Monday, July 13, 2009

Option ARM Defaults Now Worse Than Subprime

Buried on page two of the Money and Investing section of the WSJ is a very interesting article that highlights one of the few reasons why I believe a true recovery in the US economy is far off. Option ARM (or "pick-a-pay") default rates are now surpassing those of subprime. As a quick review, option ARMs were mortgages issued to borrowers with solid credit ratings that allowed them to choose from a variety of payment options. The minimum payment option was a partial interest-rate payment, where the unpaid interest portion was merely added to the loan's balance. A few years into the life of the loan, the loan would recast and require that the borrower begin to pay principal causing the monthly payment to balloon. The loans were most popular in high-priced real estate areas such as California and Florida, where they were used to aid in the purchase of houses that consumers couldn't afford with a traditional fully amortizing mortgage. As of April, 36.9% of option ARMs were at least 60 days past due, while 19% were in foreclosure, according to First American CoreLogic. This compares to 33.9% of subprime loan delinquencies and 14.5% of foreclosures. Many of my posts last year focused on the looming option ARM debacle, as it seemed very clear to me that these loans were being used as a mechanism for homeowners to "get in" on the great housing market ponzi scheme with the intention of just refinancing or selling before their payments recast and they were required to actually pay down the principal on the mortgage. The largest option arm lenders, Wachovia and Washington Mutual were predictably torpedoed by option ARMs but their toxic portfolios live on inside of their acquirers, Wells Fargo and JP Morgan. Certainly both banks took large writedowns on the option arm portfolios when they required the now-defunct lenders at distressed prices, but only time will tell how these mortgages end up performing. According to the WSJ article, Wells Fargo holds $115 billion, which it had marked at $93.2 billion, giving the bank room to absorb future losses. According to a securities filing in May, borrowers making the minimum payments accounted for 51% of its outstanding Pick-A-Pay balances as of March 31. JP Morgan holds $40.2 billion in option ARMS that it acquired from Wa Mu and another $46.5 billion sitting in complex off-balance sheet entities. Furthermore, our friends at the FDIC are picking up the tab on potential future losses on a $5 billion portfolio from BankUnited, the Florida-based bank that the FDIC seized and sold to private investors with a loss guarantee.

What is disconcerting about the option ARM debacle is that I don't believe we are near the peak in loan defaults. Most subprime lenders went bust in early 2007, and only now are we working our way through the worst period of subprime lending, which data shows was the mid-to late 2006 period of subprime lending. I wrote a post recently about the extraordinarily high default rates coming out of this period of lending from now-defunct subprime lenders. But option ARM and alt-A lending continued through 2007 and 2008, until it became clear that the credit crisis was not just contained to subprime. So, many of these loans have yet to recast and cause problems for borrowers. We have that to look forward to, which is nice.


mrbogue said...

Was at a friend's birthday party this weekend, and it appeared that everyone I spoke to was a real estate bull. Some sample quotes:

"It would be wise to get your cash together and go out and buy right now, you'll never get another chance like this"

"Everyone is buying houses, this is the very best time. Don't wait..."

...It felt like 2005 redux!

I tried to talk about rising unemployment, resetting mortgages, credit card defaults, etc. but just got alot of sneers and Mr. T "yeah pity the fool" looks.

...and I just found out yesterday two "sideliner" friends just went out and bought houses.

WTF, i'm the last bear left!

Oscar said...

what about inventory? i don't know where you are, but i still see so much on the market around me. i don't even mind seeing a few people buying; i'm not worried about having the market run away from me before i can get in. (of course, i said the same thing about the s&p at 700!)

mrbogue said...

Yeah, the friends are buying in San Jose, Sacramento, and Hercules (a small town in the East San Francisco Bay Area)

Call me crazy but I think we may revisit SP700 sooner or later. I'm already tracking "bellwethers" several smaller retail companies and homebuilders coming close to their March lows.

Mr Wrightwood said...

I have an equal number of friends who are looking to buy compared to those who wish they hadn't. I don't know many people actively looking to sell, but there are certainly no shortage of offers around by people I don't know personally.