It is rather clear that the housing market is muddling through. However, nationwide there has been a spurt in activity directly related to the Federal Reserve holding mortgage rates artificially low and the very expensive tax credit. This is a nationwide issue. But what isn’t a nationwide issue is the option ARM problem. Option ARMs, those lovable furry toxic mortgages that you wouldn’t give to even your worst enemy are still lingering on the balance sheets of many banks. Unlike nationwide housing issues, option ARMs are largely a problem of four states; California, Florida, Nevada, and Arizona. 75 percent of option ARMs sit in these states and 58 percent of all option ARMS are here in sunny California. Option ARMs are a subset of the Alt-A universe. Alternative A-paper includes option ARMs but also includes 30 year stated income loans, interest only loans, and other questionable products that were below prime. Specifically in this article we will look at option ARMs, the amount of option ARM loans outstanding comes to $189 billion that is securitized:
Soruce: T2 Partners LLC
Now do some basic math here. If 58 percent of the face value of the active loans is here in California, we have at least $109 billion in option ARMs just in the state. Keep in mind this is the lower bound estimate since Fitch only looked at securitized option ARMs. If we look at the total universe of these loans, we will find nearly 900,000 loans – 92,000 currently in foreclosure and 139,000 that are seriously delinquent but that leaves the bulk out floating in mortgage purgatory:
Option ARMs are largely a California problem. What is troubling beyond the obvious fact that these mortgages are absolute junk is that many of these loans are part of that infamous shadow inventory that we discuss and I will highlight why there is a false sense of security right now. Currently, we are sitting in the eye of the hurricane:
What is interesting about the above, is that we have largely moved through the subprime debacle which is wave 1 on the chart above. This impacted most states since every state had some volume of subprime loans. Yet the option ARM is largely a bubble state phenomenon. And there is nothing on the current table that is helping this out. This is largely a silent ticking time bomb that will go off in starting in 2010. Where a subprime loan can go badly slowly because of the lack of income from their borrower base, we can expect that many of these option ARMs will implode with strategic defaults. Why? Many of these were made at the peak and a large number are now underwater:
Soruce: T2 Partners LLC
As of January of 2009, 73 percent of all active option ARMs are underwater. In other words, California has $109 billion in option ARMs that have no remedy in this current market aside from foreclosure which lenders are obviously balking at. I would argue that even more are underwater because many of these were made at the peak with low or no down payment. They started out with little to no equity and this was before the California housing market imploded.
So we have established that option ARMs are largely an isolated problem and the majority of these loans are here in California. Many of these loans are going to implode not because of rate resets which adjust to interest rates, but the actual recast volume. Many are entering this stage earlier because of negative amortization caps being hit. Over 90 percent elected to go with the negative amortization payment option and this has actually increased the balance of many of these loans. At least with many subprime loans the balance didn’t grow.
So even a 2 percent teaser rate and 40 year extension will do little to fix these problems. The vast majority were stated income so good luck trying to get someone permanently on the HAMP when they have to verify their actual income via W-2s. The shadow inventory in higher priced markets tells us that people are already unable to make their payments on these toxic mortgages and this is validated by some examples in mid tier markets like Culver City, where homes are in pre-foreclosure and simply don’t appear on the MLS or any public stats. But where do they appear? In distress data:
And the above data is actually optimistic. Data released by Fitch in September shows that 46 percent of option ARM loans are now 30+ days late! Compare the actual issues and deterioration even more carefully. About 16 percent of option ARM loans in September of 2008 were 90 days late. September of 2009? The rate has jumped to 37 percent and these are highly distressed properties. These loans have the default characteristic chart trends of subprime loans but with a balance that is much larger and more isolated to a specific state. The reason we are seeing the wave shift forward is because of negative amortization:
Soruce: T2 Partners LLC
It is hard to tell how many of these loans will implode. Most of the loans are here in Southern California, in Los Angeles County if you really want to get specific:
The issue here is that not much can be done about these loans. They certainly don’t qualify for HAMP. Homeowners in many of these areas are more likely going to be strategic. I’ve gotten numerous e-mails from people saying that they have an option ARM and know exactly when their payment will recast. At that time, they will stop paying their mortgage and build up a fund and find a rental before their credit score is hammered by the foreclosure. Rental prices are falling so not a bad time to be a renter either. They figure they can buy about a year of time before losing their home. Why would you even want to work this kind of loan out? The interesting aspect of the option ARM is that it calls the banks on the biggest bluff. You want me to stay and pay my loan? Lower my principal. Otherwise, I walk. The spiking distress data tells you everything you need to know.
Even take the HAMP for example. In many cases, even with a 2 percent teaser and 40 year loan, the payment will be much higher than the negative amortization payment via the option ARM. There is little motivation to move on these. Banks are just buying time on these loans. Their preferred method so far has been to ignore these problems until they come to full fruition. People think the second wave will never come. It is already here! We are already near a 50 percent distress rate for all option ARMs and we have yet to hit the peak recast points – and these are heavily aggregated in California. Yet this isn’t an implosion? These people are the folks that only believe in what they see one step in front. They deny the shadow inventory or claim the tax credit worked. The home buyer tax credit cost the U.S. taxpayer roughly $40,000 for each additional home purchase. Cash for clunkers? $24,000. Incredibly inefficient programs that paper over the real issues. What really has happened is the housing fixes are now more nationwide in appeal (i.e., tax credit, mortgage rates, etc) but certain egregious loans like option ARMs have been isolated to their respective corners. They are on their own to fend for themselves in the state that developed them, California. What more would you expect? 58% are here so why would the other 49 states bail us out on a loan that only greased the mortgage broker commission?
And for those looking at the Case-Shiller or other data showing a minor move up in price, remember that prices are still dropping but the way the data is calculated, it does show minor moves up because of the shift in market sales. Lower priced homes, that subprime and foreclosure wave, made up a bulk of sales for the past year. Now, we are seeing more expensive homes sell but for cheaper prices thus the mix is moving up. For example, a hypothetical home in Pasadena bought in 1998 sold for $200,000. At the peak in 2007 it would have sold for $800,000. The home currently sells for $500,000. The Case-Shiller will show a nice gain even though prices are technically off their peak by a significant number. You can adjust the prices but you get the point. Each additional sale adds to the overall data and the median is at $275,000 for Southern California so it tends to shift the price higher. The median is not a good indicator of future prices. When the bubble took off the housing industry kept pointing to this as proof of sustainable housing prices. We know how that turned out.
Option ARMs are a major California issue. $109 billion is not a tiny number given the loss severity of these loans and this is only on securitized loans – the number is even bigger if we look at loans that are on the bank balance sheets. These can go from current to non-paying in massive waves once those recasts hit. My belief is many will default because of the amount of being underwater:
So what will happen? Expect to see more REOs whether the banks want the home or not. I’ve heard of banks converting the place into a rental but I have seen very little movement thus far. If anyone has seen the rental vacancy rate what do you think this will do to commercial real estate in say, condo conversions that are now shifting to apartments? Unintended consequences galore. In fact, most of the option ARM holders in California are not home owners. They have no equity plus they are constrained to their current location. Are they really a home “owner” in the traditional sense with negative equity? I would argue that they are a homeowner in name only. Home ownership was a way to build wealth through a slow and long-term methodical process. Option ARMs were never meant to be held onto beyond a short period of time and were designed to give mortgage brokers a healthy yield for their corrupt work. The irony is that many of those mortgage brokers that made these loans are out of work and financially strained, while their handiwork is destined to wreck havoc for years to come.
It is rather clear that the option ARM issue is largely targeted to California. Given all the bailouts and moratoriums it is surprising that California is still in horrible shape. But what it boils down to is the fact that these loans will not benefit from current government programs. And they shouldn’t. These will continue to fail because if you haven’t noticed, the underemployment rate of California is now up to 22 percent. So now we are seeing big spikes even in prime loans. Until the job market stabilizes there is little reason to believe a housing turnaround is in store. Option ARMs will fail even if the employment market picks up in California.
JP Morgan Chase now owns Washington Mutual that was an option ARM expert:
And many of these loans are just entering their recast period:
Driving in Southern California you will notice all WaMu locations are now Chase banks. Some ads say welcome to Chase WaMu customers. No, welcome to you JP Morgan and enjoy those options ARMs as they recast in your balance sheet starting in mass in 2010.