Option ARM Resets a Looming Cause for Concern

More bad mortgage news may be lurking around the corner according to information released on Tuesday by Fitch Solutions.

The ratings firm revealed that some $134 billion in ARM Residential Mortgage Backed Securities (RMBS) are due to recast by the end of 2010, raising the possibility of another wave of mortgage defaults among a group of loans that have already demonstrated a good deal of weakness.

The loans in question are Option ARMs; those mortgages in which the borrower has a monthly choice, make a full payment of principal and interest, a payment equivalent to interest only, or a payment less than the total amount of interest due.  In the later case, the unpaid interest balance is added to principal.  94 percent of Option ARM borrowers have utilized the minimum monthly payment and allowed their loans to negatively amortize.

This negative amortization feature of options has made them a cause for concern for some time, one reason that Fitch has only rated about 5 percent of the $189 billion of Option ARMs outstanding.  As the homeowner continues to make minimum or minimal payments and the principal balance increases, the loan eventually hits a pre-set cap of 110 to 125 percent of the original loan balance, and event that triggers a recast.  When the loan recasts, the required monthly payment on the loan immediately changes from the minimum permitted under the option to a payment amount sufficient to amortize the principal and interest.   This new payment is, on average, 63 percent higher than the original minimum payment and may be as much as 100 percent higher depending on the type of loan, the amount of the cap, interest rate behavior and other variables.   Under the terms of Option ARM loans, even if regular payments are made, the loan automatically recasts at 60 months.

Fitch reports that, of the 88 percent of Option ARMs originated between 2004 and 2007 have not yet recast.  In spite of the fact that the original payments are in effect, 37 percent of these are either 90 days or more delinquent, in foreclosure or already foreclosed.   Of the entire universe of Option ARMs 46 percent are running 30 days delinquent or more even though only 12 percent have recast. 

Fitch Managing Director and U.S. RMBS Group Head Huxley Somerville said on Tuesday, “Having not demonstrated their ability to make payments at the full rate, option ARM borrowers are at the greatest risk of default resulting from payment shock.”

Lenders have already modified approximately 3.5 percent of the one million option loans in anticipation of payment shock.  Modifications have included term extensions, interest rate cuts, conversion to interest only loans and other changes.  The 90+ day delinquency rate among those modified loans is running at a lower pace of 24 percent but Fitch expects that large numbers of these loans will also default when they recast because monthly payments will still drastically increase.

Fitch had expected losses on the loans to range between 35%-45%, depending on the collateral quality of the underlying mortgage loans. In addition to expectations of higher defaults, severities have also contributed to higher expected lifetime losses.  Fitch has observed that loss severities on Option ARMs have increased significantly to an average of approximately 60% from 40% a year ago.  Exacerbating the problem is the high concentration of the option loans in states where home prices continue to decline.  75 percent of the loans are on collateral located in California, Florida, Nevada, and Arizona where home prices have declined an average of 48 percent since early 2006.  Loan-to-value ratios have increased from the original average of 79 percent to 126 percent today, meaning that many of these borrowers will be unable to refinance to avoid upcoming rate shock.  

Fitch Ratings also announced launch of new Credit Default Swaps of Asset Backed Securities broad market indices for U.S. subprime assets.  The company said it is issuing the five new indices as home prices and subprime asset values show signs of stabilization.

Fitch's total market U.S. subprime Index stood at 8.34 as of Sept. 1. Though higher than the all-time low of 7.27 on May 1, the index is still significantly lower than the opening value of 42.56 on Nov. 1, 2007.

According to Fitch, the five new indices, which are presented as cash prices, will provide a total market view of all vintages as well as vintage specific indices.  They will be made available within Fitch Solutions ABCDS pricing service.

'In general, the synthetic subprime market is still seeing more activity than its cash equivalent and hence can be used as an effective proxy for asset values,' said Author and Managing Director Thomas Aubrey. 'Fitch Solutions' new indices will fill a gap by helping market participants with broader trend analysis and improving relative valuation techniques across different asset classes.'