECASTS? They surely don’t know the difference…”

Paul continued:

See, if you took out an option pay ARM loan in 2005 and bought a few properties like the hotshot 24-year old Southern California real estate mogul — on average you would be able to make 40 months of BELOW interest rate mortgage payments (I use the word payment loosely).

After about 40 months your 2% b.s. payment would make the loan grow to about 115% of the original amount and then — WHAMMO — your loan would recast to a 27-year fully amortizing mortgage. Your payments would go from $1,000 a month to over $3,000 and you would be walking around wondering, like “What is happening?” A good analogy is the three-year no-payment, no-interest Circuit City TV loan. The catch is that in month 37 you owe ALL back interest — usually about double the original charge.

The guys talking about resets are trying to confuse the situation. The option arm loan was very popular through 1Q07 - so take 40 months from that date, plus 3 months for them to go 90 days late and then and only will you see foreclosures start to level off.

To further drive home the point, Paul adds:

The reason why CFC, WM, WB, DSL and FED are all imploding is because the 2003 - 2004 pay option arm loans are all recasting and then going 90 days late. But all you need to know is pay option arm loans have a teaser payment that will last until the loan goes 110%-125% of original value and then the loan RECASTS to a fully amortizing loan. That is how a payment skyrockets - its simple math. Whereas payments can’t realistically double or triple with a simple ARM reset, most are capped every year - again the math is pretty simple.

Not that resets aren’t done. Check out this chart, courtesy of blogger Egor, who had posted a comment under another blog item here. Subprime resets may be ending, but the Option Arms have only just begun.