Good-bye sub-prime fiasco, hello Option ARM foreclosures

Every time I get some marketing piece from the loan broker who tried in vain to talk me into an Option ARM loan, I remember how hard she pushed for me to take it as opposed to the 30-year, fixed-rate loan at 5-5/8 that I ultimately chose.

At first glance, it was a tantalizing prospect -- only pay the minimal amount and still be current on the mortgage? It seemed too good to be true, so I started doing my research, and once I saw those forbidding words "negative amortization" coupled with an adjustable rate, I told her no way, no how, not ever. Plus with fixed rates so low, I was only paying a $50 monthly premium for knowing exactly what my payment would be.

Of course it also helped that right after college I worked for a mortgage company, helping to process and create loan documents and knew full well what negative amortization meant. So when my broker wouldn't let it drop, I told her if she mentioned it again I'd take my business somewhere else. Of course now I tell people with good credit and assets to simply go directly to a lender and save themselves some money.

But for those people who didn't understand the pitfalls of Option ARMs, the next wave of trouble will be focused in that arena. From an MSNBC.com story:

...as the housing recession deepens, a coming wave of payment shocks threatens to bring another surge in defaults and foreclosures as these mortgages “recast” to higher monthly payments over the next two years.

“The next wave (of foreclosures) is coming next year and in 2010, and that is primarily due to these pay-option ARMS and the five-year, adjustable-rate hybrid ARMS that are coming up for reset,” said William Longbrake, retired vice chairman of Washington Mutual...

The next wave may be even more difficult to handle than the last one.

“It’s going to get tougher to modify loans as these option ARMs come into their resets," Federal Deposit Insurance Corp. Chairwoman Sheila Bair told msnbc.com this week. "Those are more difficult than the subprime and traditional adjustable rates to modify because there is such a huge payment differential when they reset."

So why did banks promote these loans in the first place? As usual, they were promoting that national value which has eclipsed everything else: greed.

Some time after Sharren McGarry went to work as a mortgage consultant at Wachovia’s Stuart, Fla., branch in July 2007, she and her colleagues were directed to market a mortgage called the “Pick A Pay” loan. Sales commissions on the product were double the rates for conventional mortgages, and she was required to make sure nearly half the loans she sold were "Pick A Pay," she said.

These “pay option” adjustable-rate mortgages gave borrowers a choice of payments each month. They also carried a feature that came as a nasty surprise to some borrowers, called "negative amortization." If the homeowner opted to pay less than the full monthly amount, the difference was tacked onto the principal. When the loan automatically “recasted” in five or 10 years, the owner would be locked into a new, much higher, set monthly payment.

While McGarry balked at selling these pay-option ARMs, other lenders and mortgage brokers were happy to sell the loans and pocket the higher commissions.

Click here for full story.

Just. Not. Getting. It.

According to an article in the WSJ, ‘Foreclosure Effect on Home Prices May Be Small’, three economists from the National Bureau of Economic Research (it may be my ignorance, but who are these guys and where have they been?) are saying prices will only go down about 6% from 2007 to 2009:

“Even in the face of an extreme foreclosure wave such as that experienced in 2007, our evidence indicates that foreclosure shocks have relatively small effects on U.S. house prices,” the authors, Charles Calomiris of Columbia University and Stanley Longhofer and William Miles of Wichita State University wrote.

The authors’ model incorporated MBA foreclosure and Ofheo home price data from 1981 to 2007, and used home foreclosure forecasts for 2008 and 2009 from Economy.com. The model included data on employment, building permits and existing home sales. In their paper, the authors said the study was first to estimate the effect of foreclosures on home prices for all the U.S.

Even under an “extreme” foreclosure shock scenario, with foreclosures up 75% compared to the baseline in 2008 and 2009, U.S. home prices only decline about 5.5% between the the second quarter of 2007 to the end of 2009, the authors estimated.

Home prices, they wrote, “are quite sticky,” and “fears of a major fall in house prices, with all of its attendant negative macroeconomic consequences, typically are not warranted even in extreme foreclosure circumstances.”

“We conclude that a reasonable estimate of the future path of U.S. housing market prices is that they will remain essentially flat, on average, for the next two years notwithstanding the large predicted increase in foreclosures,” they wrote.

What warms my negative little heart are the comments on this article. Posters had a good time poking holes in the ‘sticky price’ argument. The comments are a bit pungent, but I am glad that so many people get it. Pricing has been anything but sticky. As the next wave of Alt A loans adjusts, we are likely to see another sharp drop.

Option ARMs expected to unleash the next wave of defaults

At first glance, the Option ARM loan seems like a great product, but only if it's used responsibly. In the past, it was tapped by astute borrowers who had a varied income (such as salespeople and the self-employed), who could elect to pay a minimum amount during some months (like on a credit card) but then make up for the shortfall when more money was available. What it wasn't intended for was as a gambit in which borrowers pay only the minimal amount and hope to refinance as housing prices rose (as least not officially). But brokers really pushed these loans, as they paid far higher commission than the traditional 30-year fixed variety.

According to an article in Business Week, the the next housing crisis -- and wave of foreclosures to hit the market -- will be the result of Option ARMs re-setting, either as the result of higher interest rates or because the borrower, through negative amortization, has added so much to the loan balance that it's triggered a re-set to a fully amortizing loan:

With the subprime mortgage crisis already crippling the U.S. economy, some experts are warning that the next wave of foreclosures will begin accelerating in April, 2009. What that means is that hundreds of thousands of borrowers who took out so-called option adjustable-rate mortgages (ARMs) will begin to see their monthly payments skyrocket as they reset. About a million borrowers have option ARMs, but only a fraction have already fallen due.

That was the catch to option ARMs; borrowers were offered low initial payments that would recast higher after several years. Many home buyers thought they could resell their homes before their payments increased. But instead, many of them got trapped. According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Some of these loans have already started to recast. About 13% of option ARMs that were issued in 2006 were delinquent by 60 days by the time they were 18 months old, Credit Suisse said...

Among the states expected to be worst-hit is already battered California. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse. Option ARMs were especially popular in the state, where they were heavily marketed during the boom by such companies as Countrywide Financial (CFC) in Calabasas, Calif.; Washington Mutual (WM) in Seattle; and Wachovia (WB) in Charlotte, N.C. Moreover, on top of their ARMs, many homeowners also refinanced their homes, driving themselves even deeper into a debt they thought they could escape by flipping their homes.

But California won't be alone. Homeowners are also frighteningly vulnerable in states such as Arizona, Florida, New Jersey, and others...

The option ARM loan defaults could accelerate next year even if subprime defaults subside, said Chandrajit Bhattacharya, vice-president and mortgage strategist at Credit Suisse Securities. He said California will see the bulk of the option ARM foreclosures and the rest will be spread out across the country...

Option ARMs, which were originally designed for self-employed people with fluctuating incomes, gained popularity with other workers during the peak of the real estate boom in 2004, when rapidly rising home values would have otherwise kept many buyers out of the market.

The loans, which were generally given to borrowers with better-than-subprime credit, give homeowners the option of making a minimum monthly payment, which covers none of the principal and only a portion of the interest, the rest of which is added to the loan balance. With years of unpaid interest accumulating and house prices falling, some homeowners have seen their equity disappear and now owe even more than their initial loan balance.

The loans automatically recast after five years, but many will recast sooner as loan balances hit specific principal caps—typically between 110% and 125% of the initial loan amount. Many of these loans are expected to recast within the next two years, meaning that borrowers' monthly payments will swell to include both principal and interest...

William Purdy, a lawyer at Simmons & Purdy in Soquel, Calif., a firm that specializes in home refinance issues, said some borrowers with option ARMs are defaulting before the loans recast because they couldn't afford even marginal increases in the minimum payments.

"It's a ticking time bomb inside your house that you can't get rid of," Purdy said. "They can try to slow down the inevitable, but sooner or later their loan is going to cap. …This year is going to be a blood bath. Next year, we'll start out just about the same."...

But options are available—even if refinancing isn't possible. Lenders have been working with borrowers to reduce loan amounts and interest rates and, in some cases, simply accept the deed in lieu of foreclosure.

The Mortgage Bankers Assn. says it appears that a growing number of homeowners are avoiding foreclosure by getting help from the Hope Now hotline (888 995-HOPE), a mortgage-counseling phone line backed by lenders and the federal government that gets 4,000 calls a day. Hotline counselors help borrowers negotiate with banks and offer advice on refinancing options. Even though foreclosure rates are rising in California and Florida, they've slowed elsewhere, the bankers association said.

Some callers to the hotline have complained about long wait times, but the group says it has beefed up its counseling staff and now gets to calls quickly.

Other option ARM borrowers could benefit from government plans now in the works. A bill approved by the House in May would allow the Federal Housing Administration to guarantee up to $300 billion in new loans to help homeowners facing foreclosure. Borrowers could get more affordable loans worth no more than 90% of the home's value, meaning that participating lenders would have to take a significant loss on the loan. The bill was sponsored by House Financial Services Committee Chairman Barney Frank (D-Mass.). Senate Banking Chairman Christopher Dodd (D-Conn.) has a similar measure....

Many California homeowners, including some with $2 million homes, are simply making their minimum payment, waiting for the recast. Then they plan to walk away, even if it damages their credit, Bedard said.