California's Ticking Option ARM Time Bomb
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"Optimists, look away now." This is the first sentence of a very brief article in last week's The Economist. The subhead reads "A nasty mortgage product promises yet more misery," and the title of the article is "Ticking time bomb." However, it's not until the fourth sentence of the first paragraph that the reader has any idea what The Economist is actually describing: Option ARM loans. And it is these type of loans that will precipitate another huge hit to the already fragile mortgage/housing market over the next 12-18 months.
The Economist does a well enough job, considering the article is only four paragraphs, of giving a remedial understanding as to what's still at stake in the mortgage crisis. The Option ARM loan, which I've mentioned at least a dozen times during the last few months, is a type of loan that allows borrowers to pay some of the interest rate monthly, leaving the principal balance unpaid and the remaining unpaid interest to compound each month, resulting in a negative amortizing loan. Typically, an Option ARM loan allows for a three or five year teaser rate payment period (introduction period that allows for a partial interest rate payment) and then the loan recasts at a new interest rate (7-9%) or the loan recasts prior to that period because the loan, as it negatively amortizes, balloons and once it exceeds the principal balance by 10-15%, it automatically recasts. Meaning one month a payment could be $1200, and the next month it could be $3200, regardless if the three or five year introductory payment period has ended or not.
Originally, banks like Washington Mutual and World Savings thought that as housing prices rose, the product made all the more sense, because when the loan hit its recast point, the borrower could refinance into a better loan, with the equity gained in the home. Since home prices have plummeted in recent months, that plan has backfired.
Now it looks like about 1.4 million households currently carry a teaser rate payment loan, most of them in California, and the interest rates have yet to recast. At stake is about $500 billion, about half of the subprime loan losses, but these loans, when they begin to rise in defaults, will be economically more severe, as the wave of recasts will fall within a much narrower window of months (6-12 months), and when property values are already low, at prices that haven't been seen since 2003 in some markets (subprime defaults helped burst the housing bubble and push home prices lower; what happens when home prices are already low?).
"When house prices are falling and refinancing is difficult, as is now the case, the option ARM is the financial equivalent of a bikini in winter. Homeowners end up owing more on a property that is worth less. Delinquencies are already rising fast. Write-offs for option ARMs at Washington Mutual, a stumbling thrift, have zoomed from .49% in the last quarter of 2007 to 3.91% in the second quarter [. . .] The biggest wave of recasts is due to happen in 2010 and 2011 [. . .] borrowers' monthly payments will then surge by 60-80%," (The Economist, 8/14/08).
Other than Wells Fargo, no bank is impervious to the looming option-ARM storm. Wachovia, for instance, sold an option-ARM product called Pick-a-Pay and it accounts for 45% of its consumer lending. Pick-a-Pay loans were used often by predatory lenders.
Banks will also be suffering further economic and legal ramifications because of these option ARM loans, as they misled borrowers and investors, the former through TILA violations, by manipulating TILA forms, thus, allowing for the amount of option ARM loans to penetrate the market. It's only a matter of time, regardless of the most optimistic economic predictions, until the option ARMs explode into unaffordable payments, ushering in another wave of foreclosures, a second declivity in home values and more failed banks.