Neutron mortgages – a real threat?

[powayseller]

The class of loans in which borrowers pay no principal, or even defer part of their interest, is something I will call a “neutron mortgage”. When it adjusts, it will blow up: the borrower has a 95% chance of ending up in foreclosure.

Why am I so confident? It is because of Americans’ proclivity to spend, to go into debt. It is a fact that consumers ask, “What is the most house I can afford”, not “how can I pay my house off the fastest”?

This preference for lower payments combined with Fannie Mae data showing 88% of refinancing last year was done at a higher interest rate so people could take cash out of theirh homes (YES – people are no longer refinancing to lower their interest rates, but are doing so to pull out cash, even if that means paying a rate 200 bps higher!), combined with data showing people are now paying 35% – 45% of their income on their mortgage, leads me to one conclusion:

People are maxed out on their mortgage payments today. If the rate goes up more than 10%, the money just is not there!

An option ARM in its 6th year, will go up 50%. Since interest rates have risen since their popularity began, an option ARM from 2003, adjusting in 2008, will double!

Those who bought after 2004 and try to sell their house in 2008 to get out from under that option ARM, could well be upside down on their mortgage.

Now that we know that 95% of people with option ARMs are basically screwed, let’s see how this will affect the economy. (I’m assuming that 5% of option ARM borrowers were able to increase their income sufficiently to make the higher payments.)

How many option ARM borrowers do we have in the US, in CA?

According to the NYT, “California, which has 14 percent of the country’s housing stock, leads the nation with 21 percent of homes purchased with adjustable-rate mortgages, and 44 percent of California borrowers have refinanced with option-A.R.M. loans so far this year, according to Loan Performance.” – NYT

Wow – 44 % of CA borrowers refinanced with neutron mortgages. The following names are fiction, but the events are typical of what is happening in this crazy crazy bubble.

Even Grandma Paula down the street, who’s had her house since 1970 and it was almost paid off, went off and got an Option ARM to do a remodel, send granddaughter Jane to college, and bail that ne’er-do-well son Edmund out of his latest DUI craze.

Paul Jones across the street traded in his 5.8% 30 year fixed loan and took the equity out of his home, which was almost paid off, to start a new business, get a boat for himself and perky breasts for his wife Tina, and a new Mustang for daughter Joelle.

Tom Morgan, the savvy investor, took the equity from his 1995 purchased home, to buy a condos in Florida and an investment house in Poway (that he is renting at a cash loss of $800/month).

The UPS man, Ted Block, cashed in his equity to buy a vacation home in Big Bear, and thanks the option ARM every day for lowering his payments enough that he can now afford that new truck.

Cindy Smith 2 blocks down got an I/O loan in 2003, but the following year, took a HELOC and in 2005 took the option ARM so she could bundle all her debt and take out some money to get those breast implants (she looks realy perky now!) and take a cruise to meet her new gigolo.

Sandy and Sam Chedester from the office paid $950K for a 2800 sq ft home in 4S Ranch December 2005, just one day out of bankrupty with 0% down; they had to state their income since it was too low for that $950K loan, but the bank was happy to help; to afford they house they could only do it with an option ARM – they are really worried right now, since their house is probably worth only $650K today, so they are fighting a lot and debating whether to sell now or wait for the spring rebound. Their realtor said sales will bounce back in the spring, so they are probably going to sell their house at that time.

So while the names above are fiction, their stories are representative of what has happened. These neutron mortgages are everywhere, and they are just as common to the guy who bought at the top of the market last year, as to the gal who bought in 1970 or in 1995. They were used as affordability products, as well as housing cash advance and mortgage reduction products.

This is the most important thing we all need to understand about these loans: their prevalence and their danger.

Fannie Mae has expressed public concern about the subprime borrower, who is showing higher rates of not making even the first mortgage payment. That is the problem that did in H&R Block’s Option One: the rising default in subprime borrowers who did not make even their FIRST payment forced the company to buy back those loans. Anyway,Fannie says the subprime borrower can be deemed reliable as long as he stays employed and his house continues to appreciate. In my opinion, both of these factors are at grave risk of occuring.

I don’t even want to speculate on what this means for the US economy. I think some on this forum will not be able to handle it, and I don’t feel like getting yelled at today, after just spent an hour providing all this data.

Just one question: the Business Week story said that many option ARM borrowers are surprised their loans are resetting several years early; is this due to a clause that requires the loan to start amortizing if the home’s value drops? Why are these loans resetting early?

[VCJIM]

Well all those purchases and refies are silly, except for the perky ones. Those are fully worthwhile.

[bob007]

i think powayseller is too negative. some folks will declare bankruptcy and move on. we will be paying for the actions of those folks. some people will give up every expense before giving up their home.

[sdrealtor]

I’m glad we now KNOW that 95% of the people holding Option ARM’s are screwed. Posts like this damage the credibility of an otherwise good post.

More accurate would be “95% of the people that took out Option ARM’s GOT SCREWED by a lender more interested in earning 1 to 3 points on the loan (2 to 10 times what they usually get)instead of doing doing what was in the best interest of their client and many of these people will get slaughtered”.

[Bugs]

They might be “representative” but I’ll bet every one of those examples was made up. The 4s Ranch home pruchased at $950k has not dropped anywhere close to $650k by now. And who would characterize a homeowner whom they were citing as an example an article as having “perky breasts”?

All these examples are just a little too convenient. I’m taking it with a grain of salt.

[powayseller]

Bugs, I made up the stories, but they are based on actual events. The perky lady spent her home equity on breast implants. The examples show how people have been spending their home equity.

I spoke with a realtor yesterday who was teling me the huge price drops over at 4S Ranch. He said the homes have dropped several hundred K, and blames the high Mello-Roos. Maybe I should change the 650K to 750K?

“are screwed” or “got screwed”, you’re right that I should have put more responsibility on the lenders. I bet the lawsuits on this will be huge! Bigger than asbestos… We’re going to find out the disclosure documents were not up to par.

Well, you can all have fun trashing my post, but I am just analyzing what I see, and providing some posts to a forum that has lost a little steam going into September.

[contraman]

Poway Seller, In response to your question concerning the resetting or what is commonly referred to as the recasting of a an Option ARM loan, here is what is happening.

An Option ARM loan with potential for Negative Amortization has a reset when the principal amount of the loan reaches 110% to 115% (based on the lender's guidelines) of the original principal that the borrower refinanced or financed at….

For example, you refinance into an Option ARM loan with an at the time balance of 400,000. Every month you defer when you make the minimum payment. Let's say you make the minimum payment and the difference between that and the fully amortized Interest Only payment is $1000.00 per month / so $12,000 per year in deferred interest.

In three years and 4 months, if you have a 110% guideline with your lender your principal is now $440,000 and the loan recasts without the minimum payment option available… This is the reason for the early recasting.

These loans are risky and potentially dangerous but they do and better yet "did" have a place for borrower's and investors. A bomb or explosive device, if used properly, and applied in the right manner can be used for good but if in the hands of someone not understanding it's potential…this is obviously dangerous….

By the way, There are "hybrid" Option ARM's now with a 5 year fixed minimum payment and a five year fixed fully amortized rate. We are moving many people into them from the standard Option ARM as a safer alternative, although I prefer to see people in at least a 7 year Interest Only product if they are going to refinance or buy…

Hope this helps….. 

Sincerely, Contraman

[PerryChase]

I don’t think the buyers stand a chance in court. They’ll try but everything was disclosed to them. They should’ve read the docs they were signing.

Option ARMs are good products for sophiticated buyers but the average Joe should not even consider them. The regulators will tighten the lending guidelines thus further depressing the market and lenghtening the downturn.

[powayseller]

contraman, how widely used is the new hybrid Option ARM? Why do people use the Option ARM instead of getting the I/O loan? How much of your business if from people refinancing out of a risky loan, how much from cash-out refis?

[contraman]

The new hybrid Option ARM was first introduced by Bear Stearns about 9 months ago and other lenders are now offering it (Loan City, Flagstar, Indy Mac, Dollar Mortgage) with several others following suite.

The problem with the standard Option ARM is people started seeing their index plus margin payment adjust upward every month and wanted something a little more predictable and stable concerning their rate and negative amortization. This is the solution for those that can't get into an interest only loan and don't want the old Option ARM.

They use the option ARM for a few reasons in my experience:

First, they just can't afford the interest only payment and are betting on a continual appreciating asset so they are willing to take the risk. Not good anymore, was good two years ago…..

Second, there are alot of self employed people in CA that have fluctuating income based on commission or by being self-employed. They have a 20,000 check one month and nothing for the following month so they want the option.

The tough thing for those in standard Option ARM's is that most lender's tied people up in a three year pre-pay to make bundles of rebate money (3% to 4% rebate) so these people are a little stuck unless they want to pay the pre-pay.

Believe it or not, most people that insisted on the Option ARM make more than the minimum payment every month as their interest only rate is in the mid 6's which would be where they would be today on a 7 year IO at WAMU or Wells Fargo.

My business is all over the place right now. I don't put harldy any people in a standard Option ARM, a lot of people in WAMU's 7 year Interest Only, and some people into the hybrid.

Not much cash out, just a lot of equity lines right now (they are free to my clients) to hedge against property value drops in the coming years.

Sincerely, Contraman

[powayseller]

If they get the Option ARM because they cannot qualify for the interest only, what is the typical payment they make, and how do you know what payment they make?

Which lenders have the most exposure to Option ARMs? Are you refinancing any people out of these products? Any comments on foreclosures? I understand if you have to maintain some anonymity…

[zk]

“Not much cash out, just a lot of equity lines right now (they are free to my clients) to hedge against property value drops in the coming years.”

How are equity lines a hedge against property value drops?

[PerryChase]

zk, I believe he meant that borrowers want to get the largest credit lines they can before their equity evaporates. How convenient, just as the equity is gone, the borrowers will dip into the HELOCs they previously secured to pay the mortgage. Kickin’ the can a little further down the road.

[contraman]

zk,

If a home is valued at 600,000 today and someone has a first mortgage of 400,000, we take a second LINE up to 100% which would be a second of $200,000 to draw from in the future if need be….

If the house drops to $500,000 in value then you can never get that extra $100,000) that you can get now in case of an emergency….

They don't come and cut your line later due to decrease in prices just like they don't cut your credit card line when your income drops from $100,000 a year to $45,000.

Follow me?  

Sincerely, Contraman

[contraman]

zk,

If a home is valued at 600,000 today and someone has a first mortgage of 400,000, we take a second LINE up to 100% which would be a second of $200,000 to draw from in the future if need be….

If the house drops to $500,000 in value then you can never get that extra $100,000) that you can get now in case of an emergency….

They don't come and cut your line later due to decrease in prices just like they don't cut your credit card line when your income drops from $100,000 a year to $45,000.

Follow me?  

Sincerely, Contraman

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