The Next Big Thing

Once again it’s nice to see the masses climb on the bandwagon. After predicting at the beginning of this year that option ARMs would displace subprime ARMs as the story of the year, I’m seeing more press devoted toward the former product. These loans offered the borrower the option of paying the fully-amortizing principal and interest (P&I) payment, the interest-only payment, or a lower payment that would result in negative amortization (adding the shortfall between the optional minimum payment and the interest-only payment to the loan’s balance each month).

Generally, the loan payments only adjust upward by 7.5% per year until the fifth year the loan is outstanding, at which time the payment jumps to the fully-amortizing P&I payment. But once the loan balance reaches 110-120% of the original amount, the payment immediately increases to the fully-amortizing P&I payment. Since the majority of these loans were made when the Fed funds target was 1.00% (thanks again, Dr. Greenspan), higher rates have resulted in higher negative amortization amounts, which means that many of these loans will hit their triggers this year and next.

Option ARMs accounted for 8.9% of the $3 trillion in US mortgage originations in 2006 alone - that's $267 billion. They made up another 8.3% of 2005 originations, so we can safely assume the total volume in those two years alone was around a half-trillion dollars. Many were securitized, and of those that were in 2007, 20% had a loan-to-value (LTV) ratio greater than 90%. As these loans begin to reach the full-am trigger, with home prices down about 5% year-over-year (thus far), it's going to get ugly - fast.

Who took out these loans? The original target market was extremely high net worth homebuyers, who often have irregular cash inflows and thus seek the lowest possible monthly payment on what is typically a sizeable transaction, but have the wherewithal to pay off the loan – or a substantial part of it – in a lump sum at some point when their ship comes in. They’re not the problem, but in about 2005, they no longer made up the bulk of the target market.

Real estate speculators accounted for 12% of option ARMs securitized last year alone. That’s a problem, because these guys have no skin in the game. To them, it’s a business loan, so the old adage that the last debt that the borrower will default on is his mortgage goes out the window. (Actually, that old adage is dead for another reason, but I’ll save that for another day.)

The remainder of option ARM borrowers were either misled by unscrupulous lenders, or were seeking to leverage themselves into more house than they could afford with a conventional mortgage or even an interest-only loan. I tend to lump these two categories together to some degree. Let’s say I’m one of these supposedly “duped” borrowers. I go to buy a house, and the lender steers me into an option ARM. Once it hits the trigger and the payment jumps, I should be able to afford the higher payment – unless one of two conditions is true.

The first is that the only way I could afford this particular house was at the minimum payment on the option ARM. Shouldn’t I have had some idea that was the case? If I make minimum wage, shouldn’t I realize that something’s fishy if I can afford a 3,000 square foot, four-bedroom, three-car garage home on a golf course? And the second condition – which may occur in concert with the first – is that I’m otherwise over-extended, and can’t afford a higher mortgage payment without defaulting on some other debt payment.

Either way, I have some culpability, and bear ultimate financial responsibility. This “I just wanted a piece of the American Dream” crap doesn’t wash with me. One has the responsibility to be able to discern whether one’s personal version of the American Dream is a shanty or a mansion. We’re all not entitled to the latter.

For the most part, these loans did not require verification of income or assets, layering an additional level of risk onto the reset risk and the high loan-to-value. (Such loans are referred to as “liar loans” because the lenders typically know the borrowers aren’t truthfully representing their income, further diluting the “victim” argument.) And most borrowers were qualified at the minimum payment, not the interest-only or fully-amortizing payment (80% of them go for the minimum-payment option – who wouldn't?).

Serious delinquencies on option ARMs (of 90 days or more) rose from 0.6% in the fourth quarter of 2006 to 5.7% for the same quarter last year. The three biggest holders of this paper are Wachovia, Washington Mutual and Countrywide. The latter wrote down its option ARM portfolio by $35 million for the quarter, up from just $1 million a year earlier. The loans have been referred to as the neutron bombs of the mortgage market: they’ll kill all the people, but leave the houses standing. Indeed, there’s a blog called "Option ARMageddon".

Even if the decline in real estate values wouldn’t prevent many option ARM borrowers from refinancing, mortgage rates would. Given the extremely low payment, converting an option ARM to a 30-year conventional fixed-rate loan at today’s rates – which are even down from a year ago – would result in an estimated 150% payment increase. These are truly “damned-if-you-do, damned-if-you-don’t” loans.