The Option ARM Kingpins: Who Holds the Elusive Option ARMs? $189 Billion Securitized and Outstanding and big Three of Wells Fargo, JP Morgan, and Bank of America Playing with Time.

Trying to get a raw number on the elusive option ARM mortgage is like asking the top banks to air their dirty laundry.  We know banks still have billions of these loans on their books but trying to get an accurate figure is like trying to audit the Fed.  In September, Fitch released data showing that $189 billion in securitized option ARMs were still out in the market.  That is one facet of the giant market.  But how much is held directly on the books of banks?  The big banking industry has a tight grip on this data because most of these mortgages are toxic.

What we do know as of today is that 40 percent of option ARM borrowers are now at least 60 days late.  Fitch in their September release stated that 70 percent of the securitized option ARMs would hit recast dates by 2011.  So the next two years will see billions of these loans transform into more trouble for banks.  In order to understand how we got here, let us look at Q2 of 2007 data I gathered on the top option ARM lenders at that time:

The top 10 option ARM lenders held onto 66 percent of the market in 2007.  2006 and 2007 saw the biggest amount of these loans made.  From 2004 to 2007 some $750 billion in option ARMs were made.  If you look at the list, only two of the institutions still stand.  Washington Mutual is now part of JP Morgan, Countrywide is now part of Bank of America, and Wachovia is now part of Wells Fargo.  The names are different but many of the loans are still out there.  These above banks dominated the entire option ARM market:

These loans are highly toxic because many had a massively low teaser rate that negatively amortized the loan.  That is, the initial balance actually grew if you decided to make the minimum payment option.  According to recent data 93 percent of option ARM borrowers elected to go with this minimum payment option.  Many of these loans were cast with a five year time frame before rates hit major recast points.  One of the more recent charts shows this wave:

The red above is shifted forward because many loans hit what is otherwise known as a negative amortization cap.  These were usually set at 115% or 125% of the initial loan.  So a $400,000 loan would cap out at $460,000 or $500,000 depending on the structure of the loan.  That is why in the chart above the original date has shifted forward.  The interest that wasn’t paid was capitalized into the balance of the mortgage.  It is also another reason why 40 percent of option ARMs are now in some form of distress.  If you look at the chart, 2010 will see the biggest hit of option ARMs.

There have been many charts like the one above and much of the confusion is around a few key points:

-1.  Banks have been circumspect given the actual number of option ARMs

-2.  Many option ARMs are in California (roughly 60 percent of the market)

-3.  Many of those behind on payments are now simply not paying their mortgage but banks are not moving

It is hard to quantify the above data since this is something banks would like to hide.  Nearly 60 percent of all current outstanding option ARMs are in the hard hit state of California.  As many of you know, the median price of a home in California has fallen by 50 percent.  The peak in home prices was reached in 2007, the last year option ARMs were made in mass.  Since that time, option ARMs were merely ticking financial bombs.

What other data do we know?  When JP Morgan acquired WaMu they issued an analysis on the balance sheet of the bank:

As of late last year, JP Morgan inherited $50 billion in WaMu option ARMs.  Many of the option ARMs were made in California and Florida, two heavily hit states.  It is very likely that many of these loans still remain (or are in the process of default).  As of November Wells Fargo had $107 billion linked to option ARMs.  So what has the solution been?  To simply ignore the problem:

“(WSJ) The fourth-largest U.S. bank by assets holds about $107 billion in debt tied to option adjustable-rate mortgages, a relic of the U.S. housing boom that allowed borrowers to make small monthly payments in return for increasing their mortgage balance. Many such borrowers now own homes worth far less than they owe in mortgage debt, and most can’t afford a full monthly payment that pays down the loan’s principal.

To solve that conundrum, Wells Fargo is taking a gamble: The San Francisco company is issuing thousands of interest-only loans that will defer borrowers’ balances for as long as six to 10 years.”

Wells Fargo is merely shifting the bulk of the option ARMs into interest only payments betting that housing will recover in the next six to 10 years.  Why?  They hope that they can claim face value of the option ARMs on their balance sheet while borrowers keep on making payments on a loan that no longer reflects the value of their home.  The best the borrower can hope is that at some point, housing will recover enough to recoup their losses.  But run this example.  Say a borrower took out a $400,000 option ARM in California.  The home is now worth $200,000 or a drop of 50%.  Is it likely home values will increase 100 percent in the next six to 10 years?  That is the bet.

“The move to shift Pick-A-Pay borrowers into interest-only loans helps Wells Fargo avoid hefty write-downs on Pick-A-Pay mortgages that would likely result from foreclosures. But the strategy will leave Wells Fargo holding billions of dollars in mortgage debt tied to distressed properties in battered markets, especially California and Florida.”

It is more hide and pretend.  JP Morgan Chase is doing similar actions:

“(Interest) The bank says it will do whatever it takes, from lowering interest rates to refinancing borrowers into 30-year, fixed-rate loans. If necessary, it will allow customers to make interest-only payments for 10 years.

All modifications will eliminate negative amortization, which allows a borrower to pay less than the total monthly interest with the difference added onto the loan balance.

The specific rates and modification terms are being determined on a case-by-case basis, according to spokesman Tom Kelly. Chase’s goal is to have each borrower’s mortgage payments consume no more than 30% to 40% of their income.

One thing JPMorgan Chase won’t do is forgive part of a borrower’s debt, spokeswoman Christine Holevas says.

That’s too bad. Forgiving debt is one of the few ways to significantly reduce monthly payments and avoid foreclosures. It also addresses one of the worst things about the option ARMs JPMorgan Chase wants to fix: Most of these borrowers owe more now than when they opened the loans.”

Now why would the banks be so reluctant to do anything that resembles a writedown?  Because this will hit their bottom line at the same time that the Wall Street banks are trying to play the game that everything is fine.  So the above recast charts are still going to happen but banks are basically trying to extend lifelines to homeowners to keep them paying.  But what if homeowners balk?  Many in California are strategically defaulting.  In many cases, unless their mortgage meets with market rents many will walk away.  Also, the California unemployment and underemployment rate is at 23 percent so no amount of modifying can help out with a loss of income.

So  let us sum up the option ARM market:

$750 billion in option ARMs were originated between 2004 and 2007.  The top 10 option ARM originators cornered over 60 percent of the market.  Of these, many are now part of the too big to fail banks.  We know that $189 billion is still securitized in investor portfolios while many billions are still on the banks books (i.e., $107 billion with Wells Fargo and $50 billion with Chase).  The bottom line is the option ARM issue is still here and we will be contending with this for the next couple of years.

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