Worth Considering

From the Pocket MBA at PLI

Term of the Week: Option ARM

Mortgage that permits the borrower to choose from among several types of repayment arrangements.
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Option ARM In The Real World:

Just when you thought it was safe to go back in the water. That was the tagline from advertisements for the sequel to the movie Jaws in the way-back time. But it could just as easily apply to the current credit/mortgage situation/crisis. Every time someone gets on television to say that the housing market has bottomed, the eerie Jaws theme music seems to start playing in Pocket MBA's ear. Da Dum...Da Dum...Dum-Dum, Dum-Dum, Dum-Dum...Aaaaarghhhhhhhh, my arm! And the shark bites again. The newsletter has previously covered subprime mortgages (Jaws) and Alt-A (Jaws 2); we seem to have weathered the threat of the first, and the second may not be as bad as originally thought, although who knows? And now comes Jaws 3-D, the ticking bomb that some say is represented by the resets in option ARM rates scheduled for next spring. Some finance people believe that to the extent the economy has avoided full-on recession this year, the option ARM problem could sink it next. That's because option ARMs represent a larger percentage of mortgages than subprime and Alt-A, and the homebuyers that took out option ARMs tended to be solid denizens of the middle class, including people who refinanced out of standard 30-year fixed mortgages. If they start to go bust, well you do the math. Da Dum...

So what is an option ARM, and how can it be the straw that breaks the camel's back, or the dangling leg (arm?) that tempts the Great White? You can Google the subject and get in-depth explanations with calculations and all that, but, simply put, an option ARM is an adjustable rate mortgage that gives the borrower up to four choices as to how much he will pay each month--that is, it gives payment options. Each of those options impacts the amount which the borrower will repay every month.

The most straightforward options are that a borrower can choose to pay the mortgage as if it were a standard 15- or 30-year mortgage. Pocket MBA imagines those who have chosen either of these two routes are probably doing just fine. After all, those are the options standard borrowers decide between when taking out a mortgage. It's the remaining two options that are problematic, although they didn't start out that way. So first, a little history.

Options ARMS are a creature of the 1980s, and as implied above, they were originally marketed to relatively high-end borrowers, many of whom had incomes that were stacked toward the end of the year, either via bonuses or self-employment arrangements. The options that attracted these borrowers were the ability to pay less than a standard fixed mortgage in certain months of the year, and then at the end of the year, when the borrowers had more income, they would make, in essence, a balloon payment to make up the difference and get back on the track they would be on with a standard mortgage. As option ARMs began being offered to those with less income, or standard earners (15th and 30th of the month, etc.), the option part of the payback started to become problematic. Dum-Dum.

The first of the non-standard options in an option ARM is to pay the mortgage as if it were an interest-only loan. Thus the borrower pays only the monthly interest on the loan (which can be fixed, but is often adjustable on a monthly basis), and the principal on the loan remains steady for whatever term the interest-only part of the loan occupies. At the end of that period, the borrower has to play catch-up. Again, this can work for a higher-end borrower who can invest the amount saved on the monthly payments and make up more than what he would have paid on the mortgage. Of course, if your investments don't work out, you're left holding the bag of a mortgage that must be paid off by the end of the mortgage term, and now you have interest and principal to pay in that amount of time. Da-Dum. Dum-Dum, Dum-Dum, Dum-Dum, Dum-Dum...

The second of the non-standard options for option ARM borrowers is the "minimum payment" or negative amortization option. This is the real killer, and again, it made sense for borrowers who had a certain threshold financial wherewithal. Under this option, the borrower pays an amount "X," that is predetermined and is less than even the accruing interest. An amount equal to the difference between X and the monthly interest owed on the loan gets tacked on to the principal balance. Thus, with the minimum payment option, the borrower owes more every month, and owns nothing, that is, his equity doesn't grow. This goes on for a year, at which point the interest rate is usually readjusted upward, but usually the monthly minimum is still relatively low. But, after a certain number of years (five or ten) or when the balance grows to a certain percentage above the original balance (say 115% or 120%), the loan gets "recast," so that it is fully amortizing. Then, no matter how much a person owes on a monthly basis to make up the negative amortization during the remainder of the loan term, that amount becomes the monthly payment, and the sky is the limit. For a slew of option ARMS on which borrowers have been paying the minimum option (and there are reports that the number of these is as high as 80% of all option ARMs), that date of reckoning is sometime next year. Dum-Dum, Dum-Dum, Dum-Dum, Dum-Dum...

So how did a loan that was meant for relatively well-off earners end up being marketed to everyday borrowers? Of course, it's the story of the credit/mortgage crisis writ large: falling interest rates create housing boom; more and more people enter the market; housing prices soar, thereby excluding the same people from the market unless banks come up with creative ways to enable affordability. Bing bang boom, you end up with a mismatch between lending product and borrower, and a potential foreclosure problem.

The funny thing is these minimum payment arrangements haven't hurt the lenders, at least until now. First, under GAAP, the banks are allowed to record as revenue the amount that would have been paid had the borrower chosen to pay at the fully amortized 30-year option. Thus the banks' bottom line looks great...at least until the borrower defaults. Then all those revenues have to be discounted. Also, as with subprime, many of these loans have been sold to investors via the securitizations that were the subject of this newsletter earlier in the year. The question is whether that will start a new round of financial institution stress. Tune in next spring to find out. Until then, it's definitely not safe to go back into the water.

Watch out below!