Option ARMS: How they work and just how ugly they can get.

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<p>from a lender's perspective we still need them. It is unfortunate, but many people still need an option to defer interest. It is much harder to qualify for these types of loans now, and they do not pay large rebates to brokers anymore. I've actually underwritten 5/1 and 7/1 fixed rate option arm loans that carred a LOWER rate than a traditional ARM. The problem was that from 04 to now, brokers were paid monster rebates for hiking up the margin. The LIBOR and MTA indices both sky rocketed during this period.</p>

<p>Funny how Greenspan touted ARMS while at the same time increasing rates 15 straight times. WTF?</p>
 
ladera1,





Were you past the 3 year window for a refi without a huge prepayment penalty? If so, it may have worked for you.





When history looks back and dissects the causes of the bubble, the Option ARM will be at the top of the list. I suspect you will find an exploding ARM at the center of all the foreclosures in Ladera.
 
<a href="http://calculatedrisk.blogspot.com/2007/10/option-arm-performance.html">Calculated Risk</a> was fortunate to get some nice er scary charts from B of A on the performance of option ARMS.
 
They're ready to explode. I must have spoken with at least 20 people that had option arms my my bank in the the last 2 months that had no chance of refinancing. These people will all lose their minimum payment within 12 months and will be forced to pay interest and principal. Some of them even had an expired prepay. the problem is they can't qualify due to LTV or income qualifications. Specifically there are no more NINA option arms. Only stated and full-doc. I have a customer who is an OCTA bus driver and maker 63k a year but owes 773k on his loan. I am not exaggerating. He can't even qualify with stated income because I'd have to stated his income @ 188k a year which I cannot do.





Here is the BEST case scenario if you are one of these people:





You can manage to make your new higher payments, but have to signficantly reduce your spending habits.
 
<p>Come on lm. . . you got to factor in some of the perks that he get as a governmental employee. . .a few nickels here and a few dimes there and you have $188K.. . .</p>

<p>It is incredible to me that people can afford any houses in orange county. People in the top 5 percent of the income bracket make 200K+ and that barely allows on to get a 3bd home in Irvine (750K). I mean some of the homes that were going for $1 million were just average 2200 square feet houses. </p>
 
<em>" You can manage to make your new higher payments, but have to signficantly reduce your spending habits."</em>





That's the rub, isn't it.





Everyone wants to keep their house, <em>and their lifestyle</em>. Everyone is hoping the lender will work something out with them that will allow them to do both. I suspect this won't happen in about 99.9% of cases.





When people took out loans with 50%+ DTIs, they were all counting on appreciation and refinancing to permit them to borrow enough to continue sustaining their lifestyle while they got rich on thier house.
 
What are the financing options for a DINK but split income couple - one self employed, one W2?



Both credit scores above 720.



In your best guesstament, how much down am I going to need piled away to get a deal done in 2 years, as the current situation is certainly going to tighten.
 
<p><em>You can manage to make your new higher payments, but have to signficantly reduce your spending habits.</em></p>

<p>Not a chance. Even at mere 6%, with 28 years remaining, his monthly payment on $773K is equal to his gross pay less Social Security tax only. </p>

<p>So basically, all taxes, living expenses and everything else needs to come out of his spouses income after taking into account the gross up due to his Fed & State tax share.</p>
 
Here is a fairly accurate picture of how an option ARM would work if the first payment on the $500k loan started in January 2005 with a 2.75% margin. I had to tweak the numbers a little to make it as close to what the <a href="http://mortgage-x.com/general/indexes/mta.asp">MTA rate was and has become</a>. But this is pretty close to what the reality of this loan.





Year 1:





<img alt="" src="http://img105.mytextgraphics.com/photolava/2007/10/30/optarmyr1-1iua1xt9.jpg" />





Year 2:





<img alt="" src="http://img107.mytextgraphics.com/photolava/2007/10/30/optarmyr2-48c3xtljc.jpg" />





Year 3:





<img alt="" src="http://img107.mytextgraphics.com/photolava/2007/10/30/optarmyr3-48c3y56pc.jpg" />





Year 4 the OMFG year:





<img alt="" src="http://img105.mytextgraphics.com/photolava/2007/10/30/optarmyr4-48c3yuj4b.jpg" />





And if you kept this loan for 30 years and some how rates stayed where they are:





<img alt="" src="http://img105.mytextgraphics.com/photolava/2007/10/30/optarmyr30-48c3zoong.jpg" />


If you got a 30 year fixed rate at 5.75% the total interest paid would be about $550k for a total of $1.05mil. The option ARM costs about $336k more over the life of the loan but that is if the MTA rate stayed where it is. How likely is that?





What would you do if your "payment" was going to double in nine months from now?





Next up I will show how this loan works when the borrower got wacked by the broker so they could make their 3% YSP on the back end.
 
Now here is what this loan looks like when the borrower got wacked. To get the 3% YSP the broker needs to up the margin to about 3.85% and stick them with a three year prepayment penalty. I cannot even begin to tell you how many chop shop brokers who were using the 3% YSP as motivation for their "loan officers" to sell this loan. I moved the first payment up to July 2005 because this is when people really started to sell this loan. It also shows a more accurate adjustment of the MTA index.





The first six months and 2006:





<img src="http://img107.mytextgraphics.com/photolava/2007/10/30/optwack1-48c4hjfvr.jpg" alt="" />





Take a look at when the loan recasts. I wouldn't want to be at their house for Christmas:





<img src="http://img107.mytextgraphics.com/photolava/2007/10/30/optwack2-48c4ih80f.jpg" alt="" />





Now here is the rub. Lets pretend this sucker bought this place for $625k, put 20% down and today it still is worth $625k. I know it's pure fantasy but play along with me. Since December is month 30 they still have a prepay of about $25k, $5k fees and $50k added to the balance making the LTV 93%. Anyone know a lender doing jumbo cash out refi's up to 95% LTV?





Of course they could wait until July when their prepay is up and pay $26k+ in monthly payments. But their loan balance hasn't changed much and they still would be at 90% LTV. Anyone know of a lender doing jumbo rate an term refi's at 90% LTV and do you think they will be doing it in July 2008? What happens if the price of the home goes down 5% or 10%?





Worse yet would be if they only put 10% down, then they would be upside down right now. If the price went down 10% they would owe $50k more than the home is worth.





This is just the beginning of a scenario that is about to get a lot worse.
 
How do borrowers get notified of these increases? Do they send out a payment schedule a year in advance or do they not know until the month before when the LTV hits 110%?
 
Graphix,





You need to do a post about this on the main blog. People need to understand the mechanics of a "timebomb loan." We talk about these loans exploding, but until you sit down and imagine yourself in the shoes of one of these borrowers, you don't fully appreciate the problem.
 
BG,





Some of the lenders like Countryfried are sending out notices well in advance letting them know their balance and P&I are. But I doubt that many people pay attention or really understand this loan so the notice probably gets ignored. This is the ticking time bomb that everyone underestimates. All the charts that show the rate adjustments are optimistic because they factor in that the recast won't happen for five years. As you can see it is happening a lot sooner than five years.





IR,





I have been thinking about doing a post on this for a while now. Now that I have the data in an image file I think I will throw a post together on it for this week. Like I said to BG this loan will recast before the five years and I think I will have to take a look at the 115% neg am version too.
 
<p>Graph--</p>

<p>Thanks for the graph's (pun intended). You've just detailed what my daily job has become. Someone posted earlier in the thread about the many others out there that have 30 year fixed loans. Even if only 20% of the homedebtors in OC had option arms, this number is more than enough to cause serious destruction.</p>

<p>Also you were using the example of the graduated minimum payment which allows the minumum payment to increase by 7.5% a year. There are also fixed minimum payments as well. There are also FORTY year option arms out there too, because the 30 year pmt was too high. As I said before, I have not seen a single Truth in lending disclosure that shows the minimum payment lasting for a full 5 years. When the TIL is generated it assumes the same rate for the life of the loan, and that couldn't be further from the truth.</p>

<p>As a matter of fact, I would say at least 70-75% of the TIL disclosures show a minimum payment lasting less than 36 months. This means that either way the borrower is f*cked. They'll have to refi and pay the ppp or absorb a higher monthly payment.</p>

<p>By the way I hope we all have been watching the asset-backed securities market. If you haven't seen the charts at calculated risk, please check them out. Once you do I will ask you this....if the secondary market appettite for this type of security is still deteriorating, how are banks still originating loans, and how are rates improving??</p>

<p>Because banks are loading up on these loans and hoping to God that they'll be able to sell them in the near future. As a bank we don't have a choice. We can't just stop doing loans altogether. We simply cannot continue to operate at our current cost levels by only doing conforming loans. Something has to give, and by give I mean collapse, hard.</p>
 
<em>"Even if only 20% of the homedebtors in OC had option arms, this number is more than enough to cause serious destruction."</em>





This is an important point many people either don't understand or chose to ignore: a small number of comps inflated the prices, and a small number of comps can destroy them.





Financing is everything. If people still had the ability to borrow $700,000, then a few REOs at $400,000 wouldn't make any difference because people would quickly bid the prices back up to $700K. However, if the ability to finance is limited at $400K, then so will house prices.
 
<p>LM, you say: "By the way I hope we all have been watching the asset-backed securities market".</p>

<p>Sorry for my ignorance but what market indicator (index or fund) are you referring to?</p>
 
LM,





I will take a look at the 5 year fixed option ARM. I still have some old rate sheets that will have the margins. Do you remember when those came out? IIRC it was late 05 or early 06. I never sold that loan because I thought it was stupid. I did sell a few of the 1 month option arms but it was mostly to people who requested them. I always tried to explain very similar to what is above to them but real estate always goes up I was told. As for the 40 year I don't think it will change things all that much because the margins were higher.





Roo,





LM is probably talking about Calculated Risk's posts on the <a href="http://calculatedrisk.blogspot.com/2007/10/abx-and-cmbx-indices.html">ABX indices</a>. Other than that it is a secretive world as to what prices MBS securities are trading at if at all.
 
<p>I believe Chevy Chase was the first to come out with this saturday night live loan. For those who think the name is funny, Chevy Chase Bank is a large portfolio lender based in Maryland. They were one of the very first to come out with a five year fixed pay program. This was much easier for brokers to sell because they'd just tell the borrower it was a five year fixed @ 1.95%. The borrower didn't question this as much as a graduated payment program.</p>

<p>Chevy Chase's Adjustable Rate Rider actually stated "your monthly payment of principal & interest was ........" when in fact that was actually the minimum payment. I believe that while extremely misleading it was within RESPA guidelines. This was the case with many wholesale banks. Later in 2005 and early 2006 banks began to make the concept of negative amortization more transparent. The documents even had a one page disclosure stating that you are signing up for a neg am loan.</p>
 
I can't remember where I first heard about this loan but I know that Bear Stearns was the buyer. Then they opened up their wholesale division and more lenders offered it. Paul Financial was one of them and I just looked at the rep with crossed eyes saying to her but it recasts in less than 5 years how can you say it is fixed for 5 years. Anyway I plugged in the numbers and at 110% it recasts in month 39 and at 115% it recasts in month 53.





Chevy Chase is also a very nice neighborhood in MD just north of DC. If I had to live in the DC area I would want to live in Chevy Chase.
 
It's a good product for certain people. Lets say your in sales and you have a bad month you can at least make the min payment. If you are using it as a rental and have no renters for a month again cheap payment. If you use it correctly its great. The problem is most who have it are not the right people!!! I think I used to sell maybe one or two a year.They should have been making at least interest only. This way they would have not adjusted before the 5 year mark. If they can only afford the min they are crazy to have got this product. Most people just were never told the positive and negative. I
 
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