Mortgage Implosion Round 2: The ‘Pay Option ARM Implosion’

Posted on July 17th, 2008 in Daily Mortgage/Housing News - The Real Story, Mr Mortgage's Personal Opinions/Research

Video Version: Mr Mortgage on the ‘Pay Option ARM Implosion

This is an updated version of several stories I have written over the past year and a half on this topic. Since all of the banks who originated, held or sold/securitized the most Pay Option ARMs seem to be the most distressed, and IndyMac was recently taken over by the Feds, I thought it was time to update the research and get ahead of this story.

I truly believe that the ‘Pay Option Implosion’  is round 2 of the mortgage and housing implosion and the fight is slated for many more rounds.


The ‘Pay Option ARM Implosion’ is upon us. These toxic loans have taken down nearly every company who has ever touched them beginning with American Home Loans last year.

Pay Option ARMs are a sub-set of the Alt-A universe, which is about 50% larger in count and dollar amount than the subprime universe. In the past several months, we have seen subprime defaults plateau and subsequently decline slightly, while Alt-A defaults have climbed sharply, led by Pay Option ARMs.  However, I do expect subprime defaults to pick up down the road because a) subprime resets are in a valley right now and b) subprime defaults after Hope-Now style non-profit modifications are surging.

There are about 230k Pay Options in California and 450k nationally out of a total of 2.5M private label Alt-A loans nationally. Roughly 55% of all Pay Option ARMs are in California; however, the true number of Option ARMs is likely much larger and being under-reported due to poor identification processes at the county recorders’ offices. Accurate reporting has never been achieved directly from all of the lenders.

The loan amounts are much larger than subprime meaning ‘the Alt-A Implosion’ could be over a $1.5 trillion problem when factoring in Agency paper.  Some estimates put Pay Option exposure as high as $750 billion nationally, but most think it is closer to $500 billion.

Also keep in mind that a large percentage of ‘prime’ loans under old vintage (easy) guidelines, although not formally classified as Alt-A, are indeed structured closer to Alt-A than Prime, and will will perform as such in the future. The ratings agencies just have not got that far yet. For example, until only recently, Pay Option ARMs were considered Prime.  See the accelerated reset schedule below.

The largest Pay Option lenders in the nation are a ‘who’s who’ of troubled lenders such as Wamu, Wachovia, Countrywide, IndyMac, Downey Savings, First Federal, Bank United, American Home Loans and even Bear Stearns, Deutsche Bank and Lehman to some degree. However, the latter three served mostly in the ‘investor’ or ‘conduit’ capacity during the bubble years, and their exposure is currently limited to the whole loans and MBS’s they were unable to dump when that market seized in early Q2 2007 for this loan type. 

I do believe that it is very likely, however, that they could still be liable for far greater damages caused to bond holders and mortgage insurers when these loans go really bad in the future. Many are turning to litigation for defaults caused by outright fraud, white-lie fraud and lender negligence.

Many banks made a conscious decision to keep these loans due to their much higher yields for ‘Prime’ borrowers than the typical 30-yr fixed loan or other ARMs. This proved to be a fatal error. A kid in a high-school investment club could have figured this one out last year, but the smartest analyst in the room, the banks and the OTS couldn’t. 


All banks holding these should have significant earnings restatements in the future due to an accepted accounting practice allowing Capitalized Interest on Negative Amortization, or CINA.  CINA, sometimes referred to as ‘deferred interest income,’ is booked as revenue and based upon the highest possible monthly payment. This is despite the fact that 80% of borrowers pay the minimum monthly amount allowed on the loan program while the differential (negative amortization) is never actually collected.

Even in the case of foreclosure, the actual revenue will likely never be realized. Banks are not recovering enough in foreclosure to even cover the first mortgage balance, let alone the negative amortization booked as income. Regardless, it may never be realized due to housing prices crashing 30% on the median over the last 12 months in California, the most popular state for these loans.

This is because most home owners cannot sell or refinance due to being under water, and homes are not selling in foreclosure. Last month, banks took back 96.8% of all homes that went to auction in California.  Please see my June Foreclosure Report for more detail.

One thing is for sure, however. Pay Option ARMs were absolutely the most toxic loan program ever created, even worse than subprime 2/28’s and 3/27’s.   -Best, Mr Mortgage


Other Related Mr Mortgage Stories

The Pay Option Implosion – Subprime’s Big Brother

Look Out! Here Comes the ALT-A Implosion!

Mr Mortgage on Mortgage Modifications – You May Qualify!

Mr Mortgage: Mortgage Modifications Part 2 – Being Forward Thinking

Mr Mortgage: June CA Foreclosure Report





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