Wells Sees 60-70% Loss Severity in Option-ARMs

The housing market may have reached a bottom, but investors should not expect the market to return to pre-bubble conditions when prices and sales ran up unsustainably, according to a structured products research report by Wells Fargo Securities. The market can also expect heavy losses among Option adjustable-rate mortgages (ARMs), a product that allowed negative amortization by letting borrowers choose to pay only the minimum monthly payment. Fitch Ratings expects significant payment shocks over the next several years as a wave of Option-ARMs recast from the minimum amount to a fully amortizing principle and interest payment. These recasts are expected to drive substantial losses among the Option-ARM sector. "Several of our investors have questioned the current loss severity in light of negative amortization and home price decline," researchers wrote in the report. "Our analysis suggests that option ARM loss severity will likely range between 60% and 70% provided home prices have stabilized." Wells Fargo researchers said investors can instead look for a return to longer-run measures. Existing home sales excluding foreclosures are likely to cap at around 3m units annually. foreclosure sales are likely to contribute 1m transactions to total sales, with a peak in foreclosure rates likely to occur in mid- to late-2010 between 1.8m and 2m units. "Overall, our forecast implies a total of 7.2 million foreclosure units by 2014," researchers wrote. "Although the foreclosure inventory will likely dampen home price appreciation, we believe most of the home price damage due to foreclosure inventory is done and that home prices will likely remain stable over the period." In light of the projections, Wells Fargo revised its loss estimates on various credit sectors. Wells Fargo researchers expect cumulative losses on prime ARMs to range from 2% among '04 vintages to 6% among '07 vintages. Cumulative losses should range between 6% and 11% among Alt-A/B ARMs and between 11% and 36% among subprime ARMs. Write to Diana Golobay.

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