Option ARMs, beyond the hype

The graph below (published by Business Week) has been circulating on the web as bloggers push their various Armageddon scenarios. It's a chart from Credit Suisse that shows the projected recast (not reset) schedule for outstanding option ARM mortgages. At recast the monthly mortgage payments for these borrowers will go up significantly and many will become delinquent.



But all the hype aside, let's take a look at option ARMs in some detail. According to Fitch, option ARMs worth $200 billion are now outstanding. The banks and mortgage dealers have been busy in 05. The option ARM mechanics are actually quite interesting. Here is an example from RealtyTrac :

A borrower wants a $500,000 mortgage and gets an option ARM. Each month for the first five years of the loan the borrower can make one of four payment choices each month:

1. Pay the loan on a 30-year self-amortizing basis just like a traditional mortgage. The monthly cost for principal and interest at 6.5 percent would be $3,160. Taxes and insurance are extra

2. Pay the loan on a 15-year self-amortizing basis. While the mortgage would be repaid in half the time when compared with a 30-year loan, the monthly cost for principal and interest would rise to $4,356.

3. Rather than amortizing the loan -- reducing the debt with each payment -- option ARMs allow borrowers to make interest-only payments during the start period. At 6.5 percent, the interest-only monthly payment falls to $2,708.

4. Lastly, we have the real attraction of option ARMs, the option payment itself, a payment which is insufficient to even pay off the monthly interest cost. How much? About $1,325 a month when calculated on a 40-year basis. Huh? Why look at 40 years and not 30? Because Fitch says that a 40-year loan term represented 4 percent of all option ARMs in 2004 -- but 38 percent by 2007.

This is a fantastic mortgage for the borrower. It gives one all these great options. It's perfect for someone with a lumpy revenue stream (like a seasonal small business or a consultant who gets a few gigs a year). When you get the cash, you pay down some principal, when you don't you pay the minimum (borrowing more to cover minimum interest payments, adding to principal.) It's effectively a revolving credit facility.

But why would a bank give one such a mortgage? The key assumption was that a drop in the housing prices will always follow by a reasonably quick rebound. That rebound will never take more than 5 years (supposedly based on some historical data). So the minimum payments could continue off and on for up to 5 years on this type of mortgage before the borrower is forced (this is the "recast") to start paying down the principal (like in a traditional mortgage.) By that time in case the borrower can not pay the increased monthly payments, the house price should be higher, and either the borrower or the bank will sell the house repaying the loan.

Of course because it allows "negative amortization", the minimum payments are so small that one can afford to also take on a home equity loan to finance the downpayment (called piggyback financing). Thus one could put down 5% cash or even less and buy a home. Leverage (of 20:1 or more) is a wonderful thing.

Since these mortgages were meant for small business owners, the self employed, etc., there was an added benefit (described here by RealtyTrac):

"You could get your option ARM or your piggyback deal with a stated-income loan application, an application where you estimated your monthly income and the lender generally did not check your figures. A report by Credit Suisse showed that 49 percent of all ALT-A mortgages -- the loan category that includes option ARMs -- were made with stated income loan applications."

So just as any useful tool, this type of mortgage became the tool of choice for house speculators (flippers), as well as those who simply didn't understand the product and were suckered into it by mortgage brokers. Talk about luck of regulatory oversight!

Late last year the media started buzzing about the fact that you don't have to wait five years before these mortgages get recast. If one makes only the minimum payments, the loan balance can grow quickly. These loans have a provision that requires recasting when the loan balance reaches 110% - 125% of the original. When the recast happens, not only does the borrower pay on a higher principal, but she must make principal payments as well. So the payments for many would go up by $1,000 or more.

But option ARM recasting did not accelerate as quickly as many anticipated for two reasons. One was that as interest rates dropped (ARMs are typically LIBOR based and reset periodically), the minimum payment required to keep the principal constant dropped, slowing down the growth of principal and delaying the recast further. The other had to do with it being a beautiful day in Mr. Obama's neighborhood. Under the Obama's loan modification plan, the taxpayer (thanks Mr. president) and many lenders would finance a cost reduction for these borrowers to get to debt-to-income ratio of 31%. The plan allows for loans to be extended to 40 years, and rates reset to minimum 2%. For many this will still mean an increase in monthly payments because they would now have to start paying down some principal.

So some mortgages got modified. Others have not, with low rates delaying the inevitable deadly recast. That's part of the reason the Fed is desperately trying to keep long-term rates low for as long as possible, trying to give those who do not qualify for the loan modification program a chance to refinance into a more manageable 30-year loan. With long-term rates on the rise and the Fed being forced to raise short-term rates in the near future (impacting monthly ARM payments), that window is closing. But prior to hitting the highs on that chart, the current administration will likely have the taxpayer bankroll these borrowers some more, pushing the peak further into the future. This housing price recovery may become the longest in history as the borrowers' pain gets delayed and spread to others.

One final item worth noting: the originating banks who have not sold these loans to be securitized are holding them on the books at par. That's right. As long as the borrower has not missed any payments (even if the borrower pays the absolute minimum and the principal is growing), the loan is deemed performing and will be held at par. The unpaid interest will be accrued as income (similar to a payment-in-kind security.)