Option ARMs, Who Thought Up these Time Bombs?

The title of this entry is a rhetorical question. We know the Wall Street answer is: "some genius who made many of us many many many hundreds of millions... did I say millions... I meant billions - until the house of cards fell over - but we still got ours." I always relay the story of certain articles that really woke me up to the housing bubble - 2 of them included

1. Some punk kid (ok ok he was somewhere in his early 20s and I was envious) who was a mortgage broker in Vegas, who was making 100s of thousands a year churning out mortgages, driving fast sports cars... WHILE flipping houses on the side (I believe from memory he owned 8-9 at time of the article) and
2. When I first read about option ARMs in a BusinessWeek article.

Now thanks to the power of Google (GOOG) I found the former story - May 30, 2005 - Riding the Boom. Honestly I just re-read it for the first time in 3 years and it's even better now than when I first read it - worth your time so you can spot the "next" bubble. Ah, the dream of milking the American system as told by Zareh Tahmassebian.

I read about the option ARM as the cover story October 2006 [Nightmare Mortgages]. Another absolute read.

As to the latter article - what's an option ARM you ask? Well after Alan Greenspan lowered rates to HISTORICAL lows, the golden era of adjustable rate mortgages was birthed. Why adjustable? Because despite historical low fixed rates you could only buy so much house at each income level with fixed rates in the 5% ranges. So we needed to find something more to qualify more buyers and goose home prices.... adjustable rate mortgages were the hot thing. But when adjustables with 10% or 5% down disqualified too many people we moved to a new era - the 0% down adjustable rate mortgage. This was dangerous territory - keep in mind the adjustable rate was many times at a teaser rate far below the "future rate" once it adjusted upward. Now I'm a well read person so I knew about this part - but not until I happened upon the BusinessWeek article did I learn about a new invention - the option ARM. This was for the person they could not qualify at 0% down, with teaser rate. So the Frankenstein was created - a mortgage where you don't even pay enough to pay down interest - at the end of each month, you make your payment, and the difference between what you would pay on a normal mortgage and what you paid on this mortgage is added to the principal. Meaning you OWE more on the house each month. Ridiculous you say? Nope! Not if the home price goes up every month, preferably at an annualized rate at 20% a year as we know all homes do! It's GENIUS. (on Wall Street)

The super cool part is we package these loans, mix them up with a bunch of other mortgages, sell them to "super smart" hedge funds with "sophisticated risk" models - along with institutional buyers across the world - and call it a day. Everyone wins.

Until the fan hits the bleep and then bounces off the wall and hits the fan again. So *THIS* is why when EVERYONE last summer (except for a very small select group of people who were pointed to as outcasts and doomsdayers) said it's "only a subprime problem", I was writing this is NOT a subprime problem.

Subprime is the tip of the iceberg - it's a symptom ... in fact it would be the first to cleanse itself and we'd be rid of this class of homeowner who frankly in most cases should never of gotten a loan in the first place. They will default quickly.

The insidious groups are the Options ARMs, the Alt As, and the "prime" borrowers (best of breed) who had to stretch way above their head just to buy a home in many of the top 10 hottest markets since they were priced out property - due to all the others clamoring in with Uncle Alan's easy money. And so we'll have wave after wave of defaults - the primes are just now beginning - if you don't believe me, just read through JPMorgan (JPM) highly respected CEO's (Jamie Dimon) comments from last quarter. And this is why there is no "recovery" coming in a few months, or when gas hits $3.25. We have systematic risk; and many many banks will be in trouble before all is said and done. Subprime? Heck we're probably 80% of the way through with those guys - they were just the canary in the coal mine. Get ready for the next waves - we'll begin with the Option ARMs. And so we're here now. Read on. And where will the capital come from as these mortgages begin to default in waves? Oh I know - printing presses. Go buy the dollar - it's going to be a "safe haven" since we are not as bad off as Europe. Surely as a trade it will work - but as anything steeped in fundamental reality of true strength: not so much.

 

• Borrowers with $25.4 billion of option adjustable-rate mortgages owe almost as much as their homes are worth, and one in eight is at least 90 days late on payments, according to Countrywide Financial, the lender bought by Bank of America last month. Option ARMs let borrowers skip part of their payments and add the balance to principal.
• As of June 30, the typical borrower owed 95 percent of the value of his home, up from 76 percent when the loan was made, Countrywide said in a regulatory filing
• Seventy-two percent of borrowers were making less than full interest payments, and 12.4 percent were at least 90 days delinquent.
• The average FICO credit score dropped to 680 from an original 715, but topped the 620 that some analysts deem a cutoff for "subprime." The data show how the nation's housing crisis has hurt borrowers with good credit (free markets WILL solve everything in the end, but really do we need to go through this mess and hurt so many people? Yes we do - because regulation has become an evil word under certain political party banners)
• Countrywide's $25.4 billion of option ARMs at its banking unit represent about 28 percent of total mortgage loans held for investment.
• Lenders industrywide have said many borrowers who owe more than their homes are worth are abandoning their properties because they don't expect to recoup their losses. (revenge of the sheep)
• "People still don't understand what a catastrophe this is," said Christopher Whalen, senior vice president and managing director of Institutional Risk Analytics of Torrance, California. (buy bank stocks, gas is going down to $3.50 and they are 'safer' than companies growing earnings 50%+; the stock market is all knowing and can discount the future perfectly - see all time highs hit October 2007 as example of its predictive prowess)
• But sinking housing prices and relaxed underwriting standards left many people with negative equity in their homes, leading to a surge in foreclosures.
• Bank of America is not the only big lender with option ARM headaches. Wachovia (WB) said borrowers in its $122 billion "Pick-a-Pay" option ARM portfolio owed 85 percent of what their homes were worth on June 30, up from an original 71 percent. In California's Central Valley, the average was 109 percent.
• Countrywide said borrowers of 83 percent of its option ARMs got their loans with little or no documentation of their income.

So let's review. Banks need to be bought because this is the upteempth bottom. We need to trust these executives who have told us for each quarter (4 in a row) it won't get worse than this, and they don't need to raise capital. Meanwhile in 2 banks alone we see $150 BILLION (that's with a B) of option ARM mortgages where the balances on the principal have been RISING for the past 2-3 years, instead of receding like a "normal" mortgage would. And that's the situation is home prices stabilized where they are TODAY, and fell no further. And that's if job losses stopped where they are TODAY, and fell no further.

So against that backdrop let me give you the saving grace: gasoline prices will fall 40-60 cents, saving people $25 a week. They can throw that against their mortgages and that solves the whole problem. Or so say quant hedge fund computers per the price action the past 7-8 weeks.

Now that you understand, please go get yourself some bank stocks because "it can't get worse" and "it's all priced in" ... or any early cycle stock because we'll be out of this non-recession soon. Very soon. Since all that matters are gasoline prices - the magic elixer. Oh wait. Did I mention the Alt A loans and Prime Loans that are just now beginning to go bad? Oops.

I can't stress again what we've allowed to happen - essentially the NASDAQ tech bubble has been overlayed on top of the housing sector. So now it effects us all - and it's poison has infected countries worldwide. How this gets solved in 13 months is beyond me but that's the current Wall Street fantasy. The one we'll be sold each time the market rebounds off oversold levels, and banks rally 60-75% in 6 weeks. Once the Kool Aid wears off, they are just better shorts the higher they rebound. This will keep working - until one day the housing market truly settles as people make transactions at prices that make sense for both buyer and seller, and are based on a normal ratio to incomes. We're not close.

So please take the time to read about Zareh Tahmassebian, at 22, the proud owner of 8 houses on his own, and 7 more with a partner throughout Arizona and Vegas in 2005, and extrapolate over the many Zareh's out there and who exactly is going to be buying all these abandoned "investor" homes on top of the growing foreclosed home inventory... even if gasoline goes down to FREE. Unicorns. Mermaids. CNBC pundits dreams of "6 months everything will be fine". All Kool Aid.

Comments

[pshah:]

Option Arms are far deadlier than subprime ever was. With subprime, the issue was unaffordable mortgages mainly due to high interest rates adjusting higher. But at least borrowers would be making full principal and interest payments and many lenders can try to solve the problem by modifying the loans and lowering their rates in some cases.

With Option Arms, borrowers were qualified using the artificially low minimum payment that simply inflates their balance each month. With home prices falling, they keep owing more on their homes every month. No amount of modfication will help because lenders will only modify them into regular principal and interest payments and these overstretched borrowers can't afford them. They just have to walk away in most cases.

2008 Aug 13 06:51 PM

[adan:]

very timely needed article - thanks!

commenter above (pshah) says it right too: "...No amount of modfication will help because lenders will only modify them into regular principal and interest payments and these overstretched borrowers can't afford them."

solutions? time and price i'm afraid, like getting over a life threatening virus....

2008 Aug 14 08:33 AM

[muley101:]

Wake up and smell the liberals. The whole subprime fiasco is just another way to redistribute your income to the 'underpriviliged', because you have plenty of money.

As John Voigt says, 'If, God forbid, we live to see Mr. Obama president, we will live through a socialist era that America has not seen before, and our country will be weakened in every way.'

2008 Aug 14 08:56 AM

[selene:]

Muley, liberals aren't running the country and weren't running the country during the run-up to the bubble. Plus hardly any of the "underprivileged" made any money off it.

2008 Aug 14 10:09 AM

[John Preston:]

Trader Mark...you article is too simplistic in its attempt to explain the current housing market and mortgage related problems.

The generation of Option ARMS you refer to actually were flawed....that part you got right....the flaw was in the amount of deferred interest which could accumulated prior to a payment recast...

The original Option ARMS...developed in the early 1980's I might add, allowed more interest to accumulate, avoiding the interim payment recasts ( before schedules 5 year recasts...). The original loans allowed the borrower to "deficit finance" up to 125% generally (some even more) of the beginning principle balance, not the 110 of the most recent generation.

FYI, the qualifying rate was never the initial payment rate...these were not about LOW qualifying....these loans were about cashflow options...they were intended for self employed, entrepreneurs...not wage earners unless they were executive-types..

Stated Income and NO Doc processing are different issues. People do not lose homes over a 7.5% change in payment....even HUD feels that modest payment increases are acceptable in designing loan programs.

The interim, uncapped payment adjustments, payment recast caused by the 110% max balance cap, are the problem, hence the flaw.

People lose homes when they can not afford the payments. I see "INCOME" as a problem. Most homeowners I know who are in trouble have 30 yr fixed rate loans...and their incomes as down 25% to 50%, or more...even w-2 wage earners.....

Acknowledging the problem if declining incomes, and the viral nature of effect housing has on the economy are central to understanding how to stem the problem. Healthy housing is key to a healthy economy.

2008 Aug 14 10:17 AM

[billddrummer:]

Another toxic effect of Option ARMS, from the banks' viewpoint, is this: Banks were allowed to count deferred interest as current income. In WaMu's case, deferred interest income represents more than 30% of total interest income from mortgage originations (look at the 10-K if you dont believe me). When these borrowers start to default, the banks will have to reverse the interest income they've already recognized.

Can you say, more writedowns?

2008 Aug 14 11:18 AM