Option Arms Chart Signals Looming Disaster

The Wall Street Journal had a fascinating story yesterday about FirstFed Financial,  a small bank based in California that focused its lending efforts on option arms to credit-worthy borrowers.  Although the bank had been heralded for its pristine underwriting standards in the past, FirstFed had lowered those standards during the housing boom to avoid losing business to competitors.  FirstFed is now facing a spike in delinquencies that is rivaling levels seen in subprime.  Forty percent of FirstFed's borrowers became at least 30 days delinquent after the payments on their adjustable-rate mortgages were recast.

For those who aren't familiar with option arms, these loans have an initial teaser rate that is significantly below the market rate.  The borrower has several options when he gets the bill every month.  The variety of choices reflect either payments towards principal, the market interest rate or merely the teaser interest rate.  The lowest payment allowed by the loan typically does not cover principal and often does not even cover the interest due, the balance of which is added to the principal amount, leading to negative amortization.  At some point, the borrower is forced to make full payments of principal and interest, either when the loan resets after a preset period (typically five years) or when the principal balance on the loan hits a preset amount (typically 110% to 125%).  When these loans reset, monthly mortgage payments can increase by 60% or more, causing credit-worthy borrowers to begin defaulting at subprime rates.

I have written about option arms ad nauseam here, particularly when I am discussing Washington Mutual and Wachovia, banks which have enormous exposure to these toxic loans.  But sometimes a really good chart is better than words.  What I found most disturbing about the chart is that we haven't even begun to see the bulk of these loans recast.  The second half of 2009 is when it starts to get really ugly, with roughly $30 billion in loans per quarter resetting to higher rates.  How many of those borrowers can really afford spikes of 40-60% in their monthly mortgage payments?  I'll let you mull that one over...