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Wednesday, September 03, 2008 12:02 AM

Option ARM Time Bomb About To Explode

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HousingWire is reporting Fitch Warns on Option ARMs; “High Defaults Await”.

Fitch Ratings on Tuesday released a wide-ranging look at option ARMs that paints a decidedly negative picture for the mortgage markets over the next 36 months. In fact, the picture is a downright scary one: the bottom line is that most outstanding neg-am mortgages won’t get out of 2011 alive, thanks to forced recasts.

Fitch analysts said they now expect roughly $29 billion in option ARMs to recast to higher monthly payments by the end of 2009, and an additional $67 billion to recast in 2010; of this, approximately $53 billion is attributed to early recasts.

“Though recent declines in the 12-month Treasury average rates have mitigated some risks, the majority of option ARM borrowers have elected to make the monthly minimum payment over the past 24 months,” Fitch said in the report. “As a result, a large number of these loans, especially those with 40-year amortization and 110% principal caps are expected to reach their recasts before the end of the five-year mark.”
My Comment: Declining treasury yields will bail out some subprime borrowers, but not Alt-A Pay Option Arms. 80 percent of pay option arm holders make only the minimum payment. That is all they can afford (if they can even afford that). The time bomb is negative amortization, and that time bomb goes off when negative amortization hits contract levels (typically 110% percent but as high as 125%).
The result? Fitch said it expects 90-day plus delinquencies — already ranging from 10 percent to 24 percent, depending on vintage — to more than double after recast for 2004-2007 vintage loans. It gets worse: Fitch also estimated that the potential average payment increase on the re-casting loans to be 63 percent, representing on average an additional $1,053 due each month.

California Will Be Hit Hard

California will be the state hit the hardest by Pay Option Arms. Florida and Las Vegas also had significant pay option arms usage. Pay option arms were least used in the Midwest where home price appreciation was more subdued than the biggest bubble areas.

For some additional thoughts on California housing, please see When Will Southern California Home Prices Bottom?

Mike "Mish" Shedlock
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