More on the Emerging Pay Option and Alt A Fiasco
Following on Monday’s post on pay option ARMs comes an item from Calculated Risk (CR) that gives further flavor on the issue and cites charts and info from a Bankamerica report. Remember pay option ARM allow debtors to make very minimal debt service payments in the early years. But then they recast to regular amortization based on various terms and conditions that I will discuss. As I mentioned in my post, it is my feeling that the earlier vintages such as 2005 will soon be subject to recasts to regular amortization at the non teaser indexed rate (typically Libor plus 2.5% for prime borrowers or about 8% today). My Winterism for this event is ARM neutron bomb, as I intend to emphasis it.
But first let’s deal with obvious questions, such as can these debtors refinance into 30 year fixed at 6.25% before that happens, or be churned into new teaser rate pay options. Clues to that (no) come from this WSJ snippet on CFC’s situation:
Countrywide said last week that under its new, more-conservative lending policies, 89% of the option ARM loans it made last year would no longer pass muster.
Indeed CR mentioned that prepayments (refis) have stalled significantly, and remember the silver dagger was really only plunged into this vampire’s heart in August. One thing CR does not mention, and maybe I can get him to follow up, is whether the Bankamerica report is based on 2Q or 3Q data, because the later will be far worse?
BoA also reports that prepayment speeds have slowed dramatically for outstanding Option Arms.
We can see why by circling back from another angle. Look at a chart from the Bankamerica report that shows how poorly even the 2006 pay option and Alt A vintages are doing. And remember most of these are the people who are still making nominal mortgage payments with teaser rates like 3-4%. Then we see that 60 day delinquencies are going parabolic for option ARMs generally. Snipped from this Business Week article:
Up to 80% of all option ARM borrowers make only the minimum payment each month, according to Fitch Ratings. The rest of the money gets added to the balance of the mortgage, a situation known as negative amortization
Next we see that this pay option market is smaller than the subprime market. However, this covers only the securitized market, and bear in mind that as credit conditions in the secondary market started to erode in late 2006, many lenders were stuck holding these 2006 vintage mortgages. Thus the size of the pay option ARM market is not fully reflected in this number. Incidentally this quarter CFC wrote off $1 billion, and reserved $934 billion against it’s holdings. Again from the WSJ piece:
-About three-quarters of the $79.5 billion of loans held as long-term investments by Countrywide Bank are either option adjustable-rate mortgages, known as option ARMs, or home-equity loans.
-According to UBS, gross issuance of securitized OA pools was $18.5 billion in 2004, $128 billion in 2005, and $175 billion in 2006.
Further these mortgages will be more lethal for recoveries because loan balances are increasing (negative amortization), not decreasing, which of course removes even more equity cushion. Further a large percentage (over half of total home purchases in Bubble markets in 2006) used piggyback home equity loans, leaving them with no equity. Combined with declining home prices, a situation emerges where these debtors are seriously upside down. This illustrates in spades why the 2006 vintages of all sorts (not just subprime) are in jeopardy.
Finally comes what I feel is the flaw in the analysis of pay option mortgages. There are two conditions that cause the neutron bomb recasts to regular amortization. One is the term, and CR mentions this. Most pay option ARMs have 3 and 5 year reset periods, only a few are less.
Less than 10% of Alt-A ARMs in 2005-2006 had an initial fixed period of less than 3 years.
So this gives the appearance that the problem is deferred to 2009-2011. I don’t follow the logic behind the pay option part of this chart at all, as both 3 years and 110% clauses are due to recast in the immediate period ahead.
However there is another condition that triggers the neutron bomb. That happens when the negative amortization caused by paying only 3-4% interest rates against the fully indexed and margined rate of 7-8% hits either 110% or 115% of the initial loan amount. The big data point I’m seeking and have searched for a year, is the percentage of Option Arms that uses 110%. In the case of 110% clauses, an aggressive neg am debtor will neutron bomb him or herself well before 3 years into the loan period.
I think few debtors are even aware of this. In July, 2005 I walked into a Countrywide office in Portland, Oregon, and asked the sales gals there (cute, “adorable” 20 somethings) to explain the reset terms to me. They didn’t seem to a have a clue as to what I was talking about, at least as far as the 110-115% clauses. They also felt it was irrelevant (just refi). Their jaws dropped out of their heads talking to a Martian like me. Finally feeling I was pulling teeth, I asked to read a disclosure. One gal pulled out a manual and copied page 79 for me. There buried in the small print was the 110% clause. I immediately went home and showered with very hot water to wash the flies and bad karma off.
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