Smackdown Week: Option ARM Resets

A couple commentors mentioned upcoming option ARM resets as a reason to be more bearish on housing. I wanted to make some quick comments about that.

First let me say that option ARM resets are a tricky thing. Most ARMs were underwritten in 2005 to early 2007. During 2005, 12-month LIBOR averaged 4%, during 2006 5.33% and in 1H 2007 it averaged 5.33% again. So the reset itself isn’t a worry at all.

Its the recast that matters. The switch from the “Option” period to the full amortization period. The tricky part there is that most option ARMs have a 5-year “Option” period. That would mean that 2010 would be a big year for recasts, and 2011 even bigger. We wouldn’t “burn out” on these things until mid 2012.

However, most option ARMs also have a provision where if the negative amortization gets to 15% (i.e., you owe 115% of the outstanding balance), it automatically reverts to the fully amortizing amount. Certainly if a borrower has managed to fall that far behind within the first couple years, the odds that that loan winds up in foreclosure is pretty high. Anyway, it throws off the theory that there is suddenly going to be a bunch of recasts in 2010 and 2011. Many of those loans are already recasting because of the neg-am element.

Here is how I see it. I track a large group of whole loan “prime” mortgage securitizations. My group is from 2006 and about half are Option ARMs, the rest are full amortization ARMs. Most are also limited documentation. So while the credit score said prime, everything else about the loan said “questionable.” I created this grouping back in 2007 to track how seemingly good borrowers who took out bad loans performed. Its a pretty good gauge of how Option ARMs are doing.

The 90+ delinquency (which includes foreclosures) is currently 11.5% of the original balance for the whole group. The figure continues to climb month-by-month but the pace has slowed considerable. The last 5 months its increased by about 0.3% per month, vs. over 1%/mo. during most of 2008. So that’s point 1, that the pace is clearly declining. Worth noting that the pools with mostly option ARMs are about 2.5 times the delinquency level of the full amortization loans.

Second, I track a similar group of sub-prime loans. That series has completely burned out, with the 90+ figure sitting at 17.5% for the last six-months. So basically what’s going to happen in sub-prime has already happened.

Put these two together and you could conclude that the continuing rise in price foreclosures is just making up for the lack of rising sub-prime foreclosures. I don’t know if the math of that exactly works, and I am sure that the sub-prime and prime loans were not typically in the same neighborhoods, but point is that a lack of new sub-prime foreclosures is at least something of an off-set.

If you drill down into some specific Option ARM deals, you find some very interesting info. Here are some stats on one of the deals in my list.

  • Pool Factor: 63.2% (meaning 36.8% has paid off)
    # of Loans: 496
  • WALTV: 83.5% (so few loans are being forcibly recast)
    90+ Delinq: 39.5%

Now here is what’s interesting to me. 37% of this loan has paid off. Another 40% is not paying. That means the potential new problems are only 23% of the remaining principal. I pull several other deals with the same kind of circumstances. What we’re seeing here is that the loans that never should have been made are already turning bad (the 40%). The loans that were made to actual good borrowers are paying off rapidly. What remains in between isn’t a very large number.

That’s the facts as I see them. I’d love to hear the other side.

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1 Comment on Smackdown Week: Option ARM Resets

  1. “That means the potential new problems are only 23% of the remaining principal.”

    Yes, assuming that:

    1) those making minimum payments (a proportion of the 36.8%, which I believe to be significant) can afford the reset. Questionable.

    2) You assume the recast rates will remain low for the life of the loan. Sorry, not going to happen. Rates will start to go up by mid 2010 and will cause big problems for those struggling to make payments already.

    “The 90+ delinquency (which includes foreclosures) is currently 11.5% of the original balance for the whole group. The figure continues to climb month-by-month but the pace has slowed considerable.”

    The lull was forecast in the option arm graph produced by Credit Suisse. The most recent interpolation of the figures shows that the reset schedule caused by the 115% neg am reset has been pushed significantly to the right as a result of lowered interest rates. It hasnt gone away, it has been delayed.

    If you look at the percentage of those making minimum payments (neg am) you will be truly shocked. This in combination with Alt-A is set to cause major problems for the economy next year.

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