Friday, January 30, 2009

Option Arms Defaults Mirroring Subprime

The Wall Street Journal has a good article about rising option arm defaults, accompanied by a nifty graph.  Nearly $750 billion option ARMs were issued from 2004 to 2007, allowing many with good credit scores to lie about their incomes and obtain mortgages to purchase properties that they couldn't afford.  The issuers of these types of loans currently reside on a distinguished list of mortgage lenders who are now no longer with us: WaMu (seized by FDIC, punted to JP Morgan) Golden West Financial (bought by Wachovia at the high, sunk Wachovia which was nearly seized by FDIC, then saved by Wells Fargo,) IndyMac (seized by FDIC) and Countrywide (bought by Bank of America for about $4 billion more than it should've paid.)  

Option ARMs, as a quick recap, were a mortgage product that allowed the borrowers to choose between a variety of payment options every month, the lowest of which was often less than the monthly interest due, causing the loan balance to grow (known as "negative amortization.")  Eventually the loans recast, principal and full interest becomes due, and the payments balloon.  Holders of these mortgages cannot afford to make the new higher payments and they become delinquent.  As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS analytics, up from 23% in September.  An additional 7% have been taken back by the lenders.  By comparison 6% of prime loans have problems (so far.) Problems with subprime are still worse, with over half of subprime loans delinquent, in foreclosure, bank-owned properties in December.  According to Goldman Sachs analysts, nearly 61% of option ARMs originated in 2007 will eventually default, assuming a further 10% decline in home prices.  Even this may be an optimistic estimate as many of these mortgages have yet to recast (see graph number two below), and housing prices continue to decline and could drop more than 10%.

Option ARMs are no longer originated as the lending community has finally figured out that perhaps it is not a good idea to allow a borrower to decide how much he should pay on his debt obligations.  Furthermore, lenders have determined that it is also silly to underwrite a loan without checking to see if a borrower actually has a job, or some income, or maybe a valuable asset or two and isn't just making stuff up on his mortgage application.  The honor system apparently doesn't work in mortgage finance.  Good social experiment, although I would've preferred that be it conducted in a lab and not cost our economy so dearly.  Finally, even if there was a lender out there that was still willing to underwrite an option ARM, I believe that congress has outlawed them, albeit about four years to late to make a difference.  

The following graph from today's Wall Street Journal article depicts option ARM delinquencies compared to subprime.  Note that neither of the two have leveled off at all, and just continue at ever steeper trajectories.            

This next graph also from the Wall Street Journal was included in a post I wrote in August entitled "Option Arms Chart Signals Looming Disaster."  The graph shows the percentage by which borrowers' payments will jump once their mortgages are recast.  One can easily conclude that delinquencies will only increase sharply as payments jump higher and borrowers are incapable of refinancing or selling their homes.

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