Option ARM Defaults As High As 61%

Here is a look at the wave of rising defaults of Option Arm Mortgages:

From the WSJ:

Defaults on a popular form of mortgage that gave home buyers a choice of how much to pay each month are rising and could rival those on subprime loans, potentially causing more trouble for investors and banks.

Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication. Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp. (BAC), J.P. Morgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) that acquired troubled option-ARM lenders.

Option ARMs typically were made to borrowers with higher credit scores than those getting subprime mortgages. But many of these borrowers were stretched thin even when they were making payments, and are particularly vulnerable to a weakening economy and falling home prices. Borrowers can face payment shock when they must begin making payments of full interest and principal.

Often, these loans were taken out without full documentation of borrowers’ incomes and assets, and the reported incomes were often overstated, analysts say. Option ARMs are concentrated in areas such as California and Florida that have seen some of the biggest home-price downturns.

Option ARMs, which have been largely abandoned, give borrowers multiple payment options, including a minimum payment that often was less than the monthly interest due. Borrowers who made the minimum payment on a regular basis often saw their loan balances grow, also known as “negative amortization.” And with home prices falling, more than 55% of borrowers with option ARMs owe more than their homes are valued at, according to J.P. Morgan Securities Inc.

As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance. That compares with 23% in September. An additional 7% involve properties that have already been taken back by the lenders. By comparison, 6% of prime loans have problems. Problems with subprime are still the worst. Just over half of subprime loans were delinquent, in foreclosure, or related to bank-owned properties as of December. The nearly $750 billion of option ARMs issued from 2004 to 2007 compares with roughly $1.9 trillion each of subprime and jumbo mortgages in that period.

Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs, which assumed a further 10% decline in home prices. That compares with a 63% default rate for subprime loans originated in 2007. Goldman estimates more than half of all option ARMs outstanding will default.

Graphic courtesy of the WSJ

Looking through this data makes me realize that the determining factor for whether or not a mortgage will go into default, is whether or not the borrower was on solid financial footing AND spent within their means. I know it sounds simplistic and rather obvious, but what else is there to say when the default rate for all prime loans is 6% and the default rate for subprime loans and exotic loans (that were often originated to prime rate consumers) is over 60%?

Better yet all loans should be put into two categories: responsible loans and irresponsible loans, while defaults should be categorized in terms of those coming from life events (divorce, job loss, etc) and those coming from a lack of affordability.

I know there are some who say that government policies that encouraged home ownership area culprit, but there is a big difference between taking a chance on a risky borrower with a sensible loan and lending said borrower more money then they could realistically pay back. The same goes for all of the exotic loans that were originated to middle and upper-middle class consumers, even if these products do have some value it just doesn’t make sense to lend more cash than a consumer can realistically afford.

Like I said earlier it’s time to put mortgages into two groups: responsible and irresponsible, and make all policy decisions accordingly.

Going back to the original topic: expect rising defaults and problems from bad mortgage loans to last for several more quarters. Because we’re going to be seeing new defaults from irresponsible loans that were originated in ‘07, and we’re also going to see defaults from more affluent buyers who were able to hang on a bit longer before going into default.

You can read more here.

Source:

WSJ: “Option ARMs See Rising Defaults” — Ruth Simon, January 30, 2009

Disclosure: at the time of publishing the author didn’t own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn’t be viewed as financial or investment advice.

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