Wednesday, December 24, 2008

Pay Option ARMs - The Implosion Is Still Coming Despite Low Rates

Mr. Mortgage:

There is some serious Pay Option ARM (POA) misinformation going around. Everywhere you look there are stories about how the low index value on the LIBOR will automatically ‘fix’ Pay Option ARMs and drop borrower’s payments to almost nothing. Sorry folks, no cigar. It is shotgun stories by the major media and television personality analysts that set the market and consumer up to for disappointment every time. Over the past year and a half this is my forth story on why a particular bailout or market event will not help the POA’s.

Like the failed mortgage modification efforts and foreclosure moratoria you read about almost daily, this will be a non-starter for most. It is truly a shame how badly constructed these loans really are and how many home owner and bank balance sheets they have destroyed. These loans are much more toxic than Subprime ever was - at least with Subprime the principal balance doesn’t grow each month! They are in a class of their own and ultimately will need a bailout of their own I am sorry to say.

The POA was a favorite across all borrower types especially the middle to upper-end home owner in the bubble states. The broad failure of this loan type will have severe consequences on already depressed CA real estate and on the middle to upper-end home owners in particular.

Monthly Payments / Neg-Am Set-up / Recasts / Qualifying / Negative-Equity

Pay Option ARMs have four or five monthly payment choices. The majority pay the minimum monthly fixed payment rate, known as the ‘teaser’ rate. The percentage of borrowers who opt for the lowest payment has increased as values have fallen. The minimum monthly payment increases 7.5% per year regardless of what happens to the underlying index value. Therefore, this recent drop in rates means nothing for most POA home owner’s monthly mortgage-related outgo.

With the low underlying index values borrowers won’t accrue as much negative amortization but at the end of the first 5-years, most will still see their payment jump sharply. If the underlying indices stay low for years into the future it will make for lower adjustments upward several years from now on subsequent resets, which may be helpful for some.

But this drop in rates does little for those who have had their loan for a few years in the near-term. These borrowers accrued large amounts of negative-amortization as the indices soared from mid-2004 to 2007 and this has to be factored into the first reset.

Past Underwriting Indiscretions — for much of the time that POA’s were in existence many banks qualified the borrowers at the minimum monthly payment rate or based upon interest only payments. Additionally, over 80% were stated or limited income documentation loans. Both of these factors make knowing how the borrower will react to even the standard 5-year hard recast nearly impossible to forecast given they were never underwritten to take into consideration a reset of any type.

What also must be taken into consideration is that a large percentage of underwater, over-leveraged Subprime, Alt-A and POA borrowers are defaulting even prior to their reset date due to the epidemic amount of negative equity. POA’s were mostly originated at higher LTV/CLTV’s in the hardest hit states meaning they are significantly underwater even without the compounding effects of negative amortization. In CA, a heavy POA state, 60% of all mortgage holders are either underwater or within 5% of being underwater unable to sell or refinance.

Pay Options Have a Floor Rate That Always Results in a Payment Spike

The margins (lender profit) were very high on these loans during the ‘POA mania’ portion of the great bubble. I have seen as high as 5% but the average for Prime MTA-based POA’s is probably around 3.25% to 3.5%. The rates below from a large-named lender still in existence today show margins as high as 4%. The margin rate will always have to be paid regardless if the underlying index value falls to zero, which is not possible. The 1HPP (one year hard pre-payment penalty) loan below was the most popular carrying a margin from 3.025% to 4.000% followed closely by the 3-year prepayment penalty loan.

The program and rates below are from July 2006, which was the peak of ‘POA mania’. It is based upon the MTA index, as 80% of all POA’s were and 80% of all Pay Option owners pay the minimum monthly payment.

Reference key for program below: Start Rate = fully amortized ‘payment’ rate. This increases 7.5% per year. Points = broker rebate (yield spread premium. This is the percentage of the loan amount paid by the lender to deliver that rate and margin). NPP Margin = No Prepayment Penalty. 1HPP = 1 year Hard Prepayment Penalty. 3HPP = 3 year Hard Prepayment Penalty.

After 5-years, most POAs (other than Wachovia’s 10-year) will hard recast to pay off the remaining balance in 25-years. When the loan is recast, the payment required to fully amortize the loan over the remaining term becomes the new minimum payment, and the previous payment cap does not apply.

Standard 5-Year Recast vs. Negative Amortization Limit Recast

The 1st Standard 5-Year Recast occurs when the 61st payment is due. Standard 5-Year Recasts occur each 60 months thereafter.

A new minimum payment is calculated for the payment due on the 61st month based on the fully indexed rate at that time, the remaining term of the loan and the loan balance at that time. There are no other payment options for this (61st) month. This new recast payment becomes the new minimum payment for the upcoming 12 months subject to a 7.5% (or whatever your payment cap is) increase the following 12 months and subject to a full recast 5 years from this payment recast, i.e. when the 121st payment is due.

The 1st Negative Amortization Limit Recast occurs when (or if) the negative amortization cap is reached. Most Pay Options have a neg-am cap of 110% to 115%. Wachovia has one of the highest at 125%. At this point, the loan is automatically recast for the remaining portion of the standard recast term (5 years) and then subject to recast at the normal scheduled (5 year) recast period.

For example, if the loan reaches the negative amortization cap on month 59, the loan goes through a Negative Amortization Limit Recast. At the end of the 5th year, on the 61st month, the loan goes through a scheduled Standard 5-Year Recast.

Most Pay Options Based Upon MTA Not LIBOR

Roughly 80%+ of all Option ARMs were based upon the MTA, which is still over 2%. The remainder is based upon the COFI, COSI and LIBOR…probably in that order as well. Very few loans outstanding are true ARM loans of any kind are based upon a short-term LIBOR index.

The MTA, also known as the 12-Month Moving Average Treasury index is the 12-month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. It is calculated by averaging the previous 12 monthly values of the 1-Year CMT (Constant Maturity Treasuries) Index.

There is more…

The CMT is a set of “theoretical” securities based on the most recently auctioned “real” securities: 1-, 3-, 6-month bills, 2-, 3-, 5-, 10-, 30-year notes, and also the ‘off-the-runs’ in the 7- to 20-year maturity range. The Constant Maturity Treasury rates are also known as “Treasury Yield Curve Rates”. The CMT indexes are volatile and move with the market but more quickly than the COFI Index or the MTA Index (see historical graph below).

Therefore, it would be something else if the CMT followed short-rates down to zero. I think if this happened there would be other things to worry about than a few hundred billion in Pay Options blowing up.

**Please note in the chart above that even though the MTA is down to 2% now, it was as high as 5.25% in 2006 and 2007 forcing large amounts of negative-amortization on most all POA’s originated from 2004 until 2007. When payment rates are so low and margins so high, many are sitting right up against their respective 110% or 115% maximum negative amortization limit which forces a hard reset prior to the 5-year scheduled reset.

Actual Pay Option ARM Payment Choices and 6-Year Payment Schedule

Below are the five payment choices available of which the majority chose the ‘Minimum Monthly Payment’, option 1). Each year the minimum monthly payment rate increases 7.5% regardless of what happens to the underlying indices.

Also below are the annual payment rates for the first 5-years up until month 61 and the hard recast. The loan scenario uses a $300k loan amount, 1.25% payment rate, 7.5% annual payment cap, 3.5% margin and is based upon the MTA taken out to the 61st month and first recast. With a 2.03% MTA and 3.5% margin the fully indexed rate is 5.53%.

It is very important to note when evaluating the following schedules that:

a) for much of the time that POA’s were in existence many banks qualified the borrowers at the minimum monthly payment rate or based upon interest only payments. Additionally, over 80% were stated or limited income documentation loans. Both of these factors make knowing how the borrower will react to the standard 5-year hard recast nearly impossible to forecast given they were never underwritten to take into consideration a reset of any type .

b) the schedules below are for new loans originated today and not take in account many who have had their loans for a few years when the underlying index values soared. All of the previously accrued negative amortization has to be re-calculated into the payment upon hard recast at 5-years or at the maximum allowable negative amortization amount of 110% to 125%.

POA Monthly Payment OPTIONS with MTA at Current 2.03% (Fully-Indexed Rate 5.53%)

  • 1) Minimum Monthly Payment: $999.76 (Deferred Interest/Neg-Am = $388.49)
  • 2) Interest Only Payment: $1388.25
  • 3) Fully Amortizing 30-year Payment: $1713.26
  • 4) Fully Amortizing 15-year Payment: $2459.70
  • 5) Fully Amortizing 40-year Payment: $1558.14

POA Monthly Payment OPTIONS if MTA Falls to 1.03% in 12-Mo’s (Fully-Indexed Rate 4.53%)

  • 1) Minimum Monthly Payment: $999.76 (Deferred Interest/Neg-Am = $138.45)
  • 2) Interest Only Payment: $1138.25
  • 3) Fully Amortizing 30-year Payment: $1529.52
  • 4) Fully Amortizing 15-year Payment: $2303.11
  • 5) Fully Amortizing 40-year Payment: $1358.93

Actual Year 1 through Year 6 - Monthly Payment Increase Schedule

  • 1) Year 1: $999.76 = Choice 1 - Minimum Monthly Payment (80% of cases)
  • 2) Year 2: $1074.74 = ($999.76 + 7.5% mandatory annual payment increase)
  • 3) Year 3: $1155.35 = ($1074.74 + 7.5% mandatory annual payment increase)
  • 4) Year 4: $1242.00 = ($1155.35 + 7.5% mandatory annual payment increase)
  • 5) Year 5: $1335.15 = ($1242.00 + 7.5% mandatory annual payment increase)
  • 6) *Month 61: = $1952.29 (Hard Recast to pay off loan in remaining 25-years)

IF the MTA drops to 1.03% from its present 2.03% over the next 12-months (no change monthly until month 61):

  • 1) Year 1: $999.76 = Choice 1 - Minimum Monthly Payment (80% of cases)
  • 2) Year 2: $1074.74 = ($999.76 + 7.5% mandatory annual payment increase)
  • 3) Year 3: $1155.35 = ($1074.74 + 7.5% mandatory annual payment increase)
  • 4) Year 4: $1242.00 = ($1155.35 + 7.5% mandatory annual payment increase)
  • 5) Year 5: $1335.15 = ($1242.00 + 7.5% mandatory annual payment increase)
  • 6) *Month 61: = $1,707.59 (Hard Recast to pay off loan in remaining 25-years)

In summary, while low interest rates are good overall, the effects that lower rates will have on the now ‘infamous’ Pay Option ARM will be muted for many reasons. The broad failure of this loan type will have severe consequences on already depressed real estate values in the bubble states.

The only way to ‘fix’ POA’s is to re-underwrite and aggressively modify like I talk about in my recent report Mr Mortgage: My Case FOR Mortgage Principal Reductions .

**For those of you looking for another take on the Pay Option crisis with the same outcome, please check out my good buddy Dr Housing Bubble’s recent report entitled: Option ARMs For Dummies - Why 4.5% Rates Will Do Absolutely Nothing For These Toxic Assets.

1 comment:

Prof. Samuel D. Bornstein said...

Under normal circumstances, small business owners are generally optimistic about our future. Today, the situation is different. As an analogy, we take an annual physical exam, even though we feel fine. However, the Blood Test usually identifies whether we are ill or healthy. Recently, the National Association for the Self-Employed (NASE) ran a survey which I created to diagnose the small business involvement in ALT-A and Option ARMs mortgages. The results were astounding.

You will note that these are the most “TOXIC” mortgages that will be RESETING in 2009 through 2012. The main problem is that 80-90% elected to make the “minimum” payments on these mortgages, thereby allowing the principle to grow and bring them into negative amortization whereby the principle was more than the original mortgage. The problem with RESET or RECAST is that now, these borowers must pay off the principle in the remaining term of the mortgage. No matter what the interest rate is modified to, the monthly payment will SKYROCKET to unsustainable amounts.

It is a tragedy when an individual borrower defaults on the mortgage and loses his/her home. The tragedy is magnified when the borrower is a small business owner, employing from 1 to 10 employees. The loss of jobs related to mortgage defaults and the resulting business failures will further weaken our economy and prolong the recession.

Job retention is as important as job creation. The small business owners are at great risk for their survival, as they must contend with personal and business debt, the recession, and the continuing forces of small business failure which have been exacerbated by the credit crunch and financial crisis. The economic downturn will dramatically increase the rate of small business failure and job losses.

I am a Professor of Accounting and Taxation at Kean University School of Business in Union, NJ.
On 4/16/08, I testified before Senator John F. Kerry’s US Senate Committee on Small Business and Entrepreneurship. I have researched the Foreclosure Crisis, and believe that you may find the following interesting as it relates to the PAY OPTION ARMs piece.

I authored a survey of small business owners which was run by the Association for the Self-Employed (NASE) which determined the involvement of the small business community in these TOXIC Mortgages that are about to RESET in the 2nd Wave of Foreclosures due in 2009.. NASE issued a Press Release on 11/21/08. The survey appears on their website at http://www.nase.org

Many fail to realize that there are millions of self-employed micro-businesses, who employ from 1-10 employees, that are holding these mortgages that are going to reset in 2009 through 2012. These borrowers are Prime and Near-Prime borrowers who hold ALT-A, Option ARMs, Interest-Only mortgages. There are $1 Trillion ALT-As, and $500-600 Billion Option ARMs.

So, here we have a major problem… These millions of small business owners will lose their homes, their business may fail, and their employees will go job-less. Obviously, the recession will exacerbate these problems. Although President-Elect Obama is stressing the need to create 3 million new jobs, we must understand that “JOB RETENTION IS AS IMPORTANT AS JOB CREATION”.

According to this survey, it is estimated that 3,709,800 small business owners hold Alt-A and other toxic mortgages, and 1,279,800 are already delinquent as they have missed one to three or more monthly mortgage payments at mid-November, before the expected Resets that are scheduled to begin in 4th Quarter 2008 through 2012.

Conclusion

Small business is the job creation engine of our economy. Proactive efforts must be taken to provide small business owners with immediate and specific financial guidance, combined with other measures, to avoid default on mortgages and other debts in this critical and challenging financial crisis.

Thank you,

Samuel D. Bornstein
Professor of Accounting & Taxation
Kean University, School of Business, Union, NJ bornsteinsong@aol.com

732-493-4799