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EconomicsAnatomy of a disaster: Option ARMs
Once upon a time, in the mortgage finance heyday circa 2004, interest rates were extremely low, credit was readily available and mortgage brokers were anxious to originate as many loans as possible to feed the insatiable mortgage-backed securities appetite of Wall Street investment bankers.
Perhaps the last major “consumer innovation” of this era was the Option ARM. Option ARMs were used from 2004 until 2007 with five-year resets (or less) to higher interest rates with standard amortization schedules. Thus, many have come into play during 2009 and we will see many more in the months ahead.
In November 2009, Standard and Poor’s completed a study of Option ARMs. Let’s look at the details, as reported by cnnmoney:
1. Option ARMs were intended for borrowers who expected to flip their transactions or refinance their purchases as property appreciated but long before the mortgage rate reset kicked in, often five years after origination.
2. Like other ARMs, these instruments began with so-called “teaser rates,” although some were not as low as might have been expected. They were all lower than what the resets would be in the future.
3. The Option: the rules required borrowers to pay something each month: either the normal principal and interest, interest-only or something less than the interest owed for the period. S&P found, perhaps not surprisingly, that 93 percent of the borrowers chose the last option!
S&P reports that nearly all of the 350,000 Option ARM borrowers now owe more than the original balance on their loans due to negative amortization (the adding of unpaid interest to the original loan balance). Not surprisingly, default rates are sky-high at 25 percent and evidence exists that the newer the loan, the more likely the default. (Those issued in 2007 tend to default after only 20 months.)
Where are these loans? Yes, in California, Nevada, Florida and Arizona, where prices have fallen the most. Borrowers are overwhelmingly underwater in these markets to begin with and are now facing severe resets (frequently over a 100-percent increase in monthly payments), no opportunities to refinance and no chance to qualify for loan modifications. Can you say default?
As if this weren’t bad enough, 80 percent of the mortgages were liar loans (where applicants reported unsubstantiated incomes at often grossly exaggerated levels in order to borrow more money than they could manage). Now, after the party, it is hopeless to expect these borrowers to be able to service their loans.
Epilogue: There are many possible villains in this regrettable story and fingers have been pointed at everyone and at each other. To be sure, borrowers were caught up in the fury, if by no other evidence: they surely knew they could not repay 100 percent or more of their monthly pay after a reset.
This sad tale will continue to unwind into 2012.
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Austin Jaffe, Ph.D. is PAR's Consulting Economist from the Smeal College of Business at Penn State University. |
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I agree whole heartedly with Dale Hart’s comment that our profession shares in the blame for the whole mess. We should not be pointing fingers at “greedy” bankers or mortgage reps when we were the ones who dealt with the buyers directly. I will admit that I’ve taken a small pleasure though in the downturn and its effect on our profession. It has been like wathching evolution in progress. Agents who work hard and who invest in their education and business are still around. A lot of the others who woke up one morning and thought “maybe I’ll try selling real estate” are not.
Melanie, you are right on target but let’s not forget or forgive Realtors who went along for the ride and kept their mouth shut when a client didn’t have cash to close, wanted and got 6% seller help and 103% financing and no home inspection. Realtors continue to puff up their chests and claim to the public they are “professionals”, yet can be found many times hiding in the corner when it comes time to intelligently guide their clients through the entire home buying process.
I’ve always said there’s enough blame to go around–greedy lenders, stupid consumers (“If it sounds too good to be true…”), loan brokers who turned a blind eye, the underwriters on Wall Street who said these loans were good investments…plenty of blame.