Option ARMs

If one were to design a loan that would blow up the maximum number of borrowers the moment home prices stopped rising, an option ARM would be it. Also known as a pay-option ARM and sold under names like Pick-A-Pay and Pick-A-Payment, this is a 30- or 40-year adjustable-rate mortgage that, for the first five years, gives the borrower the option each month of paying: (1) the fully amortizing interest and principal, (2) full interest only, or (3) an ultralow teaser rate (typically 2 to 3 percent) that doesn' t even cover the interest, in which case the unpaid interest is added to the balance of the mortgage. After five years, the loan resets ("recasts"), the interest rate floats, and it becomes fully amortizing.

As many as 80 percent of option ARM borrowers use the third option because it results in the lowest monthly payment or, said another way, a much higher level of borrowing for the same monthly payment. Thus, the rapid spread of option ARMs was the result of—but also fueled—the steep rise in home prices in bubble markets, especially California.

Lenders also loved this product because they could lend a lot of money to seemingly safe borrowers, the amount outstanding would grow every year without any effort due to negative amortization, and— this is key—they could book profits based on the full interest amount owed rather than on the much smaller amount actually paid by borrowers. This was yet another example of how bad accounting can lead to foolish behavior.

Option ARMs are toxic in so many ways it's hard to know where to begin. First, almost all of them were written during the peak bubble years in the peak bubble states, especially California, as shown in Figures 4.16 and 4.17. As with subprime and Alt-A loans, option ARMs had at one time been specialty products but then became widespread during the bubble years. A total of $749 billion of option ARMs were written from 2004 through 2007, about half of which were securitized, with the balance held by lenders. And while some borrowers have been able to refinance, $628 billion of option ARMs are left.5

Second, option ARMs often had multiple risk factors, such as being used for a cash-out refinancing, having a simultaneous second lien, and being low- or no-doc (more than 70 percent of option ARMs were

Doc Mortgages Origination Volume

Figure 4.16 Option ARM Origination Volume

Source: 2008 Mortgage Market Statistical Annual, Inside Mortgage Finance Publications, Inc. Copyright 2008. Reprinted with permission. T2 Partners estimates.

Figure 4.16 Option ARM Origination Volume

Source: 2008 Mortgage Market Statistical Annual, Inside Mortgage Finance Publications, Inc. Copyright 2008. Reprinted with permission. T2 Partners estimates.

Arizona

Arizona

Figure 4.17 Option ARM Originations by State

Source: Amherst Securities, LoanPerformance.

Figure 4.17 Option ARM Originations by State

Source: Amherst Securities, LoanPerformance.

liar's loans; for this reason, most are categorized at Alt-A rather than prime loans). Option ARMs were typically sold to borrowers with good credit—it was the affordability product used by many higher-income/ higher-FICO-score households to buy their dream home—so banks were lending based on FICO scores, the appraised value of the home, and the belief that home prices would keep rising forever, rather than on a borrower's ability to pay the fully amortizing amount after the loan reset. Such loose lending standards are coming back to haunt banks.

Third, because an option ARM is interest-only and has an ultralow teaser interest rate that nearly all borrowers choose to pay, there is severe payment shock when option ARMs reset, much worse than for any other type of mortgage. For example, one study showed that, on average, the monthly payment jumps 63 percent from $1,672 to $2,725 when an option ARM resets.6 "Payment shock' ' is a particularly apt name in this case because the jump in monthly payments comes as a shock to many borrowers, who were told only about the low monthly payments by unscrupulous mortgage brokers.

Finally, a mortgage in which the loan balance is going up (called negative amortization) is extremely dangerous, especially in an environment of declining home prices, because borrowers become more indebted every month and so go underwater faster. As a result, nearly three-fourths of option ARM borrowers are now underwater faster, a higher rate than for any other type of loan.

One would rightly conclude, then, that most option ARMs will default, given all of the risk factors, but you don 't even need to know all this—all you really have to understand is what the borrowers told you based on their behavior. Figure 4.18 shows interest rates from 2001 to 2008 for a standard 30-year fixed-rate mortgage (FRM) (the jagged line in the middle) and the typical option ARM (the dashed line that curves below the fixed-rate line until early 2005, when it rises above it).

Figure 4.18 shows that from mid-2005 onward, during the period when the majority of all option ARMs were written, an option ARM had a higher interest rate—by mid-2006, nearly 2 percentage points higher—than a fixed-rate loan. Given that most option ARM borrowers had good credit histories and could have qualified for fixed-rate loans,

8.50 8.00 7.50 ^ 7.00 I 6.50 | 6.00 5.50 5.00 4.50 4.00

Figure 4.18 Interest Rates for Conforming 30-Year Fixed-Rate Mortgage vs. Option ARM

Source: Bloomberg Finance L.P., Amherst Securities.

Figure 4.18 Interest Rates for Conforming 30-Year Fixed-Rate Mortgage vs. Option ARM

Source: Bloomberg Finance L.P., Amherst Securities.

why on earth would they take on the risk of an adjustable-rate loan and pay a much higher interest rate? (Typically, adjustable-rate mortgages such as option ARMs have lower interest rates than fixed-rate loans due to the risk of rising interest rates.)

The answer is simple: For the same loan size, option ARMs initially had much lower monthly payments—or, said another way, for the same monthly payment, a borrower could take out a much bigger mortgage with an option ARM. That's what borrowers cared about during the bubble, and it had the effect of fueling home price increases. Standard fixed-rate loans require the borrower to not only pay full interest but also pay down some principal every month, so even at significantly lower interest rates, they have higher monthly payments. Thus, in doing something that appears to be very irrational (taking out an 8 percent option ARM rather than a 6 percent fixed-rate mortgage), option ARM borrowers were saying that they couldn' t afford the full-interest-rate, fully amortizing loan, even at lower interest rates.

Therefore, the only hope for most of these option ARM borrowers is rapid home price appreciation. But now that the reverse has occurred, a significant majority of them are sure to default—we 'd guess 70 to 80 percent—in the absence of major loan modifications. Figures 4.19 and 4.20 show that option ARMs are well on their way to this level.

The only apparent good news about option ARMs is that recasts aren' t scheduled to hit until five years after the peak of the bubble, or in 2010-2012. But, alas, the wave is already upon us, because an option ARM can recast prior to five years if it negatively amortizes to 110 to 125 percent of the original balance, depending on the terms of the loan. For example, let's say a particular option ARM loan with a 120 percent trigger had a $500,000 balance at inception. If the borrower pays only the minimum, the balance will negatively amor tize and within, say, three years the loan balance will have ballooned to $600,000 (hitting the 120 percent trigger) and the loan will reset two years early. This is precisely what is happening, so the option ARM train wreck is starting to hit right now, rather than in 2010 or 2011 as some analysts have projected.

Goldman Sachs estimates that losses among option ARM loans will be 27 percent.7 We expect a number above 40 percent, based on 70 percent of these loans defaulting with 60 percent average severity.

Figure 4.19 Option ARM Mortgage Delinquency Rate

Source: Amherst Securities, LoanPerformance, T2 Partners estimates.

Figure 4.19 Option ARM Mortgage Delinquency Rate

Source: Amherst Securities, LoanPerformance, T2 Partners estimates.

Mortgage Vintage Delinquency Curves

Months of Seasoning

Figure 4.20 Option ARM Mortgage Delinquency Rate by Vintage

Source: Amherst Securities, LoanPerformance.

Months of Seasoning

Figure 4.20 Option ARM Mortgage Delinquency Rate by Vintage

Source: Amherst Securities, LoanPerformance.

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Responses

  • Conlan
    What is average rate of option arms right now?
    6 years ago
  • Rita
    How many american have multiple option arms?
    6 years ago
  • ROSA
    Who has old copies of inside mortgage finance statistial annual?
    6 years ago

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