MBA Mortgage Delinquencies Chart

Link to the MBA Mortgage Delinquencies Press Release.

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FFIEC Mortgage Delinquencies Chart

Link to the FFIEC data via the Federal Reserve..

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Mortgage Delinquencies continue rising higher

The Mortgage Bankers Association released their National Delinquency Survey for the Second Quarter of 2009. The total residential mortgages that are at least 30 days delinquent rose to 9.24%. When including loans that are in the foreclosure process the figure rises to a startling 13.16%.

The percentage of loans that are in the foreclosure process rose to 4.30% in the second quarter up from 3.85% in the first quarter.

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Mortgage Defaults Continue to Surge Higher

The Mortgage Brokers Association released the results of their National Delinquency Survey for the third quarter of 2008 last Friday. The seasonally adjusted delinquency rate for mortgages on one-four unit residential properties was at 6.99%, up from 6.41% in the previous quarter and up from 5.59% a year ago. This is the highest on record since the survey began in 1979.  Foreclosures started were at 1.07% down from 1.08% in the previous quarter and 0.78% a year ago.  The percentage of loans in the foreclosure process for the third quarter was 2.97%, up from 2.75% in the previous quarter and 1.69% a year ago.  9.96% of all loans are now delinquent or in the foreclosure process.

Subprime delinquencies rose to 20.03% from 18.67% in the previous quarter and 16.31% a year ago. However, delinquencies are not confined to subprime, prime mortgage delinquencies rose to 4.34% up from 3.93% in the second quarter of 2008 and 3.12% in the third quarter of 2007. Prime delinquencies averaged 2.37% from 2003 - 2006.

Last month, the Federal Financial Institutions Examination Council (FFIEC) released their statistics on mortgage and consumer loan delinquencies. Their definition of a 30 day late is a loan that is over 30 days late when the bank reports (page 501 on this manual). For example if a loan had a March 1st due date and payment was not received by March 31st, then the MBA survey would count that as 30 days late. The FFIEC report would count not count that as "over" 30 days late. If they payment was not received by April 30, then the FFIEC methodology would count that as over 30 days late but not "over" 60 days late. Therefore, the FFIEC numbers for a 30 day late are in between the MBA's 30 day and 90 day delinquency numbers. Nevertheless, the FFIEC delinquencies are showing similar spikes up to the MBA 30 and 90 day delinquencies. Consumer loan delinquencies rose but at a slower pace in the third quarter. Consumer delinquencies spiked up during the last two recessions and did not start to fall until after the recession ended.

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Option ARMs are no longer being ignored

In January I posted that Option ARMs would be the next storm in the mortgage crisis. At that time, I felt that the dangers of Option ARMs were being ignored. Six months later, the situation is quite different. The Non-Performing Assets (NPAs) have nearly doubled from 2007 Q4 to 2008 Q2. Moreover, the deterioration seems to be accelerating.

Here is an update of the top 10 of Option ARM lenders of 2007. 5 of out of 10 no longer in the business: Countrywide (bailed out by BofA), American Home Mortgage, IndyMac, Capital One (shut down mortgage division), and Luminent Mortgage. Most of the others are struggling for their existence.

On Tuesday Wachovia announced $6.1 billion in writedowns. However, two analysts called the bottom on the stock and the stock rallied by nearly 30%. I think it is too early to call the bottom for many reasons:

The deterioration of the Option ARM portfolio is accelerating. Non-Performing Option ARMs grew to 5.8% in Q2 (pg. 15). In addition 3.9% of the Option ARMs are more than 30 days past due and 1.3% are more than 60 days past due.

Wachovia has a portfolio of $122.026 billion in Option ARMs (pg. 16). The average LTV at origination was 71%. It has deteriorated to 85%. With falling housing prices, Wachovia projects the LTV to reach 99% at the bottom. 58% of Wachovia's Option ARM portfolio is in California ($71.211 billion). The average LTV was 70% at origination and is now 90%. Wachovia projects the California LTV to deteriorate to 104%. Any second mortgages or further negative amortization will further increase the problem.

Wachovia's commercial division is also experiencing a surge in Non-Performing Assets. Their Real Estate Financial Services division has seen an increase in NPAs from 0.46% in Q2 2007 to 3.95% in Q1 2008 to 5.1% in Q2 2008 (pg. 47). This division has $48.355 billion in assets.

In June of 2007, Wachovia was touting their 10 year recast and 125% balance limit. As chronicled in this post, other lender's Option ARMs are starting to recast. The loan Wachovia used as an example until 2011. However when it does recast, the ramifications will be a lot worse. The balance will have grown from $250,000 to $325,000. The payment will jump from an initial payment of $804 to around $2500.

Wachovia's Option ARM borrowers are already struggling as reflected in their rising delinquencies. Their credit scores are also deteriorating. The average Option ARM borrower's FICO at origination was 675 compared to the current average FICO of 661 (pg. 34). For Wachovia's traditional mortgages, the FICO improved slightly from 731 at origination to 732 currently. If borrowers are struggling during the low payment period, how are they going to react when their payments triple and Wachovia projects that many will be underwater?

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Option ARMs: The Next Real Estate Crisis

Business Week calls Option ARMs The Next Real Estate Crisis. The article opens with this analogy:

The American homeowner must feel like one of those characters in an old cartoon who has just been hit by a falling piano. After dusting himself off and touching the large bump on his head, he probably doesn't expect another piano to be dangling overhead. But he'd be wrong.

The piano is the impending crisis caused by Option ARMs resetting to higher payments. These previous posts of mine took a look at Option ARMs: original post and an update.

The Business Week article gives us an update on some key statistics:

According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Some of these loans have already started to recast. About 13% of option ARMs that were issued in 2006 were delinquent by 60 days by the time they were 18 months old, Credit Suisse said.

About a million borrowers have option ARMs, but only a fraction have already fallen due. [NOTE: should read "only a fraction have already recast."]

Among the states expected to be worst-hit is already battered California. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse.

Previously I had posted Credit Suisse's chart on resetting ARMs. This chart did not account for the payments recasting when the balance had grown larger than the recast amount of 110%, 115% or 125%.

The Business Week article now has Credit Suisse's updated chart accounting for recasts. According to the chart, the amount of Option ARMs recasting will rise from the current pace of about $2 billion a month to about $4 billion a month by the end of this year to about $10 billion a month by the end of next year. This is roughly $120 billion resetting in 2008 and 2009 with another $80 billion in 2010.

I posted this chart from IndyMac in my original Option ARM post. To update the status of the top 6: Washington Mutual stripped their CEO of the chairman title, Countrywide is being bailed out by Bank of America, American Home Mortgage went bankrupt, Wachovia fired their CEO, IndyMac is struggling to survive, and Capital One shut down their mortgage division. The others on the list are feeling the pain as well.

The mortgages that are resetting now have huge payment shocks. In an example I used in this post, a borrower with a first payment due in January 2005 had a beginning payment of $574.06 a month. The loan in that example reset in February 2008 to a payment of $1,468.43. That is a huge difference. Especially if the borrower could only afford the teaser payments. Many borrowers that took out these type of loans expected real estate prices to rise faster than their negative amortization. Instead, their loans are hitting 110% or 115% of their original balance causing resets and real estate prices instead of going up faster, have declined.

Wall Street is starting to address the potential problems involving Option ARMs. The recent surge in delinquencies is helping draw attention to this sector of loans.

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Mortgage and Consumer Loan Delinquencies Continue To Spike Up.

The Mortgage Brokers Association released the results of their National Delinquency Survey for the first quarter of 2008 today. The seasonally adjusted delinquency rate for mortgages on one - four unit residential properties was at 6.35%, up from 5.82% in the previous quarter and up from 4.84% a year ago. Foreclosures started were at 0.99% up from 0.83% in the previous quarter and 0.58% a year ago. Both of these percentages are the highest on record since the survey began in 1979.

Subprime delinquencies rose to 18.79% from 17.31% in the previous quarter and 13.77% a year ago. However, delinquencies are not confined to subprime, prime mortgage delinquencies rose to 3.71% up from 3.24% in the fourth quarter of 2007 and 2.58% in the first quarter of 2007. Prime delinquencies averaged 2.37% from 2003 - 2006.

Last month, the Federal Financial Institutions Examination Council (FFIEC) released their statistics on mortgage and consumer loan delinquencies. Their definition of a 30 day late is a loan that is over 30 days late when the bank reports (page 501 on this manual). For example if a loan had a March 1st due date and payment was not received by March 31st, then the MBA survey would count that as 30 days late. The FFIEC report would count not count that as "over" 30 days late. If they payment was not received by April 30, then the FFIEC methodology would count that as over 30 days late but not "over" 60 days late. Therefore, the FFIEC numbers for a 30 day late are in between the MBA's 30 day and 90 day delinquency numbers. Nevertheless, the FFIEC delinquencies are showing similar spikes up to the MBA 30 and 90 day delinquencies.

Consumer loan delinquencies are also spiking up. Consumer delinquencies spiked up during the last two recessions and did not start to fall until after the recession ended. It is alarming that we are having this acceleration in delinquencies without the severe effects of a recession like rising unemployment and big drops in personal income.

The stock market is pricing in that the worst is behind us. However, the delinquencies are continuing to accelerate. Home price depreciation is also accelerating. The charts are the inverse image of a falling knife. I believe it is too early to call the bottom yet especially if we do enter a full blown recession.

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Option ARM delinquencies continue to spike up; many borrowers are underwater

Indymac reported their first quarter losses today. They posted a loss of $184 million or $2.27 a share. Last quarter they announced that they expected to post a profit of $13 million for 2008. Today they reversed course announcing that they expect to lose money every quarter this year. They also released information on their non-performing assets.

In January, I had a detailed post on the intricacies of option ARMs. The delinquencies are continuing to surge. Countrywide's non-performing Option ARMs (non-performing loans are more than 90 days delinquent) jumped from 5.70% to 9.40% in just 3 months. In the beginning of the third quarter of 2007, Downey Savings launched a borrower retention program "to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loans subject to negative amortization to a less costly financing alternative. At March 31, 2008, approximately 91% of such borrowers had made all loan payments due." Any loans that were modified in that fashion are included in the Downey Savings' non-performing assets even they they may be current. Using this method, Downey Savings' non performing assets is at 11.90%. However that is more of an accounting measure than an accurate guage of delinquencies. Excluding those borrowers who are current but have received modifications, Downey Savings' non-performing assets jumped from 4.78% to 7.41%. 65% of Downey Savings loan portfolio is comprised of Option ARMs. This is down from December 31, 2007 when 74% of their portfolio was comprised of Option ARMs. Washington Mutual's non-performing assets went from 2.17% at the end of 2007 to 2.87% in the first quarter of 2008. 45% of Washington Mutual's portfolio is comprised of Option ARMs. Indymac's non-performing assets now total 6.51% up from 4.61% in the previous quarter. Option ARMs are now 29% of their portfolio held for investment, up from 22% last quarter. Wachovia's non-performing assets increase to 1.70% from 1.14%. As of the end of last year 46% of their residential mortgage portfolio was comprised of Option ARMs. Bank of America and Wells Fargo's non-performing assets increased more modestly rising to 0.84% and 1.16% respectively. Bank of America and Wells Fargo did not offer Option ARMs.

Since I posted the article on Option ARMs, there is some good news and bad news. The good news is the rates have come down quickly. A fully indexed rate on the Option ARM example I used is 5.125%. This is down from the peak of 8.375% where it was for seven months in the beginning of 2007. However, the 12 month MTA index is a 12 month average so it takes time to move up or down. The example loan with a first payment due in January 2005 in the previous post, had a beginning payment of $574.06 on a balance of $178,480. If the loan had a 110% recast and the borrower had made the minimum payments then the loan would have reset in February 2008 with new payments of $1,468.43. If the loan that had a 115% recast and assuming that rates stay the same as they are this month, then the loan won't recast until the end of five years (01/10). The payments at that time would be $1,196.80 (with a fully indexed rate of 5.125%).

The bad news is that the declining home prices have deteriorated faster. Using the Case Shiller CME futures to project future home prices, in January I posted that a borrower would owe 110% of what the house was worth at the end of 2009. Using the current futures prices they will owe 120%. The borrower in that example, will have been on a roller coaster ride. Their interest rate went from 5.375% to 8.375% and is now heading back down possibly to 5.125% or lower. Their house values went from $223,100 in January 2005 to $261,108 in June of 2006. In June of 2006 their CLTV was 79.2%. Their equity position went from their 10% down payment of $22,310 to an equity position of $54,359. Today, the example house would be worth $213,081 and if they made the minimum payments the whole time, they would now owe $221,226. They would have to bring in cash just to sell the property even without considering real estate commissions. The delinquency rates are spiking up on these option ARMs and the bad news is the majority of borrowers with these loans have not had their payments recast into fully amortized payments. At that point we will be moving into uncharted waters.

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Consumer loan growth is flat for March

U.S. Consumer debt increased in March 2008 by $15.3 billion on a seasonally adjusted basis. During the first quarter, consumer debt increased by $34 billion, the most since the first three months of 2001 before the 2001 recession. Growth in consumer debt dropped dramatically during the recession. This is typical of recessions. Consumer debt usually peaks before the start of the recession and declines during a recession as consumers tighten their belts and banks tighten their lending standards.

The headlines from the media on consumer debt suggest that the "slowing economy is forcing Americans to accumulate credit-card and other forms of debt." This would be going against the grain of the pattern of declining growth of consumer debt during recessions. On a non-seasonally adjusted basis, consumer debt actually declined by $16.3 billion since December 2007. It is the seasonal adjustments that lead to an increase of $34 billion. Year over Year on a non-seasonally adjusted basis the growth rate has turned flat. The growth rate usually vacillates with steep slopes in the growth rate. The periods where it is flat is typically at the tops and bottoms. Meanwhile, mortgage delinquencies are rising at a faster pace than consumer loan delinquencies. While consumer loan and mortgage delinquencies normally rise and fall together, consumer loan delinquencies have typically been more volatile than mortgage delinquencies. This time around, it looks like the problems are being driven by the housing crisis.

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Credit Card Delinquencies Rise and Growth Slows

The Wall Street Journal had an article on Credit Cards on their front page Friday. Here are some quotes:

America's love affair with credit cards may be headed for the rocks.

Credit-card delinquencies are rising across the nation, a sign that
some Americans are at the end of their rope financially.

In December, an average of 7.6% of credit-card loans were either at
least 60 days delinquent or had gone into default, up from 6.4% a year earlier,
according to research firm RiskMetrics Group.

Taking a look at consumer loans (including installment loans such as auto loans), delinquencies are about average. They can and probably will get a lot worse. During the past two recessions, delinquencies have risen during recessions and have peaked a few months after the recession. In the past consumer loan delinquencies have been more volatile than residential mortgages. Consumer delinquencies rose sooner and faster leading delinquencies in mortgages. This time around, it is the mortgage delinquencies that are rising faster.

Per the Wall Street Journal: "Yesterday, the Federal Reserve reported an abrupt slowdown in consumers' credit-card borrowings. In December, Americans had $944 billion in total revolving debt, most of it on credit cards, a seasonally adjusted annualized increase of 2.7%. That was off sharply from seasonally adjusted growth rates of 13.7% in November and 11.1% in October."

Revolving debt has grown at a pace of 7.5% this year. Monthly changes in debt are very volatile. Last month’s slowdown is not uncommon. October and November’s numbers were artificially high. Just this April, debt slowed to a growth rate of 0.6%. However the months before and after were at 10.0% and 12.8%.

Consumer debt goes through very pronounced cycles. Looking at consumer debt growth over since 1952, growth usually slows dramatically during a recession. Personal Income usually leads changes in consumer debt.

Looking at the rapid increases in mortgage delinquencies and the relatively moderate levels of consumer debt, it points to the housing crisis as being the driving factor. Consumer debt will follow, but it is not the cause.

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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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