Let us look at this new updated chart and try to figure out what is really going on with option ARMs but also with other toxic loans in states like California:

Source:  SNL, Credit Suisse

The data released only this month, highlights that between 2010 and 2012 some $253 billion of option ARMs will adjust and another $163 billion in Alt-A loans will reset.  This is extremely troubling because most of these loans were made in states that experienced the brunt of the subprime disaster.  You can imagine this hitting in a two wave fashion.  First, the subprime wave filtered through and now the option ARM and Alt-A wave will cast a shadow but only on a select number of states.  This older chart shows this two wave process:

Source:  Amherst Securities

For the last few months we have been in the eye of the hurricane.  While wave one has largely passed, wave two is only beginning to gear up.  One of the ideas being bandied about is that nothing will come from this second wave.  The assumption is all will be well.  We bought some time with the government loan modification programs known as HAMP but after almost one year of the program, only 168,000 permanent loan modifications have been made nationwide and many of the option ARMs don’t even qualify for this.  Banks have been trying to figure out what they can do with option ARMs but not much can be done because many of the borrowers do not or cannot continue to make payments on the loan.

Some staggering data from a Fitch report released late in 2009:

94% of borrowers made minimum payment only*

46% of all option ARMS were 30+ days late (with only 12% hitting recast)

Average loan-to-value ratios up to 126%

*With minimum payment loan balance increases through negative amortization

The above data was released back in September 2009 and most of the option ARMs are in California (roughly 50 to 60 percent).  Since that time housing prices in the state have not gone up.  So it is highly likely that more option ARMs are 30+ days late and LTV ratios are even worse as balances continue to grow while asset prices remain stagnant or retreat.  It is understandable that following nationwide coverage of the housing problem can ignore the option ARM issue because it is pinned on only a few states.  But these states will continue to face issues as these loans linger in financial limbo.  If we look at some of the option ARM lenders like WaMu (many are now gone) we can see how concentrated they were in only a handful of states:

The above is from the $52.9 billion option ARM portfolio of WaMu in 2008, at a point when the option ARM spigot had turned off.  WaMu had 50% of its option ARM loans in California.  If we add in Florida, that number jumps to 62%.  So this really is a problem that will hit a few states squarely.  But to understand the depth of this, let us first get an actual number of loans in California:

California Housing Units with a Mortgage:            5,290,276

Source:  Census, 2008 American Community Survey

We then have to figure out how many loans are currently in some form of distress or in foreclosure:

“(MBAA) The delinquency rate includes loans that are at least one payment past due but does not include loans in the process of foreclosure.  The percentage of loans in the foreclosure process at the end of the fourth quarter was 4.58 percent, an increase of 11 basis points from the third quarter of 2009 and 128 basis points from one year ago. The combined percentage of loans in foreclosure or at least one payment past due was 15.02 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey.”

The latest mortgage data shows us that 15.02 percent of all mortgages are 30+ days late or in the foreclosure process.  Now California has more troubles because of the option ARM concentration but we’ll be conservative and use the 15.02 percent figure:

5,290,276 * 15.02 percent = 794,599 properties 30+ days late or in foreclosure

I ran the numbers a few days back and found that only 154,000 properties are listed on the MLS in California.  So what is going on with those 600,000+ properties that are 30+ days late or in foreclosure?  Wells Fargo which acquired a large option ARM portfolio from failed Wachovia tried a few adjustments but they seem to be more extend and pretend methods of stalling the inevitable:

“(CNBC) Pay option ARMs are the new subprime, defaulting at high rates now thanks to adjustments as well as good ol’ unemployment. According to its Q3 earnings report, Wells Fargo, the fourth largest U.S. bank by assets, has $79.2 billion in debt on these loans alone, down from $101 billion a year ago, in addition to other ARMs and fixed-rate loans and full-term loan modifications. Wells didn’t make the Pick-a-Pay loans, they just inherited them when they bought Wachovia at the beginning of this year. Wachovia relished in selling these risky products in the most overheated housing markets. Suffice it to say, many many many of these borrowers are way way way underwater on their loans.

Enter the interest-only product, which will allow borrowers to defer their balances from 6 to 10 years. This keeps the borrowers in their homes, paying a little every month.  I called over to Wells Home Mortgage and spoke with CFO Franklin Codel. He told me that Wells has written down principal on the “vast majority of these loans.” Yep, just given that debt away, written down so far the tune of $2 billion, or about $46,000 per modified loan. So far Wells has turned about 43,500 Pick-A-Pays into interest-only ARMs.”

Since that time, mortgage distress has risen to a historic 15.02 percent and in California, there is little reason to believe the rate is any lower.  The above adjustment is yet to be seen as helping any sizeable number of borrowers.  It is also the case that banks have been reluctant to do any kind of principal reduction because this would force the bank to realize the actual loss on their balance sheet.  In other cases loans have been extended out to 40 years with lower rates but as HAMP has shown, even this isn’t enough to make a change if you have no job:

Source:  HAMP

Only 168,000 permanent loan modifications have occurred through HAMP.  What needs to be remembered that over the last decade, housing has shifted into a commodity where very little value is placed on the home as a place to set your roots and instead became a place to count your home equity.  With much of the equity stripped out, how many people will want to continue supporting a high mortgage when the home isn’t worth that value?  A handful of studies have shown that the number one predictor of foreclosure is negative home equity.  Virtually every option ARM in California is in a negative equity spot so that probably means 70 to 90 percent foreclosures on these places once we roll through the next wave.

What will banks do?  Well so far they have shown us that ignorance is bliss.  They have left the mortgages at face value and have no desire in pursuing a foreclosure (at least for now).  Why would they?  Say they have a $500,000 option ARM on a home now worth $250,000.  The loan has now grown to say $575,000 because of negative amortization but the borrower stopped paying once a recast was hit.  The bank can now claim an asset of $575,000 and lose $3,000 or $4,000 a month in missed monthly payments or realize a loss of $250,000 to $300,000 by foreclosing on the home.  So we may not see a big tsunami hitting us all at once but the wave will hit and it will be painful and drawn out.

In fact, if we pull data on some of the areas in California we will see entire blocks with massive amounts of distress:

Source:  Foreclosure Radar

Just look at the estimated equity column.  Most of these homes don’t even show up in the MLS.  But these are massive losses.  If we look at the loan data we find a few option ARMs and a few familiar names including IndyMac.

Yet that isn’t the only problem falling on a state like California.  There is also a number of jumbo loans:

California has 845,000 active jumbo loans.  And a large number are already in foreclosure or are now 30+ days late.  These loans carry big balances.  What is even more troubling is 55% of jumbo loans are adjustable rate mortgages.  With mortgage rates slated to increase this year, we can expect the foreclosure rate to zoom up.

The option ARMs, the Alt-A toxic loans, jumbo loan issues, and a 12.5 percent unemployment rate the highest in recorded history tells us the next wave will hit.  The mainstream media isn’t covering this because it really is a state specific problem.  But that is of little solace for those that live in sunny California.

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Let us look at a few other states as well:

Source:  Fitch Ratings

California by far holds the largest amount of jumbo loans.  Jumbo loans are risk and many times, lenders would require two appraisals before making the loan.  That was the case before the bubble but with that cast aside performance has faltered.  Jumbo loans are performing poorly with 11.3 percent now registering as being delinquent in California.  The only other state to have a worse performing track record is Florida where prime jumbo loans are in distress at a rate of 16.6 percent.  Now many might be asking why are these loans labeled as “prime” if such a large number of the pool is now performing badly?  The issue is the loan itself.  Many of these loans do not fall under conforming standards and carry higher interest rates but also, carry much larger balances.  In markets like Florida and California where prices have collapsed, many people now find themselves in negative equity positions and it might be that many borrowers are choosing to strategically default on these loans.  Or what is more likely are unable to service the actual mortgage.

It is a horrible track record that for 32 months jumbo loans delinquencies have been surging.  Fitch Ratings looked at prime jumbo residential mortgage-backed securities (RMBS) and found that for the entire pool of $381 billion 9.6 percent of loans were seriously delinquent.  To qualify for serious delinquency means being past due by 60+ days.

The jumbo mortgage market was once a good way to find financing but now with government loans making up the bulk of purchase money, jumbo loans are largely sidelined:

“(MDA DataQuick) The percentage of Southland homes sold above $500,000 last month rose to 20.2 percent of all sales, up from 16.5 percent a year earlier and the highest since it was 23.6 percent in August 2008. On average since 2000, $500,000-plus sales have made up 36.5 percent of total sales. Right before the credit crunch hit in August 2007, making larger “jumbo” mortgages more expensive and harder to obtain, $500,000-plus sales made up about 52 percent of Southland transactions.

More sales in once-dormant high-end communities helps explain last month’s year-over-year gain in the median sale price – the point where half of the homes sold for more, half for less.”

This trend has also played out in Northern California:

“Home loans for more than $417,000, the old “jumbo” limit, used to account for more than 60 percent of the Bay Area’s purchase financing. Last month it was 29.8 percent. That percentage rose from 17.1 in January 2009 to 28.7 last June. It has since remained at roughly 30 percent.”

Jumbo loans carry higher interest rates and ask for larger down payments.  In a market like California where consumers are financially strained these loans are becoming a smaller part of the market.  In fact, this is another reason why the million dollar plus market has seen a steady decline since 2005.

Million Dollar Home Sales (CA):

2005:     54,000

2009:     18,621

I put in a quote for a few jumbo 30 year loans in California and found the rate to be between 5.8 percent and 6.5 percent.  Compare this to loans under $417,000 with rates of 4.8 to 5.4 percent.  Now the rate itself is marginally different but the down payment requirement is the bigger deal.  Keep in mind that FHA insured loans will allow you to purchase a home with 3.5 percent down up to a maximum loan cap of $729,750.  Anything above that and you are looking at 20 percent down or 10 percent down with a handful of lenders.

The jumbo market is going to experience more pain in the upcoming year.  California and Florida are already showing the deep issues in this market.  Keep in mind when jumbo loans go bad that their losses will be larger because they are also larger in balance size.  A home that sold with a $4 million mortgage that is now worth $2 million is the equivalent of 20 houses that foreclose and each cost the banks $100,000.  This is another aspect of the mortgage market that got out of hand during the housing boom.

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