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.
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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:
Source: Mortgage-Info
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.
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