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

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, Moneynews.com’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.

Onward…

Comments

[ponchovilla]

Herb: I'm puzzled as to why you even go on the Kudlow Klown show. I watched the "show" and looked at the chart on resets. At first glance there is some truth to the interest argument making monthly payments more attractive. But there are people who couldn't afford the loan in the first place. It seems to me that Kudlow has an answer and finds some chart to prove his point and as far as he is concerned the discussion is over and "goldilocks" marches on. But I would believe the issue is much more complex than a simple reset chart. Does anyone have a handle on real data? I have seen data from 1/1/06 to 6/1/07 (Amherst Securities Group, LP re: purchasing power) that suggests $40K pretax incomes 55% debt/income was providing borrowing power in excess of $340K. It seems to me anything beyond 3.5x $40K = $140K generates trouble even at fixed rates particularly with inflation in real estate taxes, insurance, power and most consumer non-discretionary purchases.

[Pent updemand]

All these charts that I've seen graph only the first reset. A lot of the reset pain has been put off by the massive Fed cuts, but if (more like, when) they are forced to raise rates to curb inflation, the loans that have not defaulted by that time will come right back to the forefront.

[dcxavier]

Where you're going to see the huge losses isn't in the Option ARM's, but in the second mortgages that were also part of the financing. Many of these loans were financed 80% primary, 20% second. The second loses 100% of its value before the primary Option ARM loses one penny. The WM 8-K page 15 from two days ago stated that there were larger writeoffs from HELOC than subprime, and HELOC writeoffs seem to be growing exponentially over the last few quarters.

[jcrash]

Anyone got the breakdown - NATIONALLY - on the percentage of mortgages financed 30/20/15 yr fixed rates, 5/1 or 3/1 Arm, and these option arm things? I think it would be very enlightening as I can only guess that 80% of people go with the 30/20/10 fixed rate mortgages and all this prognosticating is about the other 20%.

[John Egan]

Thank you ponchovilla... I'm not sure what planet Kudlow lives on or what prescription product he consumes. He seems totally out of touch with reality. Like the hypochondriac that finally died in his sleep at 90, whose headstone reads "I told you so!", one day Kudlows prophesied 'Goldilocks awakening' will actually happen... I don't watch the show unless someone like H. Greenberg appears.... Someone not afraid to speak up!

Sorry, my rant of the day...

Thx jegan ;-)

[Clancy'sPoolroom]

Who would be the suckers doing seconds or HELOC over FED, DSL, CFC and WM in California - - - WFC, C ?

[kurt walter]

Having worked as a loan underwriter during the mortgage madness, I can tell you that I have seen plenty of mortgage notes. Will we be having loads of resets for Pay option ARMs and other adjustable exotics from 2009 to 2011.

[dcxavier]

WM did a ton of seconds over their own Option ARM's. What's bad is that they generally didn't get rid of them by securitization, there are about $40B true seconds sitting on their books.

[Ive hadenough]

Ok listen.

Look at the MTA or COFI index. These are very low. Besides Libor, these would be lowest. Rates have been adjusting downward. No one knows where rates will be in 2 yrs so stop freaking everybody out! On another note, I bet 100 bucks everything turns rosy after elections. If not, well... then who cares because we will all be in a food shortage and eating each other for dinner anyhow.

[Americandream]

As a Mortgage company owner of 10 years, we never sold the pay option arm products to any of our clients, I never beleived in this loan and I would create more enemies then referrals. The big issue with this product is how it was advertised, you can still see it today, check out any webpage $300K loan for $1200 month, as a buyer how wouldnt want that, an easy sell for a loan officer who never explains what will happen if they continue to make this monthly payment. Mortgage companies offered this product based on payment and never mention rate or neg am in any article(if they do its so small you cant even see it). This loan is the main problem, most have a prepay penalty and cant even refi out of it. Others have so much negative amorization and with a declining market value there seems to be nothing we can do. Most Lenders I know of stop offering this program do to the losses in thier portfolios seem to be from the pay option arm customers. I advise anyone who has this loan product to get out of it now, or at least dont make the minimum monthy payment, choose the interest only or one of the fixed rate payments to avoid more negative amorization.

[johnthebear]

Is there any way out of the messsssss?

I wonder about a law that freezes interest rates on all adjustable rate mortgages for 5 years. That would stop the foreclosure part of the problem while the economy heals damage already done.

The banks and other lenders would be hurt, but when they resort to such below the belt tactics, who better should feel the pain?

[toddpw]

Who cares about resets. The real issue is all the walk-aways who are underwater with negative equity. Those are exploding NOW and will only get worse as more people get laid off and decide that they owe the mortgage industry just as much integrity as the mortgage industry showed them -- none whatsoever.

[RobertTrudeau]

No one knows what the extent of this crisis will be. One would have to accurately predict too many variables including: future home prices, interest rates, economic growth/decline, employment, government actions, etc.. What we can be in agreement about is that overall home prices will decline so that they are more in line with income and equivalent rent. While I have no idea how rapidly they will decline, I estimate that nationally home prices need to fall another 20%. However, there will be real estate markets throughout the U.S. where there the decline will be far less or even non-existent. The big question is who will be on the hook for the approximately 4 trillion dollar additional decline in value. My guess is that the Fed/U.S. government will own a heck of a lot of mortgages and homes, so that ultimately you and I will pay for this mess even though we played no part in its creation. The market understands the U.S. government will simply not allow our money center banks to fail, which explains their stock price movements this past week. I don't see how we can avoid much higher future interest rates and/or inflation as we borrow our way out, putting greater downward pressure on other asset classes such as equities and cash/dollars. I am not a doom and gloomer but don't see any way we can avoid at least a severe recession within the next year.

[cromag]

Kudlow is an ego maniacal control freak who thinks he has a duty to direct the 'free' market and defend his ignorant bullish statements.