Fears are growing of a renewed surge in defaults on option ARMs (OAs). Investors have increasingly expressed concern that a spike in defaults driven by mandatory payment recalculations (the recast "time bomb") is building for the roughly $100 billion unpaid balance of 2006-issue loans, and question whether modifications under the Home Affordable Modification Program (HAMP) can be used to help significant numbers of troubled OA borrowers.
A review of this complex product's features will be helpful. The initial payment is calculated to fully amortize over the loan's term at a low "start" rate (typically 1.5%). Accrued interest is subsequently calculated at a fully-indexed rate of 12-month MTA plus a margin (usually 300-350 basis points). For a pre-designated period of time (either 60 or 120 months after issuance), the borrower can make a minimum payment, i.e. the initial payment subject to 7.5% annual increases. If a monthly payment is less than the interest-only payment (based on the fully-indexed rate), the difference is added to the loan's balance (i.e., "negative amortization"); otherwise, the difference is treated as amortization. The loan is recast either at the end of the minimum payment period, or if its balance increases to a negative amortization limit (typically 115% of the loan's original balance). After the recast, the loan becomes an annual-reset ARM, with payments determined by the fully-indexed rate and remaining term.
Few OAs are currently near the 115% negative amortization threshold, since the steady decline in MTA (to its current 0.48%) has allowed most OAs to positively amortize even when minimum payments are made. Therefore, loans that will recast in 2010 will do so by reaching the end of the minimum-payment period. This encompasses a considerable number of loans; as a proxy, data from Countrywide's 2006 deals suggest that roughly 2/3 of that vintage's outstanding loans will recast next year. Recasting loans will generally have their monthly payments increase by 20% to 25% over their current minimum payments at current rate levels.
The severity of this "payment shock" can usually be evaluated through debt-to-income (DTI) ratios. Lenders commonly represented that option ARM DTIs were calculated using fully-indexed accrual rates, and typically maxed out around 28% (a normal area for prime loans). Despite the increase in post-recast monthly payments, loans will have roughly the same or lower DTIs after the recast as at origination; the decline in MTA has offset the growth in loan balances due to negative amortization.
This implies that OA loans should not have problems with "affordability" if they were underwritten using accurate income levels. Unfortunately, a very large proportion of the 2006 vintage (more than 80% for some originators) were underwritten with reduced or no income verification, resulting in routinely inflated reported incomes and under-reported DTIs.
In this light, the major risk for future OA performance is that recast-related payment shocks will overwhelm the resources of borrowers who had originally misrepresented their incomes but were nonetheless servicing their loans. I expect that the actual number of such loans will be modest. The recent credit performance of the vintage, with more than 17% in foreclosure as of October, suggests that many no-doc loans have already ceased performing due to affordability constraints.
A final paradox is that HAMP-style modifications will not help troubled OA borrowers irrespective of the truthfulness of their income reporting, given its use of DTIs as the sole measure of affordability. Most delinquent borrowers who accurately reported their income at origination will nonetheless have DTIs below the 31% HAMP threshold. Conversely, borrowers with high DTIs who are unable to handle the higher post-recast payments most likely misrepresented their incomes at origination, and thus are not eligible for modifications.
Bill Berliner is consultant based in Southern California. His Web site is www.berlinerconsulting.net
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