The next storm in the mortgage crisis

The Subprime crisis is dominating the news. Wall Street and lenders have been shocked by how swiftly the market turned on them. Calling it a subprime problem is easy. It absolves us from blame and puts it on them: the subprime borrowers. Michael Lewis (author of many great books including Liar’s Poker, Moneyball, and the Blind Side) took on these unspoken prejudices in an article dripping with satire. He opened the article with this sentence: “So right after the Bear Stearns funds blew up, I had a thought: This is what happens when you lend money to poor people.”

Here is a chart on subprime delinquencies from the Dallas Fed. Subprime lenders started taking serious hits at the end of 2006. At that time, delinquencies were still at low historical levels. However, it was becoming apparent that the lenders had not eliminated risk from subprime lending; subprime reverted to acting like subprime. Wall Street somehow believed that they had sliced and diced risk out of the equation; unfortunately that was not the case. It is interesting that subprime is receiving all the blame, when subprime has mirrored the increase of delinquencies in prime.

Now Option ARM delinquencies are starting to rise at a fast pace. Here is a chart on non-performing assets compared to total assets. You can click on the chart for a larger view.

Non-performing assets are loans that are delinquent by more than 90 days. Non-performing Option ARMs are rising faster than the subprime delinquencies did in 2005. Countywide is the only lender on the chart that breaks out their performance for Option ARMs. The chart lists the non-performing assets for Countrywide’s Option ARM portfolio and not their total portfolio. The other lenders give the aggregate performance of their whole portfolio and the chart reflects their total portfolio.
Of Downey Savings’ residential mortgage portfolio, 74% is in Option ARMs; Washington Mutual (Wamu) is at 47%; Indymac, 22%; and Wachovia (World Savings), 53%. Bank of America and Wells Fargo do noFt have Option ARMs. Looking at the non-performance chart you can see the difference in the lender's with Option ARM exposure. Downey Savings, Washington Mutual, and Wachovia have more seasoned Option ARM portfolios as they have been making these types of loans for a long time. Countrywide and Indymac entered the market in the last few years. The Top Residential Option ARMs Lender chart came from Indymac's 3rd quarter 2007 review. American Home Mortgage went bankrupt in 2007. Capital One exited the mortgage industry.

Option ARM originations grew significantly over the last few years. According to Loan Performance, Option ARMs accounted for .22% of originations in 12/02, 1.75% in 12/03, 7.40% in 12/04, and 23.69% in 12/05. In terms of percentage of non-agency Mortgage Backed Securities (MBS), Option ARMs comprised 1.1% in 2002, 0.6% in 2003, 6.6% in 2004, 14.3% in 2005, and 18.3% in 2006. Scott Reckard, from the L.A. Times, writes ”Traditionally, good candidates for stated-income option ARM loans were self-employed professionals, small-business owners and salespeople with complicated finances and fluctuating earnings.” Low payments allow the borrowers to minimize payments at their discretion; when a borrower had excess cash flow, they could apply extra payments to principle or keep it for other investments.

In recent years as the Option ARMs moved to mainstream borrowers, more and more salaried borrowers used the products. According to Fitch Ratings for option ARM loans originated in 2006 almost 90% were non-full documentation (stated income, etc.) The Option ARMs were being used as an affordability product. They were also deceptively attractive. In the beginning of 2005, the MTA index was at 1.887%. This made for a deceptively low interest rate. For example, with a 3.375% margin, the fully indexed rate was 5.25%. The conforming 30 year fixed rate at that time was 5.750%. Currently the 30 year fixed rate is 5.48%. The 12 MTA is currently at 4.522%. An Option ARM with a 3.375% margin is fully indexed at 7.875%. The index is a 12 month average of the 1 year treasury, so it is slower moving than a fully adjusting index like the 1 month LIBOR. Complicating things, the Truth in Lending that the mortgage companies would disclose as part of the mortgage application process would use the current rate of the index. They would show what the payments would look like if the index would stay the same. For example, in January of 2005, they were showing the fully indexed interest accruing at a rate of 5.25% Even though the 1 year Treasury was at 2.67% which if rates stayed the same, the 12 MTA and the margin would make the fully indexed rate 6.00%.

This spreadsheet shows how the Option ARMs work. You can click on the spreadsheet for a larger view.

Bear Stearns in a filing with the SEC gave insight into a typical Option ARM scenario. Their weighted average margin for their portfolio at that time was 3.375%. Their typical loan to value (LTV) was 78%. A typical CLTV was 90%. At one point, Bear Stearns was even offering 100% CLTV Stated Income Option ARMs.

For my example, I am using a margin of 3.375%, an 80% LTV, and 90% CLTV. I am using the median value of homes of $223,100 in January 2005 as the purchase price. I am assuming paying interest only on a HELOC.

This next spreadsheet compares the balances from the previous spreadsheet to home values (Updated on 1/29/08 to reflect November 2007 Home Prices).A lot of borrowers didn’t mind going negative 2-3% a year when their properties were appreciating at a faster rate. More and more borrowers are going negative on their Option ARMs. In their SEC filings, Countrywide reports that "During the nine months ended September 30, 2007, 76% of borrowers elected to make less than full interest payments, an increase from 66% during the nine months ended September 30, 2006." As of September 30, 2007, 89% of the borrowers at Downey Savings were "utilizing negative amortization"; one year prior 86% were going negative. Indymac reported that as of September 30, 2007, "approximately 88% (based on loan count) of our pay option ARM loans had negatively amortized...This is an increase from 80% and 83% at September 30, 2006 and December 31, 2006."

If a borrower puts 10% down on a property ($22,310 in my example), and a property appreciates at 5%, then the equity would grow from $22,310 to $56,366 after 5 years. However, home values are not exactly cooperating. Declining values puts a lot of pressure on Option ARMs. Borrowers that use them are relying on values appreciating faster than they go negative. Looking at the non-performing asset chart (second chart from the top), values peaked in the second quarter of 2006. Since then values have come down and the non-performing loans have shot up rapidly.

According to the Case-Shiller index, homes appreciated at 15.9% in 2005, 0.2% in 2006. The Chicago Mercantile Exchange (CME) offers futures based on the Case Shiller index. The Case Shiller CME indexes are published on the last Tuesday of the month reflecting the data for two months prior. For example, this Tuesday, January 29, 2008, they published data for November 2007. One contract is $250 times the current value of each respective housing index value (if the index is at 200, then the contract would be $50,000). There are four quarterly contracts (February, May, August, and November). The February contract represents data from the previous October, November, December (2 month lag). As of data from Tuesday, January 29, the last trade on the November 2008 contract was at 189.80 compared to the current index of 205.09 (data for November 2007 that was released January 2008). This means that the futures are implying that the home sales in July, August, and September of 2008 will fall to 189.80 compared to the current value of 205.09.

Using the CME futures, we can get the projected values through September 2012. The CME futures are predicting that housing will go down in value by 9.3% in 2007 (December 2007 data will be released on (2/26/08)), down by 4.5% in 2008, and down by 6.7% in 2009. The futures are then implying that prices will float around that level until 2012. One caveat is that these futures are thinly traded.

I used the CME futures in my spreadsheet to estimate what values will do to calculate how much equity the borrowers will have with their Option ARMs. If the values continue as projected, then this month the borrower in my example would be at 96.5% CLTV. This is making it harder to refinance. Real estate markets vary considerably. Many will have more equity; some will owe more than their house is worth by now. The borrower in my example would have negative equity by the end of this year and would end up at a 110% CLTV after 5 years. After 5 years, Option ARMs will lose their minimum payment option. At that time they will have to pay their fully amortized payment. Option ARMs also recast when they hit their recast amount. These range from 110% to 125%. In 2005, Washington Mutual and World Savings normally were at 125%, Countrywide and Indymac were at 115%. Some other lenders had recasts at 110%.

One thing that is not being talked about on Wall Street and in the media, is that the Option ARMs with the 110% recasts that were originated in 2005 are starting to recast this year. In the example in the spreadsheet, a loan with a first payment in January of 2005 is recasting this month. Loans with a 115% recast will recast close to the 5 year mark.

The rise in delinquencies in Option ARMs is particularly alarming as most Option ARMs are still in the minimum payment phase. We already know how subprime borrowers have struggled when their payments recast. However the jump on a subprime loan is a lot less than the jump on an Option ARM. The Center for Responsible Lending did a case study on some subprime ARMs made by Option One Mortgage Corporation to borrowers in Charlotte, North Carolina in the first three quarters of 2004. The teaser rate for 2 years averaged 7.5% and had a margin of 5.4% over the 6 month LIBOR (currently at 4.6%). Using 90% of the $223,100 median price for a home in the U.S. on January 2005, a borrower with a first payment in January 2005 would have a payment of $1,403.95. On January 2007, the 2 year ARM would adjust to a fully indexed rate of 10.75% making the payment $1,857.07. This is an increase of $453.12 or a 32.3% increase in payment.

Using the same scenario, a borrower with an Option ARM would have initial payments of $574.06 for their first year on their first mortgage and perhaps a payment of $225 on a HELOC. Assuming the borrower made the minimum payment the whole time, the payment on the Option ARM would go to $617.12 in month 13, $663.40 in month 25, $713.16 in month 37. If the borrower had a 110% cap, then they would reach that point on the 37th month. They would then have to pay a fully amortized payment. Their payment would jump up to $1,468.43 in month 38. That is an increase of $755.27 over month 37 or an increase of 105.9% for the first mortgage.

One problem facing the Option ARMs is it will be difficult to restructure the loans. If a rate is restructured into a 30 year fixed rate at 7.5% in the subprime example, then there will be no change in payment (it goes from the teaser rate of 7.5% to a fixed rate of 7.5%). On the Option ARM, if the rate was restructured into a fixed rate at 6.00% in month 38, the payment would go from $713.16 to $1,228.95. This is still a large increase in payment even with a rate as low as 6.00%. Another problem is that with the low initial payments ($574.06 for the first mortgage in our example), many borrowers borrowed more than they could afford. Most borrowers are still in their teaser rate period. The rapid rise in non-performing Option ARMs is mainly comprised of borrowers still in their minimum payment period ($663.40 in our example). If borrowers are struggling with those payments, how are borrowers going to perform when the payment resets to over $1,400?

Credit Suisse has a chart shown right that shows what we are up against. Their chart shows 2010 as the start of the recasts. These are reflecting the influx of 2005 originations. However, if the borrower has made the minimum payment the whole time, then the 2005 originations with a 110% recast are already starting to recast this year.

Complicating the situation, Option ARMs were often sold with 3 year prepayment penalties to give higher compensation to the originators. This is unfortunate, because within those three years the situation changed dramatically. The fully indexed interest rate rose rapidly, home values started deteriorating, and lender guidelines changed.

One possible reason for the rise in delinquencies is that the borrowers are looking to refi out of the Option ARMs and are realizing that their equity has diminished and the underwriting guidelines have tightened. While they may have qualified with their original ltv and loan balance, they may not qualify at the new ltv, with their higher loan balance, and with the new tighter guidelines.

Subprime was the official word of the year for 2007. I suspect that in 2008, we will learn we were wrong to call it a subprime crisis. The mortgage crisis is too deep; there are too many factors. I think in 2008 the buzzword will change from a "subprime mortgage crisis" to just a "mortgage crisis."

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