Thought the mortgage meltdown was just a sub-prime affair? Think again. There’s another time bomb waiting to explode, experts say: risky loans made to people with good credit.
Believe it or not, above quote is not lifted from the pages of the Nerd’s Eye View, despite my longstanding tendency to rant to that very effect. It comes from none other than the Los Angeles Times, in a very good article on the looming foreclosure risks posed by option ARM loans.
A more traditional mortgage requires the borrower to pay a certain amount of principal (the amount owed) in addition to some interest each month. An option ARM, in contrast, allows a borrower to make a monthly payment so small that it covers no interest and only a portion of the principal. The interest and principal that the borrower did not pay is then tacked on to the balance of the loan. Eventually, when the loan balance grows larger than a specified amount, such as 115 percent of its original size, the required payment adjusts sharply upward.
These loans were very popular here in San Diego during the late-stage housing boom. The small monthly payments allowed buyers to get into nicer homes than they could have otherwise afforded, and people by and large seemed to assume that the growth to the loan balance would be more than offset by the expected perpetual rise in home prices.
Now, between the recent home price declines and the tendency for these loans to increase in size, many option ARM borrowers are probably underwater.
read more at voiceofsandiego.org
That’s why we call them
That’s why we call them put-option ARMs.
WCVarones has it right.
WCVarones has it right. People allowed to buy with low down payments are being given a put option at a very low price. If you put down $X of your own money, and you place a monetary value of $Y on your credit, then you’re effectively buying a put option on the house for $X+$Y, where the strike price is equal to the loan balance.
With a low money down option ARM, you pay very little for the put option, and the strike price is high, so its value is high. The moron lenders are throwing money at you. If I get bored, I’ll calculate the option value on some sample loans, but this analysis is so obvious that surely the results have already been published and explained. Anyone got a reference?
Oh, and just as people tried for a long time to pretend that the loan problem was inherently restricted to sub-prime loans, so people will continue to cling to the belief that it’s possible to make money lending with low money down. In a non-recourse state, it almost doesn’t matter what the borrower’s credit or income or circumstances are, if they put down less than, say, 20% of their own cash, the value of the put option they are being given is so large that you can’t charge enough on that type of loan to make money over all the cycles. Someone please show me the math to prove me wrong or right!
Patient renter in OC
My crystal ball says, that
My crystal ball says, that for Option ARMS, the triggers to recast at say 110%, 115%, or 120% of sales price (original loan) of house will happen way sooner than what that famous ARMS Reset chart showed. The negative amortization calculations of LTV were again very optimistic when the loans were made and when the salestalks were given by the mortgage-lender brown suits to the math-stunted buyers. These Option ARMS are horribly negatively amortizing (the principal balances (or the Loans in the LTV ratio) get bigger and bigger every month much more rapidly than first thought or calculated – another of those “unexpected” events by the top economists) such that the triggers happen way sooner. Plus, it becomes very hard to ignore that the Value (in the LTV ratio) of the house deflates every month.
Of course, the math-challenged buyers picked the option of the least monthly payment such that the interest partially only gets covered and unpaid interest gets tacked on to the principal amount making the whole loan bigger. Every month, it gets worse, for sure.
NANCY’S CRYSTAL
NANCY’S CRYSTAL BALLS
“…when the salestalks were given by the mortgage-lender brown suits to the math-stunted buyers.”
dayum, that thar’s poesy, sho nuff!
well said…
Voz
What pray tell did Ms Olsen
What pray tell did Ms Olsen do with the cash-out money when she re-financed? Yes I know the article doesn’t state that she did do a cash-out, but I’d wager she did.
Josh
This has probably been
This has probably been posted on here somewhere but I think it is a nice fit for this topic. This is a mortgage insider at Herb Greenberg’s blog that went into some detail about the Option Arm crisis coming upon us. There are about 600 comments many that are worth the read.
http://tinyurl.com/yv748q
here is an excerpt;
“In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.
Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.”
That excerpt certainly puts
That excerpt certainly puts it all in perspective doesn’t it ; )
I’ll check out the link
What has not been said yet
What has not been said yet is that the banks and mortgage holders have been booking the increased debt as income in the current year. So not only have the bad loans been feeding the balance sheet, they have been feeding the income statement with ficticious income.
This is also true of the “reverse mortgage” situations. Lenders are booking the non-existent revenue stream as if it was cash comming in the door.
I wonder how they will handle the reversals? What is a reverse mortgage worth if the property is underwater?
EXACTLY!!!!! Bubba99
I’ve
EXACTLY!!!!! Bubba99
I’ve posted that issue here and elsewhere and it’s consequences are HUGE!. Accrual accounting allows banks and lenders to book income now that has not yet been received AND NEVER WILL BE in many, if not most, cases.
The number of banks and lenders having to very soon reissue restated financial statements will be many and the swing in those restated financial statements will be so wide that havoc and panic will ensue.
Other than that, everything will be ok (a little sarcasm here)
Update: Thanks to a reader
Update: Thanks to a reader who pointed out that I got a minor detail backwards. The option ARM mortgage payments are applied first to the interest, and then to the principal. My correspondent does a good job of describing the process, saying, “The borrowers you’re describing are paying only a portion of the interest that is accruing each month, and none of the principal –- and the portion of the accrued interest that they are not paying is what is what is being added to their principal balance each month (i.e., their negative amortization).”
I don’t think most of the
I don’t think most of the lenders will arbitrarily execute their option to reset based on the increased LTVs. I think they’ll play the long shot in the (forlorn) hope that the price declines will reverse and subsequent price increases will restore the value of their collateral. I think a lot of these lenders really want to believe the NARs spin on these pricing trends.
In lieu of the premature resets, I think the second wave of ARM resets will arrive as contractually scheduled. I think that its effects could possibly be even more severe than those of the first wave. It’ll be worse partly because there’s a larger percentage of the really toxic stuff and partly as a result of the cumulative effect on the market psychology. Coming so soon after the first wave, this second smaller wave could do even more damage. I think it will be the knockout punch of this one-two combination.
I came late to the real
I came late to the real estate bubble/bust. I thank blogs like this one and Ben’s but most of all my boss for my not being in Olsen’s situation. I went loan shopping and every broker except one — the only one recommended to me via word of mouth — was pushing this kind of loan. That the initial monthly payments would be $300 less than a fixed-rate 30-year loan was very tempting. When I showed my boss one such “good faith estimate,” he tore it up and threw it at me. I ended up with a 30-year fixed rate at 6.25.
The lesson I learned this late in my life is that word of mouth from your friends is the only way to go. This has been true with plumbers, gardeners, etc. Don’t want to kiss ass, but…my thanks to everyone here.
So rate freezes for
So rate freezes for sub-prime, where people at least (in theory) covered the interest on their loan, and maybe even some principal.
Now for the “prime” borrowers, many of whom didn’t even pay the full interest, what’s ‘ol Hanky P. gonna do, rate reversal? Interest forgiveness?
BTW, what do the Agency loans in the IMF mortgage reset chart refer to?
Now, with all the exotic
Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households.
In addition to this, on a million $ home, given the type of financing programs available for that amount, a lender would require 20% down under current guidelines. That would mean $200,000 down and then transaction costs. Which first time buyer has $200k+ sitting in the bank? My guess is virtually zero.
Since property values are declining move up buyers are non-existant for the fact that they either can’t get their existing home sold for an amount that would make sense to move up.