The Option ARM Hitch
The end is near. The 60-month period from the origination of a certain type of mortgage to the readjustment of its monthly payment is drawing to a close. And the reverberations are likely to push a number of these loans into delinquency and default. Various research agrees a wave of pay-option adjustable-rate mortgages (option ARMs) are coming home to roost in the next couple of years as monthly payments reset, or “recast,” from a minimum amount. But the extent of this recast event and its effect on the broader mortgage market might not warrant the alarmist coverage of the issue. Multiple Options, and None Good The problem with option ARMs is the inherent disposition toward negative amortization, according to a late-November global credit research piece by Standard & Poor’s. The report, authored by managing director of global surveillance analytics Diane Westerback and primary credit analysts Brian Grow and Nancy Reeis, indicates option ARMs allowed borrowers to increase the size of their mortgage each month through the use of minimum payments. Option ARM borrowers have a choice regarding payment: 30- or 15-year fully amortizing payment of principal and interest, interest-only payment or minimum payment that is less than interest due. “Historically, most option ARM borrowers chose to make only the minimum payment,” Westerback said. “The payment is based on an initial interest rate that is generally below the market rate and is only in effect for a few months. When the initial period ends, the applicable interest rate is based on the applied index-based market rate.” ... Recast at Arm's Length An early September research note by Fitch Ratings indicated that $134 billion of option ARMs will recast over the next two years. Of the $189 billion securitized option ARM loans outstanding, 88 percent have not yet experienced a recast event. Of these, Fitch found that 94 percent employed the minimum monthly payment strategy, which allowed negative amortization. In the last year, the number of outstanding securitized option ARMs either 90 or more days delinquent, in foreclosure or real estate-owned proceedings rose from 16 percent to 37 percent. “Having not demonstrated their ability to make payments at the full rate, option ARM borrowers are at the greatest risk of default resulting from payment shock,” said Huxley Somerville, Fitch’s U.S. RMBS group head. “Negative equity and payment shocks will continue as option ARM loans recast in large numbers in the coming years.” ... The prospect of option ARMs swollen with negative amortization coming to recast and defaulting on a massive scale inspires bond investor fear — and hysterical headlines — but the real fallout might be dimmed by the share of loans that have already foreclosed and no longer remain in the pool. As much as 43 percent of the volume of option ARMs seen at the peak of activity has paid off or gone into foreclosure, according to Steve Berg, managing director of applied analytics at Lender Processing Services. And the remaining loans number only in the hundreds of thousands. “Looking at our database — which covers maybe 70 percent of the market — a year and a half ago, active option ARMs accounted for only 1.4 million loans,” Berg tells HousingWire. “We’re now down to about 800,000 active option ARMs.” TO READ THE FULL STORY, SUBSCRIBE NOW.