BY KATHLEEN DOLER
FOR INVESTOR'S BUSINESS DAILY
After a deluge of mortgage defaults, the proverbial perfect storm is building and the
Home Seller Assist program created by
John Alexander is riding the wave!
A confluence of negative equity, resetting mortgages and rising unemployment is expected to bring a new wave of foreclosures pressing down on home values. California and Florida are at the greatest risk.
The mortgage-trouble catalyst this time isn't general subprime lending. It is resets, to higher required monthly payments, on nearly $100 billion worth of "pay option" adjustable-rate mortgages issued during the housing boom.
Low Payments, For A While
Also called option ARMs, these loans give borrowers the option of making low minimum monthly payments, but with a catch. When they choose to pay less than 100% of the interest due each month, the difference then gets tacked onto the loan's principal. That's negative amortization.
But many borrowers don't realize that once the loan reaches 110% to 125% of the original principal it recasts, or resets, to require full interest-plus-principal payments.
"I didn't really scrutinize the concept of negative amortization," said Arizona property owner Jae Kim. "It should have really been explained better. It's a very dangerous product in a down-market economy."
Kim is trying to get his option-ARM modified through mortgage-consulting firm Loan Safe Solutions, in Corona, Calif.
Moe Bedard, its president, says 99% of the 600 option-ARM borrowers his company has spoken to "claim they had no idea that the loan would recast early if only the minimum payment was made."
Loan documents disclose that the mortgages will recast early if the full interest isn't paid each month, but the information is often buried in densely worded disclosures.
Wrong Borrowers
A Federal Reserve tutorial cites option ARMs as potentially appropriate for borrowers with:
• Future income increases considered reasonably certain.
• Plans to invest funds that would otherwise go toward principal (plus sizable home equity).
• Seasonal earnings, commissions or other irregular income making payment flexibility ideal.
But relatively few option-ARM borrowers have opted for flexibility. In the past 24 months more than 65% have paid just the minimum monthly payment. The number goes up to more than 85% for the 2006 and 2007 loan vintages, according to Fitch Ratings. Complicating matters, the interest rate on some option ARMs changes often.
Some option-ARM loans have already begun to reset. About $29 billion will do so by the end of next year and $67 billion in 2010, Fitch says.
As an option ARM nears its recast level, lenders usually send out a "side letter," notifying the borrower of the impending change, says Eric Rice, chief executive of DyerBeech Enterprises, a San Diego-based financial-planning and loan-modification consulting firm.
The recast information typically doesn't appear on the monthly payment coupon, he says, and many borrowers throw the side letter away unseen — thinking it's just a promotional offer.
States apt to be worst-hit by a coming storm of option-ARM resets include California and Florida — with markets already pummeled by subprime mortgage defaults.
California has eight of the top 10 riskiest markets for loan delinquency and default, says data analysis firm First American CoreLogic.
Of California mortgages originated from 2005 to 2007 and securitized, 55% to 60% were option ARMs, says Grant Bailey, a Fitch senior director.
"We're assuming between 30% and 40%" will default, he said.
Other estimates aren't as high, but the potential for problems looms.
Trouble Compounds
Home values have crashed in markets where these loans were sold heavily. So many borrowers who owe more than their homes are worth are stuck, unable to refinance or sell. Now they face the prospect of a doubling or tripling of their required monthly mortgage payment, amid rough economic conditions.
First American Chief Economist Mark Fleming says making just minimum payments drives foreclosures. Borrowers are "leveraging up to the negative-equity cap in a market with strong house-price declines," he said. "And now unemployment rates (are) rising."
Option ARMs were already a sore spot. "These loans have had high delinquency rates before the recast," said Guy Cecala, publisher of the newsletter Inside Mortgage Finance, in Bethesda, Md.
And this despite the fact that many of these loans were made to Alt-A buyers — originally a category of people considered to have good credit standing but perhaps limited income documentation.
Stuck On The Books
Fitch estimates about $300 billion in lenders' option ARMs have been packaged and sold to investors as securities. But many were not sold, "because the payments fluctuate and they're hard to market," Cecala said.
The top five players in option ARMs have been Wachovia (WB), Washington Mutual, Countrywide, Downey Savings and IndyMac, according to Inside Mortgage Finance.
All but IndyMac have been sold to, or are in the process of being acquired by, bigger players. The Federal Deposit Insurance Corp. has operated IndyMac since taking it over as a failed bank in July. The FDIC facilitated the sale of WaMu and Downey, which appear on the agency's failed-bank list.
Many other banks were in the option-ARM game, and now face a new wave of loan defaults. "You couldn't compete unless you offered these squirrelly things," Cecala said of subprime ARMs and option ARMs.
Some lenders have begun trying to modify option-ARM loans to aid strapped borrowers.
