Option ARM Suffering

[powayseller]

MarketWatch writes Just how much are borrowers with Option ARMs going to suffer?

Much worse than I thought, in my opinion. Industry estimates are that 70% of borrowers are making only the minimum payment, thus seeing their principal rise. This can be a problem when they try to sell and home values are less than the now higher mortgage, in my opinion.

In the example, a $231K loan on which the borrower paid only part interest, grew 15% in 5 years because the unpaid interest was added to the loan balance! Yikes! This is a loan that grows with you in my opinion… If the borrower pays all the interest but no principal during the first four years, the payment still jumps in year 5 because principal repayment must begin in year 5. If you refinance, just hope you didn’t get one of those Option ARMs with a 6 month or 12 month interest-prepay-penalty, in my opinion.

In my opinion, people who bought their homes in 2004 are already at break-even on their sale today, due to lower prices, so a mortgage that has increased due to accruing unpaid interest would mean the seller is underwater by at least the amount of unpaid interest.

In my opinion, 70% of Option ARM borrowers who purchased their homes in 2003 are at break-even if you account for their now higher principal.

About 40,000 San Diegans who bought homes in 2004 and 2005 are only making the minimum payments on their Option ARMs and are thus faced with a mortgage higher than their purchase loan (67% of loans were Option ARMs, 40K homes sold per year, 70% make min. payment) according to Loan Performance.

We can make a lot more analysis on how much their loans will go up, and whether they can afford the higher payments. With the high debt, negative savings rate, and acknowledgement that Option ARMs were used as affordability products, in my opinion the people only making the minimum payment now simply cannot afford to make the whole payment and will be even less able to make the new payment that is 50% – 100% higher.

So if anybody wants to correct me or MarketWatch on our understanding of Option ARMs, this is the place to do so. This loan product is getting a lot of bad press now, because it is the most dangerous product out there in my opinion, and in my opinion, will lead to tens of thousands of foreclosures in San Diego alone. Nationwide, we could see millions of foreclosures, in my opinion.

However, it is important that we fully understand this product, and since it is so complex, I welcome any further explanation of its features.

(For clarification, the above is a combination of fact and opinion. )

[powayseller]

Here’s a post from a lady who manages a sales team for Aames Home Loan which will become Home Funds Direct in about 2 weeks, and be a part of Accredited Home Lenders. The merge of the companies will make them the 6th largest originator in the nation according to Wall Street

I am posting her insider’s view, because I think that understanding the depth and breadth of exotic lending will go a long way in predicting how this housing market shakes out. The majority of Americans will default when their loans adjust, in my opinion. After all, if we could handle the 50% – 100% higher mortgage payments, the IMF would not be warning of global recession due to the US housing market, and Greenspan would not have warned of systemic risk to the financial system. The risk being written about are due to the loans whose principal rises, and whose payments will shoot up. I believe Business Week called them neutron mortgages.

From a lender who deals in a the sub-subprime market, perhaps representative, perhaps not?

QUOTE

My office of 7 loan officers takes +/- 100 loan applications per week, 90% of that coming from cold calls.

Of the last 100, I have taken some simple statistics and have found the following:
*
68/100 had LTV’s over 80% at time of application
*
16/100 had LTV’s over 100% at time of application
*
78/100 had back end DTI’s over 55%
*
31/100 had back end DTI’s over 70%
*
23/100 had FICO’s under 500
*
81/100 had credit card debt above $10,000
*
54/100 had credit card debt above $20,000
*
18/100 had credit card debt above $50,000
*
66/100 had Pay-option ARMs
*
27/100 had Pay-option ARMs and mortgage lates
*
22/100 were either in forbearance or had been in forbearance within the past 12 months

We took 14 applications today and we cannot qualify a single borrower for any type of loan. We are sub-prime, in fact, sometimes I say we are sub-sub-prime. We can qualify almost anyone for a loan. Not today.

Let me tell you about just one borrower from today:
* Husband and wife
* Husband on fixed income military retirement $1800/mo
* Wife makes $9500/mo as a registered nurse
* 5 properties with $3,400,000 in mortgages
* All mortgages currently have prepays
* 8 interest-only mortgages
* 1 option ARM deferring $3500/mo
* 3 in Chula Vista and 2 in Escondido
* No more than $75,000 equity in any of the homes (verified by comp checks with 3 appraisers)
* All properties with front end LTV over 90%
* $65,000 credit card debt $672 Mercedes payment
* One property had 3 mortgages, one of them hard money
* 621 mid FICO
* 2×30 in the past 12 months
* Not a dime in the bank

They have been making mortgage payments with their credit cards and refinancing to pay off the credit cards. They are at the end of their rope, but refuse to throw in the towel.

This is not even an “extreme” example. I could show you dozens of these every single week.

I just wish the experts would see what I see. I think the statistics released would be different.

Granted, I only see applications from San Diego and Imperial Counties, but this is just getting out of hand.
UNQUOTE

She goes on to explain that many people do not understand their principal is increasing, and that elderly people who had a house almost paid off, now have a much higher loan that is about to reset. This is the same stuff I have been writing about for months now.

QUOTE
The bread and butter of my office is selling people out of option arms and IO and back into a “real payment.” The broker office next door simply can’t believe that we stay in business without an option arm to sell.

I will say this without any hesitation: 9/10 borrowers who currently have Option ARMs have no real understanding of what their loan is doing. I have had more than a few old ladies cry in my office when I show them the amount of deferred interest on their loan.

They were careless enough to sign a bad loan (ultimately the responsibility of the borrower to read the docs before signing), but it doesn’t help that every hack broker out there is pitching the option arm just because the rebate is so high.

Almost daily I see 70-year-old+ borrowers who used to owe $50k on their home now owing $600k on option arms.

UNQUOTE

That last part is just amazing. I think the number of refis into Option ARMs is going to be a surprise to the general public. The perception that these loans are held by new buyers is simply wrong. As Kelly Bennett reported in the Voice last week, Loan Performance records show that 68% of refinances in San Diego in 2004 and 2005 were Option ARMs.

[sdrealtor]

I saw this post somewhere else that you cut and pasted it from. It is pretty scary. The major flaw with it is that the sample selection is very biased and taken from a subprime lender.

“My office of 7 loan officers takes +/- 100 loan applications per week, 90% of that coming from cold calls.”

Sorry but you are dealing with the bottom of the barrel in terms of borrowers when you are drawing your leads from cold calls. How many of us on this board would refinance our mortgage with someone that just cold called you?

With that said, it is still frightening that the most vulnerable people in society are being exploited so badly.

[PerryChase]

powayseller, I love your post. I like the “in my opinion” sprinkled throughout your text. How about alternating with “in my view, I feel, I think, I surmise, i deduce” etc… 🙂

It’s scary indeed. I’ve come accross a lot of annecdotal evidence that buyers are in over their heads. A friend talked me into visiting an $800k + development in Del Sur and the loan officer told me that that majority of buyers do interest only 100% financing or as little downpayment as they could. I told her that I didn’t want to put any downpayment. She said that she would find me a good payment plan.

Of course, I’m not buying. I’m taking advantage of the time to become familiar with the neighborhoods in San Diego so when the right time comes, I’ll be ready.

By the time all this unravels, people might be wishing for only a 50% drop from the peak.

[jimklinge]

Very nice post powayseller – easy to read and inviting, it makes me want to participate! Here’s my two cents on:

Option-ARMs or Neg-Ams

You’ll see Option-ARM terms described like this:

$500,000 loan, 1.5% start rate, 2.80% margin over cost of funds, 11.95% lifetime cap, 125%/10-year reset cap

The initial MINIMUM payment is based on the 1.5% start rate, and changes +/- 7.5% per year. That is a mathematical formula that has nothing to do with interest rates.

When you first hear that it’s hard to fathom how a mortgage payment can adjust with no regard to interest rates, because in every other case, it’s the interest rate that determines the payment. The minimum payment is initially based on an artificially-low interest rate, but that’s the only time it has anything to do with interest.

In this example, that MINIMUM payment is:

1st year – $1,725.60
2nd year – $1,855.02
3rd year – $1,994.15
4th year – $2,143.71
and so on.

(take the last payment X 1.075 to find new pmt.)

The FULLY-AMORTIZED payment IS figured by an interest rate, and it’s determined by adding the margin to the index. Today’s index is 4.11% + 2.80 = 6.91%.

The fully-amortized payment on the $500,000 is $3,296.35.

If you only pay the minimum payment, you ADD THE DIFFERENCE onto the loan balance. – In this case, add $1,570.75/mo.

Once you’ve added/deferred enough to reach 125% of the original loan balance, the loan resets and you then pay principal and interest monthly, amortized over the remainder of the loan.

In this example, the simple math shows that the reset kicks in around month 80, or between years six and seven. But remember that the minimum payment is going up every year, so if rates stay the same or go down, the gap is narrowed and the reset could be extended further out. In any case, the loan will reset after the tenth year – heck, you have to start paying it down sooner or later.

Obviously if rates go up, the deferred-interest gap widens, and the reset could kick in sooner.

This is your standard World Savings Neg-Am mortgage, also used by Downey Savings and Washington Mutual.

Countrywide and others tweaked the 125%/10-year reset cap to 115% or five years, and those borrowers who didn’t catch it are looking at a reset as soon as 30 months, if they aren’t careful.

The example in Business Week was a reset after 30 months, and the payment went from $1,600 to $4,000 per month. Ouch.

The mortgage industry better be working on a way to re-negotiate those terms (like raising from 115% to 125%), or they will be owning A LOT of houses in the near future. Not sure how they can re-negotiate on loans sold to MBS buyers, but somebody better do something.

If John Dugan said the payments will double when rates go from 6% to 8%, he is wrong. Payments could double (or higher) IF RESET EARLY – is the accurate fact.

Sorry for the long post, but you have the intimate details of how the Option-ARMs work.

Jim the Realtor

[barnaby33]

Good posts, both of you. Thanks. Now that I understand how dangerous these loans are, I think I’ll hold off on buying myself a faux chateau in Carmel Valley with one just a bit longer.

Josh

[PerryChase]

I don’t think that there’s any way an existing loan can be renegotiated with more lenient payment terms. It’s against regulations as far as a know. A new note has to be funded with the old note being paid-off, even if it’s with the same lender.

Imagine that prices are tanking and borrowers are making minimum payments. Their notes outstanding are increasing as the value of their houses are decreasing. If it continues on a while, borrowers may just walk and let the lenders have the collateral.

[Anonymous]

Suffering, man oh man. The other day one of the posts linked to an mass auction to take place in the Michigan area with some 250 or so homes (purportedly foreclosures) that were going to go auction sometime this month.

As I scrolled through the photographs of several of the homes my heart sank. I couldn’t get past the feelings that must have been associated with the loss of those homes by hardworking families – it saddened me greatly.

Those who have lost their homes and had their lives so greatly disturbed are in my prayers and I hope they will be in yours as well.

[powayseller]

Jim, thank you for explaining Option ARMs. Can you explain why a payment does not double when the interest rate has risen from 6% to 8% at the time of the loan reset?

This chart, from Forbes, shows that Americans are increasingly using cash from their homes to make up for a savings shortfall. This graph is the reason that I believe we as a nation are not prepared for mortgage payment increases. This chart is scary. I think most people with adjusting mortgages will need to find a way out. This graph shows there is no savings to fall back on, and that cash from homes has been used up. Where is the equity? What has been done with the cash that was extracted? It certainly didn’t go into savings.

[img_assist|nid=1631|title=Hey, Big Spender|desc=Americans are using cash from homes to replace savings|link=node|align=left|width=400|height=352]

[jimklinge]

Since you asked so nicely, I’d be happy to answer that.

Here are the fully-amortized payments on a $500,000 mortgage:

$3,296.35 per month, at 6.91%

$3,990.78 per month, at 8.91%

A hefty $694.43 increase per month, but not double.

And you still have the MINIMUM payment as an option too.

The only thing that would cause an Option-ARM mortgage payment to double is a reset.

Jim the Realtor

[powayseller]

Since you responded so nicely, I’d be happy to share this excerpt of the April 2006 speech from John Dugan

“… a payment option ARM allows the borrower to obtain a much lower monthly payment initially in exchange for a much higher monthly payment later. How big is that jump likely to be? Well, in one typical example that I have used involving a modest rise in interest rates of only two percent, the monthly payment can literally double overnight, at the end of the initial period.

Needless to say, that type of “payment shock” has gotten our attention. As a result, last December the bank regulatory agencies proposed guidelines to address the fundamental issues raised by nontraditional mortgages – specifically, that, over time, borrowers will experience substantial increases in required monthly payments that (1) they may not be able to afford, putting their homeownership at risk and exposing banks to substantial losses; and (2) they may not understand.” – John Dugan, April 2006

He explains why lending guidelines are needed. “If monthly payments are likely to jump because of negative amortization and/or reduced amortization periods, then lenders must take these likely increases into account in demonstrating a borrower’s capacity to meet the terms of the loan.” He expressed concern about inadequate disclosures, namely that marketing materials emphasize low intial payments and not the possibility of payments rising later.

In Dugan’s October 2005 speech, which I referred to earlier, Dugan exlains that the payment on a $360,000 option ARM (he uses the conforming loan limit) at 6% allows the borrower to make a minimum payment of $1200/month, which gradually rises to $1600/month at the end of the 5 year intro period.

At the beginning of year 6, the payment goes up 50%, from $1600 to $2500 if the interest rate is unchanged at 6%. If the interest rate has risen to 8%, the payment nearly doubles to $3,166!

So the Option ARM minimum payment doubles when the introductory period ends and interest rates have gone up 200bps. Otherwise, it only goes up 50%.

How many people can handle a 50% – 100% jump in their mortgage payment? I can say that I could *not*.

Dugan goes on to say the borrower could refinance, but what happens if interest rates have risen or the house is worth less than the new higher principal (since the mortgage increases over the 5 year period)? The borrower could be unable to refinance.

These payment shocks occur after the teaser period ends and the loan resets.

[no_such_reality]

Poway, you’re talking about the double whammy. The interest rate rising at the same time the teaser rate and option payment expires. Technically, you’re both correct. Interest rate alone going from 6-8 won’t do it. Going from teaser or losing their minimum payment will.

Jim, quick questions, I was under the impression that the option ARMs were more stringent than your example. I thought most were coming in with a 110% cap cuasing reset which in turn drops the reset to about 29 months. 2.5 years.

[powayseller]

I did not say Option ARMs will cause payment shock *before* the reset period. They cause payment shock once the loan resets. Same with ARMs and I/Os. While you are in the intro teaser-rate period, the payment stays the same (or changes a little bit as Jim explained).

Even if the Fed lowers interest rates back to 2002 levels, the resets are going to cause a payment shock for tens of thousands of San Diegans who made minimum payments on their Option ARMs. What effect will that have on the housing market?

[Anonymous]

Most arms are 110-115% maximum negative amortization which triggers a reset, World is unusual in that they go to 125% max. neg am. – which is why they (World) can say they have never had a reset based on neg am. Additionally, they feature a 10 year recast period versus a much more frequent 5 year recast period.

[jimklinge]

I confirmed it, Washington Mutual is now running 110% resets.

Probably getting ready to sell company to some unsuspecting Wachovia-type corporation.

Jim the Realtor

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