By Daniel Griffith, Carnegie Mellon University
As the market begins to calm, a new threat quickly approaches. Over the next 2 years, roughly $389 billion option ARMS will reset, creating potential for massive losses in Real Estate Mortgage Backed Securities.
As the U.S. begins to see “steady” growth again (through the USD as well as GDP figures), many economists claim to see the light at the end of the recession. The financial markets seem to have stabilized, and some analysts claim we’re in the clear. The TARP program has somewhat curbed the effects of toxic assets on the economy, and in most people’s eyes, is no longer a problem to worry about. One potential oversight however, is mortgages which will be resetting over the next year or so. As Option Adjustable Rate Mortgages (option ARMs) currently stand, nearly $134 billion will be recast during 2010, at higher monthly payments. These mortgages make up significant portions of residential mortgage backed securities (RMBS), nearly 45,000 of which have been rerated by Moody’s over the last 6 years due to increased loss projections as delinquencies increase. According to the rating agency, housing prices will continue to decrease until the Quarter 3 of 2010, with an assumed 11% until the residential market hits the bottom. The continuing price declines, along with oversupply in the housing market, weak demand, and rising unemployment only further strain RMBS performance.
What is an option ARM?
An Option Adjustable Rate Mortgage is typically a 15 or 30 year mortgage, with an adjustable interest rate (normally tied to LIBOR, the Bill Bank Swap Rate, or Cost of Funds Index). An option ARM has an incredibly low initial interest rate (as low as 1%), but consistently increases over the term of the loan. One of the most attractive features of the option ARM is referred to as “negative amortization”, meaning that if a homeowner is unable to make an entire payment one month, the remaining unpaid balance with simply roll over to the next month, essentially giving the borrower leeway towards making their payments. However, every 5 years, the ARM is reevaluated with respect to the remaining unpaid interest (built up over the term of the loan so far). This loan reset will raise the interest rate of the loan, to provide the lender with a fully amortizing loan by the end of the loan term (essentially adding back in the unpaid balance). This is the one time loan rates can increase by more than the 2% per year cap (and some may substantially increase). In addition, during housing booms, lenders often underwrite borrowers based on mortgage payments which enable them to qualify for larger loans than would be realistic.
A Quick Example:
A homeowner takes a new $300,000, 30 year option ARM with negative amortization. The mortgage has an initial rate of 4% for 3 months, after which the rate adjusts monthly. We’ll assume this ARM is indexed to Cost of Funds Index (COFI), the value of which was 1.54% in 2006, with a spread of 2.5% (for the example, we’ll assume the loan recasts in 2011). The maximum rate the mortgage can reach over the life of the loan is 14%, with the minimum being 4%. For the first year, the payments are only interest (amounting to $1000), and adjusts annually after that, with a cap of 7.5%. The problem which is fast approaching is that 5th year recast, where the payment becomes fully amortizing, even if the increase in principal is greater than 7.5%. So, in the example, if the borrower has an outstanding balance of $30,000 on their mortgage after 5 years, the principal payments will be adjusted (increased) in order to factor in the unpaid $30,000. In our example even with a flat interest rate environment the reset at the end of the fifth year would push the monthly payment from $1,000 to almost $1,600 due to the deferral of interest and amortization of principal now being over a 25 year period rather than the initial 30 year. There is no limit to this increase, which could cripple the borrower (this is what’s known as “payshock”).
The Big Picture:
With that being said, a new problem is beginning to arise in the U.S. real estate market- by the end of 2012, nearly $389 billion of option ARMs will be resetting, and “negative amortization” could potentially end up destroying an even larger part of the housing market than subprime mortgages did. Moody’s projects 20% cumulative loss on option ARM RMBS issued in 2005, 41% for 2006 securitizations, and 51% for those issued in 2007. Credit Suisse publised a market review in 2007, noting the current volume of option ARMS on the market rivals that of the subprime mortgages (the outcome of which we are all aware).
According to Fitch, as mortgages begin to reset, the estimated increase in costs could be up to 63%, well beyond the means of most borrowers. Coupled with the dip in housing prices, and the increasing unemployment, a significant percentage of borrowers may experience payshock, and default on their mortgages.
The one question that remains to be answered is, how accurate are Moody’s projections? There is no way to truly know until the mortgages reset (over the next 12-32 months), and borrowers default. Given the precedent set by subprime mortgages, the future looks grim. Hence economists are beginning to see the current recovery simply as the eye of the storm, while the second wall is quickly approaching (option ARMS).
