The New Mortgage Dynamics and the Anatomy of a Pay Option ARM Borrower. 850,000 Option ARMs Still Outstanding and 40 Percent in Distress. 4 Reasons to Walk Away from your Option ARM.
It is hard to believe that 13 percent of all mortgages are either in foreclosure or some other form of distress. This can stem from a missed payment from an unexpected job loss or mounting pressure of servicing current debt. To a large degree the allure of the option ARM product came from the ability to sell this idea that monthly cash flow will free up. This free cash flow would have been useful if set aside in an investment account yielding a high interest rate but the stock market collapsed and savings accounts are essentially brick and mortar mattresses thanks to the corporatocracy. Yet people never used the freed up money to save. It was used to maintain a lifestyle that was unsupportable and full of consumption. A case of musical mortgage chairs.
The option ARM world is now largely a historical story. Option ARMs are now banned in states like California and rightfully so. Yet these mortgages are still out in the market. The OCC and OTS released their third quarter report covering 65 percent of all U.S. mortgages. In their set they cover 850,000 active option ARMs. The data on this loan is highly troubling:
The above chart is telling. Fewer and fewer loans are performing while foreclosure rates are soaring. 40 percent of option ARMs are in distress or in foreclosure. And that leaves 580,000 loans that are performing. But it is likely many of these loans will recast and end up in distress as well.
Nearly 60 percent of these loans are in California. So a conventional look would estimate that 348,000 active option ARM loans are in one state. These loans also carry higher balances. Let us run a hypothetical scenario to show how insidious this mortgage really is. Let us assume that you bought in 2006 a $500,000 home in California. This was the median price in 2006 and 2007 so not uncommon at all. You decided to go with only 5 percent down but took out an option ARM. Here is what your financial situation would look like:
93 percent of option ARM borrowers went with the minimum payment. So a $475,000 mortgage would cost you $1,939 a month. This is for principal and interest. You still have taxes and insurance but let us set that aside for the moment. Now looking at the above, you notice that each year $10,572 is negatively amortized. That is, your actual loan balance will increase. Now here is the interesting thing. The actual term on many of the option ARMs was five years or 60 months with the minimum payment. But many had ceiling caps of 110 or 125 percent. In the above, we are assuming a 110 percent cap. So in fact, the borrower will hit a recast date in the fourth year because of the negative amortization.
The initial loan balance of $475,000 will grow to $522,500 if the minimum payment is made. But once the recast hits, the loan will go to $3,708. For many this is unsupportable. And keep in mind that the home value in California might now be $250,000 or $300,000 depending on the area. So the borrower now has a $522,500 balance on a home that is worth half that. Walking away at this point makes absolute sense. And here is why:
4 Reasons to Walk Away from an Option ARM
-A) Banks are not moving on homes quickly. So let us assume the borrower will hit the recast date starting in January of 2010. What would they do? Well if their new payment is $3,708 they can stop making their mortgage payment altogether. It is likely that the way banks are moving, they can have at least 12 months of payment free living before getting the boot. So how much can they save here?
$3,708 x 12 months = $44,496
That is a large amount of money. In the mean time they can find a rental before their foreclosure completes and their credit is hit. In California vacancy rates are high and rents are stagnant. It is likely they can find a comparable rental for $2,000 a month.
-B) The borrower is unlikely to recover the current lost equity. If the home is worth $300,000 the borrower is now in the hole for $222,500. When will they recover this? It could be a decade or if we follow something similar to Japan it can be two decades. Plus, it might be the case that the borrower simply cannot afford the $3,709 payment.
-C) The borrower can buy the same home for half off. If they manage to save some money and buy another home (all they need is a minimal amount with FHA loans) then they can move into another place and lower their mortgage payment. Once the new home is secured the other home can be let go back to the bank.
-D) Option ARMs do not qualify for HAMP. These loans are much too underwater. Banks like Wells Fargo and JP Morgan are trying to convert these option ARMs to interest only loans but you are basically paying the bank for their bad bets. Is it any wonder why these loans are having such horrible stats?
Option ARMs are prime candidates for strategic defaults. That is, even people that can pay refusing to do so. This isn’t advice or a suggestion to do so but you can understand why so many people are using this strategy to bail on their mortgages. And the moral argument is nonsense since the corporatocracy has walked away from many of their bad bets while saddling taxpayers with the bill. You think Wall Street is honoring any of their debts? In fact, they are using taxpayer money to avoid losing a cent.
When I read articles that option ARMs are of little concern this may be true for 46 states. But this chart is more pertinent to the option ARM states of California, Florida, Nevada, and Arizona:
Those that are walking away are doing it for specific reasons. I know this must rub many the wrong way. The prudent reader is probably ticked off at banks and those that over extended themselves. I sympathize. Yet if we want to change this we need to push for a higher down payment. After all, the mortgage market right now is all government backed (aka your money). Then, say we require even 10 percent down, a borrower is leaving a good amount of their money on the table if they walk away. With low down and zero down mortgages people will walk away in mass:
“(TIME) Boemio specializes in short selling, in a particularly Vegas way. Basically, she finds clients who owe more on their house than the house is worth (and that’s about 60% of homeowners in Las Vegas) and sells them a new house similar to the one they’ve been living in at half the price they paid for their old house. Then she tells them to stop paying the mortgage on their old place until the bank becomes so fed up that it’s willing to let the owner sell the house at a huge loss rather than dragging everyone through foreclosure. Since that takes about nine months, many of the owners even rent out their old house in the interim, pocketing a profit. (See pictures of modernist houses available for rent.)
Tons of people were doing this, but there were consequences. Renters were being evicted, through no fault of theirs, with a couple of days’ notice when the house finally went on the market. People are now paying a premium to live in apartment buildings, which in Vegas are almost always owned by a corporation. Sure, short selling damages the sellers’ credit rating, but they just bought a new house, so they don’t care.
It’s an entire city of John Dillingers, feeling guiltless for stealing from the banks. Boemio is well aware that short selling isn’t ethical and is exacerbating Vegas’ economic problems. People, she believes, should make their payments, accept their paper losses and ride out the crash. “Guess what, a______s of Las Vegas. That’s what gambling is about. That’s what investing is about,” she says. “It’s greedy. But we’re all doing it. Because why not?” It’s very hard, she says, to suffer as the one honest person in a town of successful con artists.”
When leadership is lacking in the financial markets people are going to quickly realize who is gaming the system. I just don’t see why anyone would stick it out with an option ARM product especially those in California. Those that think the bottom is here still don’t realize that we have many other dominoes to fall in the next few years. A bubble constructed over multiple decades doesn’t clean up in two years.
FDIC and the Bank Failures of First Federal Bank and Imperial Capital in California. Two Banks Brought Down by Option ARMs and Commercial Real Estate.
First Federal Bank of California failed on Friday because of a heavy over indulgence on risky option ARMs. Imperial Capital also failed on the same day because of an inability to raise capital and also mounting losses of commercial real estate loans. These two bank failures, two of the 140 in 2009, show that the reason for defaults is shifting. Option ARMs have brought down many lenders including IndyMac and Washington Mutual. For the latter two banks, option ARMs were merely another toxic loan in a portfolio of years of horrible lending. So who acquires First Fed? OneWest. Who is OneWest you ask? The bank that emerged from the failure of IndyMac.
First Fed was a big failure. It has $6.1 billion in total assets. Imperial Capital has $4 billion. This brings bigger issues for the FDIC since they are now in the red and these bank failures will cost additional sums of money. Money the FDIC doesn’t have. The failure of First Fed shows us the reality that option ARMs are still wrecking havoc on the balance sheet of banks.
You don’t need to be an expert to know First Fed was heading into trouble. Take a look at their option ARM sheet sent to brokers during the boom:
Anyone reading the above will see that the sheet looks like a bullet point of toxic lending guidelines. 100 percent option ARMs for loans up to $500,000. You also see gigantic cash out options being made at the peak of the bubble. No income and no assets were no problem with the above. Only 12 months of bank statements and even then there was room to fudge. The bottom line is First Fed put decades of stability in front of risky toxic lending. They are not the first and last to be lured by the Wall Street siren call. The sheet above was issued in January of 2007. Almost three years later they fully implode.
And let us look at how their balance sheet looked like in January of 2008:
So by January of 2008 First Fed had some $3.2 billion in one-year ARMs that included option ARMs and $1.1 billion in three-to-five year ARMs that also included option ARMs. By this time First Fed was already feeling the brunt of its mistake in toxic mortgage lending. Many of those one-year loans blew up in its face since First Fed has been losing money for seven straight quarters until Friday’s seizure.
Those that think option ARMs have a way out are mistaken. The bulk of these loans sit in California. 60% of outstanding option ARMs are here in the state. The vast majority do not qualify for HAMP or any other programs. Wells Fargo and JP Morgan have gone ahead and pushed these loans into interest only products but 40% of the borrowers are already in some form of distress. It is hard to see how these banks don’t have additional problems. Just because they are too big to fail doesn’t mean money isn’t being lost.
What is happening with the FDIC is that they are creating even bigger banks that will have a harder time failing but have a direct lifeline to taxpayer money. Take for example the above failures. City National will now pick up Imperial Capital and will have $21 billion in assets while OneWest will pick up First Fed and have $24 billion in assets. It is a twist of economic insanity that failing banks are only getting bigger.
Some might argue that seeing this fall with First Fed was hard to predict. Actually some saw this back in 2006 and made big bets on it:
“(LA Times) Seiver recommended short sales of stock in the parent company, FirstFed Financial Corp. He wasn’t the first to suggest this strategy, which would turn a profit if the company’s stock price fell: In fact, the volume of such short-sale bets against First Federal nearly tripled from late 2004 to early this year, before dropping slightly in March after the thrift reported solid earnings.
The short sellers question whether First Federal’s financial results are being inflated by accounting rules, which they contend may overvalue risky loans. And they are among those predicting a meltdown in California’s recently superheated housing market.
Other critics accuse First Federal and other West Coast thrifts of overindulging borrowers’ lust for artificially low initial payments. By generating so-called exotic or nontraditional mortgages, they warn, these S&Ls have allowed speculators to buy homes they can ill afford — and will be unable to resell when the mortgage payments rise and home prices take a tumble.”
It was only a matter of time that these ticking time bombs would hit hard. That is why banks like Wells Fargo, Chase, and Bank of America through their acquisitions of toxic mortgage lenders will be facing years of pain with option ARMs. Not only with option ARMs, but with commercial real estate.
The failure of Imperial Capital shows us that CRE is now here and hitting California hard. The big problem with Imperial Capital was with loans on apartments and commercial mortgages. The CRE market is slated as the next big issue in the coming years. With $3 trillion in CRE loans outstanding many regional banks such as Imperial Capital will face failure. However with what occurred on Friday, it is disturbing to see the FDIC funnel these banks into larger too big to fail banks that have direct access to taxpayer money. What they are inevitably doing is putting the taxpayer on the hook for additional losses.
What is clear with the failure of First Fed and Imperial Capital is we are in the middle innings of the option ARM and CRE fallout. Those that doubted these loans as problems should put that notion to rest.
Housing’s Treacherous Path: From 44 Percent Homeownership to 70 Percent. The Levittown Dream and Nothing Down Madness. How a Nation lost its way with Homeownership.
It is a fascinating case study in the perceived power of homeownership that even after our economy was brought to its economic knees by a massive housing bubble that the government, Wall Street, home buyers, and sellers somehow view homeownership as our ticket to getting out of the financial mess. That is, the housing poison is also the cure. In our current culture long term memory is more of a burden when it comes to economic calamity. People seem to forget that only in March of this year the entire global economy was melting down before our very eyes because of toxic loans. Instead of questioning decades of assumptions that proved wrong we jumped on the same beat up bandwagon and here we are repeating the same song.
The cookie cutter planned community madness started with Levittown after World War II. These towns were built in communities in New York, Pennsylvania, New Jersey, and Puerto Rico. The communities were built with speed and efficiency. It is interesting that the communities started out as rental units and within two days 2,000 units had been rented. With demand surging the properties were then sold as purchase units with the help of the Federal Housing Administration (more on them later).
Levittown is now used in a derogatory sense to highlight massive cookie cutter suburbia. Many people in these communities actually enjoyed their towns but critics were everywhere. Yet we went from Levittowns to McMansion Villages with the twist that homes were bigger for ever smaller families. Once the credit markets were freed from any shackles by deregulation banks pushed the limits on the borrowing population. That is how places like California saw home prices triple in less than a decade.
The problem with believing that homeownership is part of the American Dream is that it misses the fundamental economic question. By labeling something a dream it makes it harder to confront with factual data. This reminds me of the parents that let their kids audition for American Idol even though they sound like a cat in heat. Many people should not be homeowners and that is okay. Yet politically this must be like kryptonite because who in the world is going to want to pop that dream? Can you imagine being labeled the anti-homeownership candidate?
This insistence on allowing the homeownership dream to permeate the country has pushed the homeownership rate to unsupportable levels:
Now during the Great Depression homeownership dropped to 44 percent. It is also the case that during this time many loans were also based on 5 year balloons which made it hard for many to borrow, especially in the bank failing environment of the depression. Yet after that bump, homeownership increased from 1941 all the way to our housing peak in 2005 reaching a peak near 70 percent. Yet very few even bothered to ask if this was even good for our economy? Clearly it wasn’t.
The perversion of mortgage products during the recent bubble is enough to make anyone ill. Products like option ARMs, mutant mortgages that have no place in any market, suddenly became commonplace and allowed a monthly payment obsessed culture to purchase homes they could never sensibly afford. A $500,000 home became a $1,500 minimum payment and a $50,000 leased car became a $500 monthly payment. Banks knew that these loans were never going to be paid back. They just hoped that by the time the owner sells the home, the loan would be off their books if it wasn’t already in some mortgage backed security pool.
This housing obsession has now led us into a very tight corner. Mortgage rates have nowhere to go but up and everything is being done to keep rates at historical lows:
The only reason rates are this low is because the Federal Reserve is keeping the Fed funds rate hovering at zero. As you can see from the chart above, our current rate environment is a total anomaly. The average mortgage rate over 40 years is 9 percent (match that to today’s 5.5 percent rate). Yet even if rates went up to historical averages this will destroy the monthly payment mentality. Let us run the numbers for two mortgages:
5.5% – $200,000
9% – $200,000
PI: $1,609 (41% higher)
Now the above is significant. In our current troubled economy monthly payments matter for budget constrained Americans. Assuming the $1,135 is all the homeowner can afford and rates go up to 9%, the mortgage will need to come down by $60,000. You can see how this becomes problematic. If there is a dollar shock or if inflation starts picking up the Fed is going to be stuck and the housing market is done. The current environment is completely artificial.
The problem with the homeownership propaganda is that it doesn’t produce a balanced forum of discussion. The NAR and NAHB have major lobbying arms in Congress. What is the renter lobbying arm? In many cases renting is a better option for people yet you rarely hear this side of the coin. Renting is typically cheaper and in some communities in California nearly half as cheap. The analysis isn’t so cut and dry. Yet again, you run into that American Dream propaganda pushed by the banks that actually caused much of this mess. Do you really think it was George Washington who said, “yes, let us fight a revolutionary war so people can purchase McMansions they can’t afford and drive around gas guzzling cars with lease payments the size of a mortgage.” Somewhere along the line something got really messed up.
I put a big blame on the down payment, or lack of it. Back in the 1980s it was the rage to see on infomercials these nothing down pitches. They had to talk about nothing down because mortgage rates were up to 17.5 percent! So people just wanted a bone thrown their way and the majority didn’t believe in this pipe dream. But this was only a tiny part of the market. Most of the money wasn’t made on the nothing down side but by pitchmen that sold the sizzle. Many who plunked down hundreds for this dream ended up getting a stale steak. But over the next 20 years as regulation was chomped away by the corporatocracy we suddenly had a way to make loans to any living being so long as they had the wrist power to sign a document. Zero down in California became the new booming market. And with the removal of income verification, suddenly 100 percent of the citizenry was primed for the American Dream of owning a home. So prices got pushed up to ridiculous levels. What was once a late night infomercial joke had become standard practice. California became Levittown in state form. And not only California, but the entire country.
So where do we go from here? Remember how Levittown grew because of the FHA? The FHA now makes 4 out of 10 loans in California and backs similar numbers nationwide. The problem? They only require 3.5 percent down and with the tax credit, depending on your purchase price, you might be able to buy a home with nothing down. Is it any wonder that default rates on FHA loans are now spiking?
At a certain point the homeownership dream is nothing more than a mirage. If you can’t afford the payment and put your monthly budget at risk, then why buy? Many, unlike the corporate banking cronies, do not have access to unlimited bailouts. And with nearly 4 million foreclosure filings in 2009 many are realizing the homeownership nightmare.