Wednesday, June 3, 2009

The US Mortgage Crisis and why it's going to get worse (Part 2: Option ARMs/Alt-A).


Yesterday we talked about the subprime mortgage mess. So much has been made of the subprime mortgage implosion that you would think it was almost totally responsible for the economic collapse, and that once the subprime problem was fixed then the worst would be over.

Well... the subprime implosion is now mostly behind us and the worst is yet to come.

Over the last few years you have heard all about 'subprime mortgages'. Let's now focus on another type of mortgage: Option ARMs.

An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change).

ARMs generally permitted borrowers to lower their initial payments if they were willing to assume the risk of interest rate changes. For the borrower, adjustable rate mortgages may be less expensive, but at the price of bearing higher risk. Many ARMs have 'teaser periods' which are relatively short initial fixed-rate periods. The teaser period may induce some borrowers to view an ARM as more of a bargain than it really represents. A low teaser rate predisposes an ARM to sustain above-average payment increases.

The most important basic features of ARMs are that they have an initial interest rate and then they have an adjustment period (this is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the monthly loan payment is recalculated).

An 'option ARM' is typically a 30-year ARM that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment

Option ARMs are often offered with a very low teaser rate (often as low as 1%) which translates into very low minimum payments for the first portion of the ARM.

When evaluating an Option ARM, prudent borrowers will not focus on the teaser rate or initial payment level. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize.

When a borrower makes a Pay-Option ARM payment that is less than the accruing interest, there is 'negative amortization', which means that the unpaid portion of the accruing interest is added to the outstanding principal balance. For example, if the borrower makes a minimum payment of $1,000 and the ARM has accrued monthly interest in arrears of $1,500, $500 will be added to the borrower's loan balance. Moreover, the next month's interest-only payment will be calculated using the new, higher principal balance.

The danger of the Option ARM is nasty feature known as 'payment shock'. This is when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

Subprime mortgages had resets of 2-3 years and the bulk of those resets has past us now. The domino effect of failing subprime mortgages has collapsed housing values all over the USA. Millions of American homeowners are now in a negative equity position (the value of their home is now less than the amount of their mortgage).

Compounding this condition is the fact that millions of American homeowners began treating their home equity as some sort of housing ATM, meaning they have taken out loans against the inflated values of their houses and used the money to buy things. Some would refinance to pay off credit cards. Others would take out a home equity line of credit to buy a new car or to fund home repairs or both.

The end result is that subprime isn't the mortgage class in the most danger,Option-ARMs are because there are way more Option-ARM mortgages than there were subprime mortgages. Moreover the housing collapse has left far more Option-ARMs in a negative (underwater) equity position than there were underwater subprime mortgages. (click on image to enlarge)

So while the huge wave of subprime mortgages resettings from 'teaser' rates to market rates has virtually ended, we are still dealing with the aftermath of the resettings. Specifically there is a massive spike in subprime mortgages going into default and foreclosure.

And as the housing market struggles to absorb all these foreclosures, along comes the Option-ARM resets. The resetting of these 'teaser' rate mortgages into market rate mortgages has only just begun.

Negative equity is profoundly affecting these mortgage classes even before their teaser rates have expired. While most subprime mortgages had teaser rates lasting 2 or 3 years. Option-ARM mortgages (and a third class of mortgages called Alt-A) usually have teaser rates of 5 to 7 years. All these Option-ARM and Alt-A mortgages are only now just coming due for reset.

Worse, most Option-ARM mortgages have 'triggers' in their contracts that mandates that they automatically amortize once they've reached a certain level of negative equity, usually around 110%.

Alt-A and Option-ARM mortgages are only just now starting to implode with these 'resets' and 'triggers'.

It may be several year before many of these mortgages have to reset, yet we are already seeing defaults skyrocketing because of these 'triggers'.

T2 Partners report titled "An Overview of the Housing/Credit Crisis and Why There is More Pain to Come" outlines all of these coming mortgage problems (see report here).

If this trend continues Alt-A and Option-ARM will easily become the worst mortgage class of them all and they will dwarf the carnage created by the subprime meltdown.


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