Saturday, January 01, 2011

What about those Option ARMs?

by Bill McBride on 1/01/2011 02:15:00 PM

I've seen versions of the following chart being used to warn about Option ARM defaults in 2011. This chart is from the IMF in early 2007: Assessing Risks to Global Financial Stability

IMF Credit Suisse Reset Chart
Warning: Out of date!

This chart from Credit Suisse, via the IMF, showed the substantial subprime resets in 2007 and 2008, and it showed the potential reset/recast problems with Alt-A and Option ARM loans in 2010 through 2012.

There were many subprime defaults in 2007 and 2008, and many people have been worried about a "2nd wave" of Option ARM and Alt-A defaults.

Here is an updated chart from Zach Fox at SNL Financial as of February 2010: Credit Suisse: $1 trillion worth of ARMs still face resets
Most of the resets are expected to occur through 2012. Between 2010 and 2012, the chart indicates that $253.25 billion of option ARMs will adjust, while Alt-A loans totaling $163.71 billion will reset over that time. Altogether, $1.010 trillion worth of ARMs will reset or recast during the three-year period.
excerpts with permission
Option ARM Recast Click on graph for larger image in new window.

Source: SNL Financial.

The chart is labeled "resets" with a comment on "recasts" at the bottom. Resets are not a problem right now with low interest rates.

From Tanta on resets and recasts:
"Reset" refers to a rate change. "Recast" refers to a payment change. ... "Recast" is really just a shorter word for "reamortize": you take the new interest rate, the current balance, and the remaining term of the loan, and recalculate a new payment that will fully amortize the loan over the remaining term.
Looking at the 2nd chart, it appears there is another wave coming in 2011 and 2012 - but probably not a large wave for several reasons.

First, many of the loans have already defaulted. There is a difference between the original recast date, and the actual recast date - because negatively amortizing loans hit the recast ceiling earlier than the original forecast - and those loans have already defaulted (or have been modified).

Second, some of these loans were modified (Option ARMs and Alt-A loans were targeted by the banks for internal modification programs), and some of these borrowers have probably refinanced - the few that had some equity.

Also some of the loans (mostly Wells Fargo with 10 year recast) will probably recast later than the Credit Suisse chart.

There was a peak on the 2nd chart in 2010, and so far there hasn't been a huge surge in Option ARM and Alt-A defaults (they were already defaulting in large numbers). Here are a couple of graph from LPS Applied Analytics' November Mortgage Performance data.

Delinquency Rate by Type Click on graph for larger image in graph gallery.

This graph provided by LPS Applied Analytics shows the percent delinquent by product type. As the graph shows, the Option ARM and Alt-A loans have already been defaulting in large numbers.

The Option ARM defaults did increase in 2010 but nothing like what the Credit Suisse chart seemed to suggest.

Foreclosure Rate by Type We also need to include the loans in the foreclosure process. The percent in the foreclosure process is trending up recently because of the foreclosure moratoriums.

But what these graphs don't show is a huge spike in Option ARM and Alt-A loans delinquent or in the foreclosure process. Although there will probably be more delinquent Option ARM and Alt-A loans next year, I'm more concerned about falling house prices and negative equity than a huge wave of Option ARM and Alt-A defaults.

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