Posted on April 6th, 2008 in Mr Mortgage's Personal Opinions/Research
Below is a great piece from Mish regarding ARM resets and how they still present a huge problem going forward. The story mostly covers the Hybrid Intermediate-Term ARMs (3/1, 5/1, 7/1 and 10/1) but also touches upon the most toxic, Pay Option ARMs. For many, including the banks, there is no way out of these loans because there is nothing in existence today that compares to these loan’s affordability. The majority of people just don’t qualify for a jumbo 8% fully amortized 30-yr fixed rate loan. We have gone back to 1990 lending overnight. Even the new Fannie/Freddie ‘jumbos’ have significant pricing adjustments, making the rates substantially higher than their conforming products.
There are a few areas in his research I view differently regarding Intermediate-Term ARM’s. His Pay Option analysis is on the money. Most of the Intermediate-Term ARM’s were done at No Points, meaning a higher interest rate. This is because these loans have a teaser interest only period (in the past, 100-200 bps below 30-yr fixed) for the initial 3, 5, 7 or 10-years and it was assumed borrowers could just refi into a new interest only loan before the teaser period was up. They were wrong. Therefore, there will be payment shock on the majority of these even if they do reset lower. For example, a $400k 3/1 interest only at 5% has a monthly payment of $1667.00 whereas a 4.5% fully indexed monthly payment rate after the first adjustment DOWNWARD is $2026.74. This represents nearly a 20% payment increase. The Intermediate-Term ARM was widely used from 2003-2005 in CA, in addition to all other bubble States due to its affordability vs. a 30-yr fixed. Each of the major lenders program guidelines differed but many allowed up to 100% combined loan-to-value, as low as 620 scores, qualification at the interest only start rate, up to 50% debt-to-income ratios and went up to $1 million. Stated Income and Stated Asset was allowed. Much of it without major price adjustments higher. In retrospect, these are anything but ‘Prime’. The popularity of this loan type diminished in late 2005-2006 when spreads narrowed to the 30-yr fixed and the Pay Option ARM’s ultimate affordability features swept the bubble States. A great percentage of these loans are still in existence because rates have risen so much, borrowers have had no reason to refi. So, in order to keep the ATM machine running, many used Home Equity loans over the years in place of MEW. Due to this and values being off to such a great degree in States in which these loans were the most prevalent, many of the borrowers are currently underwater presenting a much greater default risk than is currently being assumed by the ratings agencies. Wells Fargo, CITI, Chase, WAMU, CFC were the primary sources for this money. Thornburg also specialized in this product type, which gives an example of the illiquidity of this product type. These loans also came in an Alt-A version called 5/6 or 10/6. They are fixed for the initial 5 or 10 years and then convert to a 6-month adjustable LIBOR based upon that index value plus a margin of 2.25 to 2.75%. The primary sources of this loan type were Lehman, CFC, Wells and IndyMac. Another factor most forget is the near impossibility establishing a true value for this loan type and what impact they have on a banks balance sheet. These loans all had teaser rates compared to 30-yr fixed because they were meant to be short-term loans or meant to adjust higher after the initial fixed period.
These loans were never meant to sit on the books at teaser rates (4 – 5.5%) and below for as long as they have been and will be. Many, including the banks, will be stuck with these for much longer due to the inability to refi without bringing cash in to close or without a principal balance reduction. http://globaleconomicanalysis.blogspot.com/2008/04/closer-look-at-arms-reset-problem.html