Pay Option ARMs – Up to 48% Default Rate! First Federal Featured

Posted on August 5th, 2008 in Daily Mortgage/Housing News - The Real Story, Mr Mortgage's Personal Opinions/Research

I have been preaching that the ‘Pay Option Implosion’  will make the ‘Subprime Implosion’ look like a hiccup in states in which this loan program was widely used such as CA. This is because this loan program knows no socio-economic boundaries and was very heavy used in more affluent areas because of its ultimate affordability feature, negative amortization.

The Pay Option ARM (POA) is the most toxic of all loan programs with up to 80% of borrowers making the minimum monthly payment and acruing negative. Combine that with a house price crash of 32% in the past 13 months in CA and most of these borrowers owe more than their home is worth and are at an exponentially greater risk of loan default. Remember, these were once PRIME borrowers in many cases.

Part of my day job is analyzing banks and mortgage lenders using proprietary data and tracking mortgage loan defaults and REO by bank.  I can see near real-time what is happening on a bank level and it is not pretty. About four months ago I noticed the subprime defaults waning, which I have been telling all of you about ever since.  Over the past four months subprime defaults in CA are down about 25% but total Notice of Defaults have remained near historic highs of 43k per month. This is because Alt-A defaults have filled the gap.

The Alt-A universe is much larger in unit count and dollar volume than subprime so even though we are just at the beginning of the ‘Alt-A Implosion’, they have already filled in the subprime default void. Scarier yet, roughly 65% of all Alt-A defaults are POA’s. The ‘POA Implosion’ is upon us.

As a matter of fact, just last week S&P, Moody’s and Fitch all hit Alt-A hard with an emphasis on Pay Option ARMs. (Story Link).

Below is a few stories I have written on the topic lately.

Below is an accelerated recast schedule for the POA. You can see how the recast numbers have just begun to grow and do not peak until Dec 2009!

The Wall Street Journal just came out with a story about how First Federal has been hurt badly due to the POA.  It has already been a leading contributer in the take-down of American Home, IndyMac, Countrywide and arguably Bear Stearns. If not for this loan WaMu, Wachovia, Lehman, Downey Savings, Bank United and Capital One would be in much better shape than they are today.

The Journal’s great story  about First Fed tells everything you need to know about this nightmare. Below is a recap. -Best Mr Mortgage

  • Forty percent of its borrowers became at least 30 days delinquent after the payments on their adjustable-rate mortgages were recast.
  • The number of foreclosed homes held by the bank doubled in the second quarter from the first quarter.
  • the Los Angeles bank (First Fed)  is on the front lines of what could be the next big mortgage debacle: payment option mortgages.
  • These loans went mainly to people with good credit, but they are likely to experience defaults that are nearly as high as — in some cases higher than — those for subprime.
  • Barclays Capital estimates that as many as 45% of option ARMs originated in 2006 and 2007 could wind up in default.
  • UBS AG, suggests that defaults on option ARMs originated in 2006 could be as high as 48%, slightly higher than its estimate for defaults on subprime loans.
  • FirstFed’s experience highlights the challenges lenders face as option ARMs recast.
  • FirstFed is a relatively small lender, with just $7.2 billion in assets.
  • option ARMs were “a very good loan for the borrower and the bank” for more than 20 years. But that changed, she said, when investment-banking firms entered the industry and set lower lending standards, which FirstFed and others followed.
  • As long as interest rates were flat or falling, the minimum payment was enough to cover the interest due, making the option ARM equivalent to an interest-only loan in the early years of the mortgage.
  • As competition increased, lenders dropped the introductory rate on option ARMs to 1% or even lower and made more loans to borrowers who didn’t fully document their income or assets.
  • Rather than shut its doors, FirstFed joined the crowd and business boomed.
  • borrowers making the minimum payment weren’t covering even the interest due.
  • Others lenders are seeing borrowers fall behind even before recasts.
  • FirstFed is scrambling to modify the loans of borrowers who can’t afford the higher payments.
  • Instead of waiting for borrowers to fall behind, the company sends borrowers letters as their loan balances swell, offering them a chance to modify their mortgages. From January through June, the company had modified 705 loans totaling $345 million.
  • Many borrowers took out home-equity loans with other lenders after getting an option ARM from FirstFed.
  • Many borrowers submitted loan applications that overstated their financial condition. “You expect a 20% fudge. You don’t expect 500%.”
  • Frederick Cannon, an analyst with Keefe, Bruyette & Woods, believes the company should be “well enough capitalized” to absorb the losses.


38 Responses to “Pay Option ARMs – Up to 48% Default Rate! First Federal Featured”

  1. Mr. M, do you happen to have total CA POAs that have been defaulted upon. Curious as to the % of the 200K POAs originated in CA that have defaulted. This may help us understand how many we have remaining. Given some default rate assumptions. Furthermore, are you privy to the allocation of POAs across the state? Which counties have what, etc?

  2. If you have more than $100,000 in FirstFed you better do a transfer out right away.

  3. Frederick Cannon, an analyst with Keefe, Bruyette & Woods, believes the company should be “well enough capitalized” to absorb the losses.

    Hi Mark.
    Doesn’this sound all too familiar? “We don’t need to raise more capital”..blah blah..yeah right! Somehow I think you will be seeing these guys saying they will be needing to aquire more cash in the near future. As you pointed out we are in the first stage of this. Slightly off the topic, you have documented this whole debacle very well and I agree with your observations, but I am curious if you could entertain the question of Why the markets are largely igoring these horrifying events and continues to be in party mode? Unless of course Cramer called the bottom…again and everyone (except for a few of us) believe it. I’m sure your readers would appreciate your feedback on this. Thanks for what you do..your research and insights are well appreciated.

  4. Mr. M,

    Do you think FED is going to zero? If so, in what time frame. Thanks. (I’m holding puts that I bought when this thing was 28 and when it was 16.)

  5. Judgement day will come.

  6. the market is on bailout auto polot and finishing its C wave just like it was after bear stearns until things seized up again, which they will again. I dont think more than another week of this if not this week. I think tomorrow if we dont open red, rally midday and close red we will rally out of the gate and lose 200 by close.

    The BOE rate cut (or not) will be interesting but in the grand scheme of things it should not mean anything.

    Given the data, I think fed is a failure. I am surprised it has not happened yet.

  7. This is all so sordid, there is no other word for it. A sordid orgy of greed and excess.

  8. What does this mean for the RE market in California? How much further will this push prices down if these homes go back to the lenders? I always thought I’d see 30% reductions in price, this is going to make it more like 50-60% off peak.

    Hurray for those of us who waited!!!

  9. Is there a state by state analysis (or metro analysis) of the amount of POAs. I’m just starting to run a model for Chicago metro area and am tryingto figure out the impact that POAs will have on this market over the next three years. Subprime was big here but no ohe has talked about POAs. I’m wondering how impacted the high end markets will be here due to this implosion.


  10. David, this may unfortunately be one of those instances of be careful what you wish for because you just might get it. I was wishing for prices to fall 20% – 30% so I could assist my daughter with getting a place of her own. Not happening now however… I didn’t anticipate the bank failures and total unprecedented impact our economy has taken from this hit. In fact her biggest worry right now is a job and not where she is going to rent and / or live. I had the fear in the back of my head that this may not unfold in a positive manner for me due to the excesses that have taken place. I knew if it unraveled quickly and with no interference I might have a small window of opportunity to pounce, but that is not what took place. We have had massive Government interference that has only served to slow this down and make it much more painful in the end. Now not only will we have less opportunities, but less credit available, fewer jobs, higher interest rates, and an overall economy where one would be a fool to purchase with so much uncertainty. Not only in where prices will go, but if you will have a job, if you can even afford the payments anymore. She has come to the same conclusion that she will be a renter for quite a few more years until this shakes itself out and we stand on stable ground. Not the worst thing in the world, but a major disappointment seeing as how she played the game correctly. She saved, she was prudent, she didn’t jump into a spiraling situation and now while she is happy she didn’t, it would appear that she has been forced out of the market for many other reasons as well now. Let us not forget the tax hikes coming and additional Government interference sure to follow with the bank failures coming and millions upon millions more foreclosures on their way. I figure around 2012 – 2015 she may be able to buy and until then keep saving and don’t fall for the hype!!!

    P.S. How ironic that in the first report out by Freddie since they claimed they were well capitalized and their dividend was safe, blah, blah, blah… They report 4 times more losses than analyst had expected (Analyst = .41 / Actual = 1.63). They also slashed their dividend by 80% (Old = .25 / New = .05). Also I noted a comment in the report that there estimated core capital slipped (I think they meant to say lost) by 1.2 Billion. Where did it go and why? Is it because it is all estimated to begin with… hmm?

    This was a dismal report indeed but one that will look really nice come next quarter in my opinion…

  11. The only choice the FED has is a MASSIVE devaulation of DEBT through cheap money = INFLATION.

    1% Money got us into trouble, so whats the solution
    2% Money.

  12. If the recast numbers peaking in Dec 09 weren’t bad enough, they’re going to stay high for the following three years.

  13. Shah, right now, at least, inflating our way out of this mess is clearly not an option. In my personal opinion it was never an option. Deflation is mounting and a huge wave is about to come crashing down and printing more money or increased credit, where is it going to come from? Credit has all but dried up and the discount window is taking an absolute beating with incredible unprecedented borrowing going on (see link).

    We will have to print like crazy just to meet our interest payments on the borrowing to allow us to continue to “Bail Out” everyone and their brother… literally!!! None of this cash is going back into our economy and creating jobs. This is all going overseas and we the Tax Payers of this country will be paying for it all through increased taxes for many, many years to come.

    You cannot just inflate the debt away unless you are creating some additional wealth to strengthen our own economy. Just pissing it away on interest is not going to help and in the long term place us in even more trouble and actually just increase our debt. The end result will not be pretty.

    We need to raise interest rates and tighten credit even further to stop this insatiable appetite for risk with no reward by the Fed. We must allow this natural progression of a recession to take place or risk creating a depression in its place. Borrowing from Pater to pay Paul is no longer the answer. It is time to tighten things up, stop spending, stop Bailing Out, stop entitlement services, stop Government hiring, lower property taxes and create tax credits for job creation. We need forward thinking actions to take place and not simply more of the same. Anyone can just print money, and issue more credit… just ask any third world country and they will tell you.

  14. What would happen is the lenders just came to the conclusion of lets protect our investment and lowered the POA across the board to lets say 5.5% for the life of the loan. How this could be done is in my mind very simple. Today you deposit your money in a CD, Money Market or savings account and get 2-4% interest from banks. Well if they in turn lend this money back to the home owner they would still make anywhere from 1.5%-3.5% on their money not a bad return compared with what they are currently getting ZERO and in some cases its even costing them to service the loan. I don’t have a degree in economics but I can add 2 + 2 and know that 4 is better then nothing.

  15. Bye bye Freddie Mac….
    Freddie’s last CEO just stated that he doesn’t think Freddie will survive.

  16. I will admit I’m really stunned at how these financial companies have managed to stay alive this long. I’m starting to wonder if the govt bailout will work, simply because Wall Street needs it to.

    I’m losing faith in seeing the ‘right thing’ happen..

    : (

  17. We will have to print like crazy just to meet our interest payments on the borrowing to allow us to continue to “Bail Out” everyone and their brother… literally!!! None of this cash is going back into our economy and creating jobs. This is all going overseas and we the Tax Payers of this country will be paying for it all through increased taxes for many, many years to come.


    The bailout is just one huge deflationary black hole, devouring enormous amounts of money. Tanta and CR over at Calculated Risk posted a video of Meredith Whitney from last week, where she talked about how all the investment in the banking and brokerage sectors had done nothing to “add value”, it was just “plugging holes”.

    Translation: the billions invested by sovereign funds was merely covering debts instad financing the creation of any production or services from which future profits could be made

    We are living in extraordinary times. Both the Fed and foreign investors are literally burning money before our eyes. If the Fed had put money into a national infrastructure program, a la the New Deal, that might have put in a floor on asset values by creating jobs and stabilizing demand.

    But now, it’s merely an academic discussion.

  18. AIG’s earnings out – worse than expected so watch the Dow rally more tomorrow.. D’oh.

  19. Despite Mr. Cramer’s call for a bottom, I see this rally scenario of late about over. This is short squeezing, manipulation and a false direction of 401K funds by large players in mutuals. A come along suckers and buy now so we can dump and salvage something of what is left in our holdings!!!

  20. Jeff – you are certainly on the right track my man. Modifications are the only way to avoid mass defaults. Ultimately I believe it’s going to have to go beyond rate/payment freezes and include principal write-downs. I’m not holding my breath for this, but we are going down into the worm hole with this stuff and anything is possible. We have certainly not heard the last from our most mighty and learned government on this.

    No matter and in any event, real estate is going to devaluate to pre-bubble price levels. Across the board. If the guy in the house on the hilltop with the Benz in the driveway thinks he is going to be spared he is in for a rude awakening in the years to come. Underway is the greatest evaporation of equity that we are likely to ever see.

  21. I thought the bottom would hit between 2011 and 2013. But with pay option ARMs failing this fast, it now looks like the bottom will be between 2009 and 2010 and the fall in prices will be steeper.

    If the top was 2005, and the bottom is 2010, that is only five years.

    If there is a major earthquake on the southern San Andreas in California, the bottom could be reached within months of the event.

  22. At least we can get over it sooner.

  23. In California you have to be a fool not to walk away from an underwater pay option mortgage. Purchase money mortgages are non-recourse to the borrower and the lender can look only to the property.

  24. Wrong Pac – banks don’t want it back and Green Credit Solutions is getting principal cut by 50%, rates at 4% interest only for 5 years etc from banks as a result. They will bend over backward. Why walk when you can undo the bad purchase and finance decision you made.

  25. But what about the “recourse”?

    Can creditors come after your cash in the bank? Your retirement funds?

    Is pacpal right about that?

  26. CaptiousNut, if your loan is in a state that is non-recourse to the lender then the only thing the lender can do if you walk away is take back the property. That is all you agreed upon when you signed on the bottom line. If you do not pay then they take the house back. A second loan or HELOC can be different however and I am not 100% sure, but I believe if it was used towards the purchase (80/20) then it too is non-recourse, but if taken out after the fact as a loan or line of credit then it is held to the standards of say a credit card and is totally recourse. Someone please correct me if I am wrong about that. Your 401K cannot be touched under any circumstances including bankruptcy I do believe. That is why it is so foolish to pull retirement funds out to salvage your home for a few years to then lose it down the line and be left with nothing at all in the end. Lenders can be very persuasive however and will try to get you to do so for their benefit. I don’t think a financial planner worth his salt would approve of this and if they did it would be under a very unique situation in my opinion.

  27. Stu – you are correct, a 2nd mortgage if taken out to purchase the property is non-recourse in CA. Plenty of lenders were offering HELOCs as purchase money on 80/20 deals and they are all non-recourse.

    I am counseling several folks who are preparing to stop payment on their 2nds as their home values have dropped to the point where the 2nd would be completely sold-out in a foreclosure sale. Both borrowers have ability but simply want to dispose of the 2nd to reduce monthly outflow and most importantly to dramatically reduce their underwater depth. The goal is to ultimately negotiate a pennies-on-the-dollar short pay of the 2nd. We’ll see how it goes.

  28. Thanks Stu.

    In hindsight, I should have bought homes, taken cash out, made leveraged bets on commodities, and then walked away from the properties.

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