Coming soon: $1,000bn resetting, recasting US ARMs
In 2007, Credit Suisse achieved something of a coup in what was then a much smaller, less mainstream financial blogosphere.
Analysts at the bank produced the following chart, which quickly (and uniquely) went viral, appearing on Calculated Risk and a slew of other housing and financial blogs. The chart even made a cameo appearance in the pages of an IMF report on ‘risks to global financial stability’.
Various versions of the chart have percolated ever since – a more recent edition popped up in an FT graphic accompanying a downbeat housing story in 2009; another in a cautiously optimistic BusinessWeek piece.
Here’s more from SNL, who spoke to Credit Suisse about their most recent conclusions (including, as the chart shows, that more than $1,100bn of US ARM loans – adjustable rate mortgages – will either reset or recast between 2010 and 2012).
Emphasis FT Alphaville’s:
Though option ARMs have grabbed some headlines recently, they are not the primary concern for analysts such as [Chandrajit] Bhattacharya [head of non-agency RMBS and ABS strategy at Credit Suisse] and Greg McBride, senior financial analyst at Bankrate.com. McBride told SNL he is more concerned about ARMs that do not even show up on Credit Suisse’s chart.
Borrowers who already have seen their ARMs reset might be sitting on their hands and not refinancing into fixed-rate products, McBride said. Because mortgage rates have been so low recently, resets can actually lower, not raise, monthly payments. When that happens, borrowers might feel little urge to refinance into a fixed-rate product that would cost more per month. Alternatively, ARM borrowers might simply struggle to qualify for a refinance because of low or negative equity.
Bhattacharya said the ARM reset chart does not portend the all-out doom some housing bears infer. For one, option ARMs are concentrated in just a few states. A Fitch Ratings study from Sept. 8, 2009, reported that three-quarters of all option ARMs were in California, Florida, Nevada and Arizona.
McBride is worried about the prime ARMs posted in the Credit Suisse chart. The chart shows $10 billion to $15 billion resetting each month. If a substantial number of those borrowers do not refinance and interest rates shoot up, McBride said he could see $50 billion worth of prime ARMs facing payment shocks each month by 2011.
Small wonder Fannie Mae and Freddie Mac on Monday announced an extension to the HARP program, which is designed to encourage homeowners to refinance loans on houses facing falling, or even negative equity.
$134bn of US Option ARM RMBS to recast by 2011, Fitch says
First, some definitions and context (via Tanta, RIP). Emphasis FT Alphaville’s:
“Reset” refers to a rate change. “Recast” refers to a payment change.
Option ARMs do not “recast” until the sooner of 1) the loan reaching its balance cap or 2) the first “scheduled” recast date, which is usually 60 months from origination.
By and large, the biggest danger for Option ARMs and IO ARMs is the recast date, not the first or subsequent rate reset dates. However, for any ARM borrower who qualified at the highest possible debt-to-income ratio they could manage, any payment change, even one not quite as shocking as the recast on an OA or an IO, can tip the balance. As we are talking in this specific context about Alt-A, I for one believe that most of these loans did stretch too far in the beginning, and so even first rate resets on IOs or fully-amortizing ARMs will cause a marked increase in delinquencies in the absence of the borrower’s ability to refinance at reset into a new discounted ARM, which will be the case for some time.
According to Fitch, more than $100bn of Option ARM mortgages – an adjustable-rate home loan that allows the borrower to choose whether to pay interest or principal – will recast within the next two years, which may lead to significant payment shock for US home owners.
From the press release, emphasis ours:
Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event, though it should be noted that Fitch rated only approximately 5% of Option ARM transactions.
Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize. ‘Having not demonstrated their ability to make payments at the full rate, option ARM borrowers are at the greatest risk of default resulting from payment shock,’ said Group Managing Director and U.S. RMBS group head Huxley Somerville.
(Negative amortisation describes a situation that arises whenever a borrower pays less toward the principal on the mortgage than the interest that has accrued over the period. In other words, the outstanding balance on the loan actually increases over time. When coupled with falling house prices and wide-spread negative equity, theoutlook for the US option ARM holder is bleak.)
Back to Fitch:
Further evidence of option ARM underperformance in the last year lies inthe number of outstanding securitized Option ARMs either 90 days or more delinquent, in foreclosure or real estate-owned proceedings, which has increased from 16% to 37%. Total 30+ day delinquencies are now 46%, despite the fact that only 12% have recast and experienced an associated payment shock. Instead, negative and declining equity has presented a larger problem:due to high concentrations in California, Florida, and other states with rapidly declining home prices, average loan-to-value ratios have increased from 79% at origination to 126% today. ‘Negative equity and payment shocks will continue as Option ARM loans recast in large numbers in the coming years,’ said Somerville.
Option ARM loans have been a concern for some time specifically because of negative amortization. This feature allows for the loan balance is able to grow over time; typically to a balance cap of 110%-125% of the original mortgage. In an event known as ‘Recast’, once the loan hits the balance cap or reaches 60 months in age, the borrower’s monthly payment obligation increases from a minimum monthly payment to a fully amortizing P&I payment. This fully amortizing P&I payment is on average 63% higher than the MMP, and can be more than double depending on loan attributes and interest rate behavior. These concerns at the securitization issuance are largely what drove Fitch to rate such a small number of Option ARM transactions.
(MMP = minimum monthly payment)
To date, 3.5% of the approximately one million 2004-2007 vintage securitized Option ARM loans have been modified, in an attempt to mitigate effects from the payment shock. Modification types have included term extension, conversion to interest only loans, interest rate cuts, and others. These modifications have been somewhat successful, with 24% of modified Option ARM loans being 90+ days delinquent, compared with 37% of the overall Option ARM universe. However, because this product features lower MMP payments than would be available after recast, even with substantially favorable modification terms, there may still be material payment shock. Therefore, Fitch expects a high default percentage for modified Option ARM loans.
Overall, Fitch’s expected losses for recent-vintage Option ARMs range between approximately 35%-45%, depending on the collateral quality of the underlying mortgage loans. In addition to expectations of higher defaults, severities have also contributed to higher expected lifetime losses. Fitch has observed that loss severities on Option ARMs have increased significantly to an average of approximately 60% from 40% a year ago. A key driver in the worsening severities is the fact that 75% percent of Option ARM loans are secured by properties located in California, Florida, Nevada, and Arizona, which have experienced average declines of 48% from second quarter-2006 to date. Even without further declines in home values, defaults on Option ARM loans are expected to soar as loan recasts occur, as these borrowers are unable to effectively refinance into alternative mortgage product.
UPDATE: The NY Times had a great human interest story on “exotic mortgage resets” and sykrocketing payments on Wednesday. Worth reading, not least for stats like this one:
Dean Janis, a Southern California lawyer who bought a $950,000 home in 2004, will see his interest-only loan reset in December. He calculates that will send his payments up a minimum of 27 percent, to $3,726. A rise in rates could eventually push it as high as $6,700.