Saturday, March 17, 2007

Tanta: Negative Amortization for UberNerds

by Bill McBride on 3/17/2007 06:44:00 PM

Confusion about Option ARMs and other kinds of negative amortization keep coming up in the comments. If you really want to know how this stuff works, you should know up front that it’s a long story. If you’re not up for the long story, skip to the next post. I would never dream of holding it against you; the following is hard-core UberNerdism, and there’s nothing wrong with just being a normal reader of the blog. In fact, I envy you. Someday the rest of us will get help for our UberNerdism; until then . . .

With a regularly amortizing ARM, the rate adjusts on some schedule that is laid out in the original contract (the note). Take a 5/1: the rate adjusts after five years, and then every year thereafter. But because it is a regularly amortizing ARM, the payment adjusts after the rate adjusts, so that the payment is always enough to cover the interest due plus sufficient principal to retire the debt at maturity (that's the definition of "amortization"). With this loan, there are no "payment caps." There are "rate caps." This means some limitation on how high or low the rate can go at any given adjustment, or over the life of the loan. The lack of “payment caps” means that the payment must go as high (or low) as it needs to in order to satisfy the rate increase (decrease). If there’s “rate shock” in this loan, you feel it immediately, because you immediately begin making payments at the “shocking” interest rate.

Negative amortization loans can work by calculating two "rates": the actual accrual rate (the real interest charged) and the payment rate (a kind of "artificial rate" used to set the minimum payment). The payment rate might also be an “introductory rate.” Here’s an example of a neg am variant on the old 5/1 ARM. (Important: this is just an example. There are jillions of unique neg am ARMs out there, and the Option ARM is even more complicated than the following. Do not assume that the following example is how they all work in exact terms; it’s just how they work in overall concept.)

In our example loan, the introductory accrual rate is 1.95% for three months. This means that the first three payments are based on an actual rate of 1.95%, and so for three months the loan amortizes (the payment due is equal to the payment required to satisfy all interest and a portion of principal.) Let’s assume a loan with an original balance of $90,000 used to purchase a property with a sales price of $100,000. For the first three payments, you get this:

#Beginning BalancePMT RateMinimum PMTAccrual RateAccrued InterestScheduled principalShort- fallEnding BalanceOriginal Prop ValueLTV
190,000.001.95%($330.41)1.95%($146.25)($184.16)0.0089,815.84100.000.000.9000
289,815.841.95%($330.41)1.95%($145.95)($184.46)0.0089,631.38100,000.000.8982
389,631.381.95%($330.41)1.95%($145.65)($184.76)0.0089,446.62100.000.000.8963

After three months, the accrual rate changes to 6.50% for the remaining 57 months of the initial 5-year period. However, the minimum payment remains fixed for the remaining 57 months.* What this means is that the minimum payment required is calculated at a lower rate than the actual accrual, and so if the borrower makes the minimum payment, the loan negatively amortizes, meaning that the difference between interest accrued at 6.50% but paid at 1.95% is added to the loan balance. The borrower is not forced to make the minimum payment, although of course we’re seeing people take these loans precisely because they can’t afford the amortizing payment. You can see right here that the borrower already got “rate-shocked” in real terms, going from 1.95% to 6.50%. The borrower just doesn’t feel rate-shocked, because by making the minimum payment, the borrower is in essence borrowing enough money each month to subsidize the debt service.

Here’s what the loan looks like (condensed) for the remaining 57 months. I have broken out the “fully amortizing” payment at the accrual rate into its principal and interest components; the required payment from the borrower to actually amortize the loan (satisfy all interest due plus retire some principal) would be the total of the two. If the loan were an Option ARM with the choice of making an interest only payment rather than a fully-amortizing or negatively-amortizing (minimum) payment, the required IO payment would be the portion shown below as “accrued interest.” This chart shows the “shortfall” as the total difference between the amortizing payment and the minimum payment; the ending balance, however, is equal to the beginning balance less the difference between “accrued interest” and “minimum payment” (because “scheduled principal reduction” does not happen with a minimum payment). An alternative way to calculate that is to subtract the scheduled principal from the beginning balance, then add back the entire shortfall (not just the interest shortfall) to get the ending balance. (You may wish to have a drink before continuing.)

#Beginning BalancePMT RateMinimum PMTAccrual RateAccrued InterestScheduled principalShort- fallEnding BalanceOriginal Prop ValueLTV
490,000.001.95%($330.41)6.50%($484.50)($82.41)(236.50)89,600.71100.000.000.8945
589,600.711.95%($330.41)6.50%($485.34)($83.07)(238.00)89,755.63100,000.000.8960
689,755.631.95%($330.41)6.50%($486.18)($83.74)(239.51)89,911.40100.000.000.8976
...
5698,673.001.95%($330.41)6.50%($534.48)($127.42)(331.49)98,877.07100.000.000.9867
5798,877.071.95%($330.41)6.50%($535.58)($128.54)(333.71)99,082.24100,000.000.9888
5899,082.241.95%($330.41)6.50%($536.70)($129.67)(335.96)99,288.52100.000.000.9908
5999,288,521.95%($330.41)6.50%($537.81)($130.82)(338.22)99,495.92100,000.000.9929
6099,495.921.95%($330.41)6.50%($538.94)($131.98)(340.50)99,704.45100.000.000.9950

You notice here that the ending balance of the loan after 60 payments is $99,704.45, or just over 110% of its original balance. This will become important below. Also notice that the LTV here is based on a constant original appraised value. You can make any changes you want to that original value and get a better or worse looking current LTV. But the contractual limitations on a neg am loan have to do with the relationship of current balance to original balance, not LTV. In the real world, of course, a borrower who is negatively amortizing at the same time that the appraised value of the property is dropping is getting much further underwater than this example indicates; I’m just trying to show effect on LTV if value stays constant.

After 60 months, the accrual rate adjusts to the formula of index plus margin, just like any other 5/1 ARM. However, the required payment after the first adjustment (at 60 months) is capped at 7.50% of the prior payment. If the adjustment to the new accrual rate would require a new payment greater than 107.5% of the old payment in order to fully amortize the loan, and the borrower makes the minimum payment instead, the loan negatively amortizes. The 7.50% payment cap is different from the rate cap. On a 5/1 ARM, the rate cap could be 5.00% at the first adjustment and 2.00% at each subsequent adjustment. What that means is that the rate will not increase more than five points at the first adjustment or more than two points at subsequent adjustments. If the initial accrual rate is 6.50%, at the first adjustment the rate will never be higher than 11.50% (6.50% plus five points). The payment cap, on the other hand, is a percent limitation, not points. In other words, to calculate the new minimum payment, you take the old payment and multiply by 1.075.

Using our example above, and assuming that the accrual rate increases only by 2.00% to 8.50%, the new fully amortizing payment is $802.85 ($706.24 interest plus $96.61 principal). However, the payment cap of 7.50% would limit the new minimum payment to $355.19 ($330.41 times 1.075%). On this example loan, that won’t actually happen, though. Keep reading; it just gets more complicated.

At each point, the amortizing payment is calculated on the actual loan balance outstanding. This is how neg am becomes turbo-charged ugly: if you make only the minimum payment each month, the difference between accrued and paid interest is added to your balance. Therefore, next month, your accrued interest is charged on a higher balance than last month—you are paying interest on interest. So neg am becomes “exponential” instead of “arithmetical.” It’s the reverse of compounding interest in a savings account.

So, in order to keep this exponential growth of the loan balance under control, the neg am ARM has “recast” mechanisms. These are separate from rate and payment caps and adjustments. One of the big problems with understanding all this is that too many people (including our fine media) use the terms “reset” and “recast” as if they were synonyms. You’ll never understand a neg am ARM if you do that. What we went through above was “resets” of the rate and payment. What we’re about to go through now is “recast.”

To understand recast, think of it as a process that is concurrent with but not on the same schedule as the reset process. Resets (adjustments to rates and therefore required and minimum payments) happen according to the pre-arranged terms laid out in the original note (such as every year after the first five years). But, contractually, the borrower is not required to negatively amortize; one can make the full payment, not just the minimum payment. (On an Option ARM, one can also make a full interest only payment; that doesn’t lower the balance, but it doesn’t increase it because all interest due is paid for the month.) One can also make occasional curtailments (lump sum payments of principal that don’t pay off the loan in full but that reduce its balance substantially). So for any given neg am loan, you can’t know ahead of time whether and at what point and how fast it will negatively amortize. By “how fast,” we are also referring to the magnitude of the interest rate adjustments. With any ARM, you cannot know in advance how much the rate might change at the first adjustment or any subsequent adjustment, because the new rate is determined by the formula margin (constant, spelled out in the note) plus index value (variable; the index chosen is in the note, but the actual value of it in the future is unknown). The higher the future accrual rate increases, the faster the loan will (potentially) negatively amortize.

So the “recast” provisions are a separate process of monitoring and forcing the restructure of the loan, over time, to make sure that any negative amortization doesn’t get too far out of hand. Recast provisions can be as complicated as resets, but here’s a common setup:

First, there is a provision to reamortize the loan every 60 months. What this means is that every five years, the servicer has to recalculate the minimum payment by ignoring those 7.50% payment caps. This may or may not produce huge payment shock to the borrower; it will depend on how significant the rate resets were in the preceding 60-month period, or, for the very first recast, how deep the discount was between the accrual rate (6.50% in our example) and the payment rate (1.95%). Remember that it is possible at any rate change date that the rate adjustment was small enough that the new required payment was less than 1.075% of the old payment. It is of course possible that it wasn’t, and this can hurt. In any case, this 60-month recast brings the minimum payment up to fully amortizing, but it doesn’t cancel out the regular rate and payment resets that can happen in the next five years as outlined above. So, with an ARM with annual accrual rate adjustments, the 60-month rolling recast keeps the loan amortizing for the following year; after that, neg am could start happening again (until the next 60-month recast). Think of it as a way of “catching the borrower up” every five years, but allowing them to start “getting behind again” eventually. So that is one reason why our example loan above is not going to get a new payment of $335.19, even though that’s what it would be just using the 7.50% increase limitation. The issue is that the first rate adjustment date happens to coincide with the first 60-month recast date. If the example loan didn’t have an initial fixed period of five years—say it was a 3/1 type structure—then the 7.50% payment cap might have come into play after 36 or 48 payments. (Have another drink; we’re not done yet.)

Second, there is a provision to force the loan to amortize whenever the balance hits 110% of the original balance. This is not “scheduled” like the 60-month rolling recast above; it is triggered only for a given loan if and when it has hit the 110% mark, and thus will not necessarily happen on a rate or payment change date; for some loans, it might never happen at all, if the borrower only occasionally makes the minimum payment, or makes a periodic curtailment that brings the balance down. If it does happen, the loan must become a fully amortizing loan—no more minimum payment allowed, all payments must be sufficient to pay all interest due and sufficient principal to amortize the loan over the remaining term. The percent of original balance limitation, in other words, marks the day that neg am is no longer an option for the borrower, and the loan has to start paying down principal from here on out—the borrower is “caught up,” and never again allowed to “get behind.” In our example above, the loan hit the 110% limit after the application of payment 57. So even though this loan was not scheduled for a rate increase or rolling recast until month 60, the servicer would have sent notice to the borrower that as of payment 58, the required payment is the fully-amortizing payment. Note that the loan remains an ARM, even though it is now no longer a neg am ARM. That means that the borrower’s payment can still increase or decrease at future rate change dates. It will simply be, from here on out, an increase or decrease from one fully-amortizing payment to a new fully-amortizing payment.

Neg am ARMs are structured such that the minimum payment will always satisfy at least some interest due. This is true because with a neg am loan, like any mortgage loan, payments are applied to interest before principal. I have noticed that this confuses a lot of people, undoubtedly because we all tend to think in terms of “regular” amortization, which assumes that some portion of a loan payment always goes to principal, and so people imagine that the “principal portion” of the scheduled payment could be larger than the minimum payment, which would result in no cash interest paid in a month. That cannot, however, happen. It doesn’t matter what the “scheduled principal” part of a payment might be; if the borrower’s minimum payment isn’t enough to satisfy both scheduled principal and accrued interest, the payment is applied to the interest, the unpaid interest amount is added to the balance, and no “scheduled” principal reduction occurs. (Compare that to an interest only loan, where the full interest amount is paid by the borrower in cash, but no principal, so the loan balance neither increases nor decreases.) To a borrower in hock, that’s probably a distinction without a difference, but for accounting and regulatory purposes, it’s important (see below under “noncash income” to the lender).

Has your head exploded yet?

But that’s the real point, isn’t it? If your head just exploded, and you’re the kind of person who usually reads CR, just imagine what the kind of person who doesn’t usually read CR makes of all this during some ten-minute spiel by some loan officer. We already know that there are lots of loan officers and brokers who don’t understand how these loans work; remember Babs the Wonder Broker? (One of MaxedOutMama’s finds: someone who is apparently a mortgage Account Executive who was convinced that neg am loans do not charge interest on interest. The only way that could happen is if the required payment each month were calculated only on the original balance, not the original balance plus prior shortfalls. That would, if you did it that way, leave a portion of the total loan balance that isn’t accruing interest. Of course, even if you did that during the neg am period of the loan, once you got to the 60-month recast or the 110% balance cap, you would use the total balance to recalculate the payment, and so from that point forward you would be charging interest on the capitalized interest. That’s not how these loans actually work, but the point is that even if they did work that way you couldn’t consider the capitalized balance to be “free money,” just slightly cheaper money.) So imagine some poor consumer getting “the explanation” from a loan officer who doesn’t understand how neg am works. You’d think that most adults, generally, would be suspicious if they were told by some joker on the internet (say) that banks will actually lend you money without charging interest on it. But if a broker tells you that? They must know, right?

A few more points: the issue of lenders counting negative amortization as interest income keeps coming up in the comments. I hope this example above shows why they do that: it is, actually, interest earned by the lender. It’s just interest that has not yet been paid by the borrower, which makes it “noncash” interest income. It is therefore only as “good as” the collectability of the loan as a whole. Some of us believe that as a loan negatively amortizes, its “collectability as a whole,” as a matter of probability, goes down. Some of us further believe that there are lenders out there who don’t seem to agree, and who therefore under-reserve for these loans (that is, they consider the $99,000 balance just as collectable as the original $90,000 balance, without taking into account that the more the borrower owes, the higher marginal odds of default are, and that a borrower who is making minimum payments might be doing so because the full payment is simply unaffordable).

Also, this discussion I hope makes clear that the “rate shock” issues on neg am ARMs are different from the same issue on a fully-amortizing ARM. As I said earlier, neg am ARMs are by definition a way to “smooth out” rate changes by keeping them from “shocking” the payment. Certainly, not every neg am ARM out there has a five-year initial fixed period, as my example does, or such a deep “teaser” (1.95% vs. 6.50%). Any loan with more potential rate movement in the early years of the loan can negatively amortize faster or slower than my example. We simply need to bear in mind that what is in store for a lot of these loans is the recast shock, and that that shock doesn’t necessarily happen on a scheduled rate change date. The real bad news, friends, is that these things can start blowing up more or less any time, given enough early negative amortization to start kicking in the balance caps. And yes, there are loans out there with 115% caps rather than 110% caps. So it’s incredibly difficult to project out “shocks” on these loans considered as a total portfolio, because they’re not really a homogeneous portfolio when it comes down to details like initial fixed period, depth of initial discount, rate caps, balance caps, etc. Even if they were, one would have to keep modeling “recast shock” predictions based on the actual amount of negative amortization going on, since neg am is a function of what the borrower decides to pay each month. Some of us (OK, me) are worried that the “models” aren’t being “updated” to reflect the actual amount of neg am piling up out there, or that if they are, the lenders aren’t sharing that information with the rest of us.

Last, there’s this question just raised in the comments about why or whether a lender wouldn’t just refinance these neg am borrowers into a new loan, to start the teaser rate thing all over again. Well, they could and they did when house prices were busy rising. The reason it’s a problem now is that the loan originated at a 90% LTV may now have a 99% LTV. To refinance that borrower into another neg am loan is to risk the LTV becoming 109%. I suggested at one point a while ago that a good way to think of a neg am ARM is this: a borrower makes a down payment (neg ams are usually limited to no more than 90% LTV), and then borrows it back, a little bit a month, to subsidize the monthly payment. It’s a mini monthly cash out. That can continue only as long as there is down payment to keep putting down and then slowly borrowing back, and those who refinanced a balance-capped Option ARM to a new Option ARM in the height of the boom were doing so by using that vapor-equity as the new down payment. Once that’s off the table, there’s nowhere to go with these loans except eventual amortization.

Tanta

*In this example, the initial minimum payment is simply fixed for five years. It isn’t actually recalculated every month at 1.95% instead of 6.50%. If it were, the minimum payment would increase slightly every month, because it would be calculated on a slightly higher balance every month (as the actual accrual payment is). I did it this way because many neg am loans work with this “fixed payment” thing. That’s how borrowers get confused into thinking the 1.95% is a fixed rate (when it’s really just a fixed payment “rate”). You could structure the loan such that the minimum payment is actually calculated each month at 1.95%; that would slow the negative amortization slightly by increasing the minimum payment slightly.