Dr. Housing Bubble Blog

December 19th, 2008

Option ARMs for Dummies: Why 4.5 Percent Mortgages Rates will do Absolutely Nothing for these Toxic Assets.

I’ve been sorting through numerous e-mails especially after the 60 Minute show looking at Option ARM mortgages. If anything, I think the show has caused more confusion and I have even seen some articles posted online that are incredibly off base on this one subject area. Some now think that the 4.5% mortgage rate is somehow going to save those in Option ARMs. It is not that simple. In addition, there is a difference between a re-cast (as in, re-calculating your loan) and a loan adjustment on more bread and butter adjustable rate mortgages. The thing about option ARMs is they fly under the umbrella of adjustable rate mortgages yet are insanely toxic. There are many implications that are being missed and I feel it warrants and article to clear up at least the most elementary components of the loan.

What is an Option ARM mortgages?

The option ARM is a loan that is an adjustable rate mortgage with the added flexibility of a variety of payment options on your monthly mortgage. The gist of these mortgages was to increase the flexibility of your monthly payment. These loans have a low introductory rate that allows you to make very low initial payments and the low qualifying rate also allowed many people to buy more home than they could otherwise afford with more conventional mortgages. When I show you a real case example of an Option ARM, you will completely understand why these mortgages had no place in the marketplace.

The option ARM has four major type payment options:

(a) Minimum payment - the initial minimum payment is set for the first 12 months usually with the initial interest rate. After that the payment changes on an annual basis with payment caps that limit increases or decrease each year. Keep in mind the minimum payment was selected by many borrowers during the initial months and many times did not even cover the full interest of the principal balance which was deferred and any unpaid interest was tacked on to the initial principal balance. In other words, your mortgage can actually grow.

(b) Interest-Only Payment - with this payment option the borrower avoids any deferred interest yet this option was not available on all loans if the interest only payment was less than the minimum payment option. This payment option does not result in any principal reduction. The payment is based on the ARM index used to determine the fully indexed rate (FIR) for the mortgage. I’ll get into how these rates are calculated since I think this is where people are simply missing the boat with the 4.5% mortgage argument.

(c) Fully Amortizing 30-year fixed payment - In this case, you are paying both the principal and interest and keep your loan on schedule.

(d) Fully Amortizing 15-year fixed payment - We should call this option the “why do we even have this on the menu” option. Here, you are actually accelerating and paying off your mortgage on a 15 year accelerated time frame.

The number of people selecting option “c” and “d” is practically non-existent in option ARMs. In fact, from surveys I have seen anywhere from 70 to 80 percent of option ARM borrowers elected to go with the minimum only payment option.

Fully Indexed Rate

I think this is where people get confused. You need to remember that many of the option ARMs are based on a blended rate system. That is, you have a variable index like the LIBOR or MTA and a margin rate. For example, let us use the MTA (12-month Treasury Average) for November 2008 which came in at 2.053%. A typical margin rate is 2.75%. So the fully-indexed rate is 4.803%. Normally the FIR is rounded to the nearest 0.125% so the rate in this case would be 4.75%.

Why is this important? Because I’ve been noticing some article with a weird fixation to the LIBOR index alone:

Okay, without a doubt the LIBOR has fallen drastically over the past year. This is excellent news for those in more conventional adjustable rate mortgages. In the case of options ARMs, first, not all are indexed to the LIBOR but more importantly the margin rate is fixed. So assuming the 2.75% margin rate and the .47 1-month LIBOR the new blended rate is 3.22%. A good deal for readjustments but not for re-casts. And for the purposes of option ARMs, this does very little because keep in mind most people are making the minimum payment only and even if rates went down to zero (which they may) it doesn’t remove the margin or the fact that the monthly payment will be going up no matter what. Why? Because they are on a negative amortization schedule and even with a zero percent rate, the principal and interest will amortize causing the payment to go up.

And speaking of index options, not everything is tied to the LIBOR (London Interbank Offered Rate). I’m not sure what is going on with this obsession with this rate and option ARMs recently. It is merely one of the many index options. Most commonly used are:

MTA: Monthly Treasury Average

COSI: Cost of Savings Index
LIBOR: London InterBank Offered Rate

COFI: 11^th District Cost of Funds Index

And these rates vary anywhere from 1 to 2 percent which is a world of difference when you are talking about $500,000 mortgages. It is important to get these details correct because we have a tsunami of $500 billion in option ARM mortgages that will flood the markets in the upcoming years. It helps to get the terminology right so we can better understand how these mortgages will hit the market.

It usually helps to look at a real world example. In a lawsuit filed by the State of California against Countrywide, examples of some real world option ARM mortgages show us how absurd these loan products really are. Let us look at the details first:

;

I know at a quick glance, you are probably shaking your head at the absurdity of the terms above. We are looking at an option ARM with a 1% teaser rate offered by Countrywide. The margin on this mortgage is 2.9%. That is why you saw people spending like A-list celebrities because with the initial one year payment of $1,479 a month, they had money to spend even though the mortgage itself was negatively amortizing. Little by little the payment went up until it hit the 5^th year and explodes to $3,747.83. How can that happen? Well the note negatively amortized such that the balance of the loan increased to approximately $523,792.33. That is right the note grew. Many of these notes had 110% or 115% re-cast ceilings but when you’re dealing with a $460,000 mortgage 10% or 15% is enough rope to do yourself in.

And just for giggles, let us see what happens if a borrower actually made the interest only payment for 5 years and then refinanced into a 30-year fixed rate of 4.5%:

Big difference from the teaser $1,479 monthly payment. Lower rates are a drop in the bucket for option ARMs.

It also doesn’t help that California and areas like Southern California are now quickly approaching a 50% reduction in home prices from the peak levels reached in 2007. So assuming the current rate declines, let us assume the person went zero down and the home was worth $460,000 when it was bought and now it is selling for $250,000. You can take a wild guess what little use the 4.5% rate is going to do.

And not all lenders created the same option ARMs:

*Source: Mortgage-X.com

This is my point that not all option ARMs are created equal. Countrywide used a variety of index options and IndyMac went with the MTA. These mortgages are simply laughable. I want to make one point very clear:

The most important thing about buying a home is the price.

Repeat this to yourself ten times because I’m seeing people fixate on these index changes which mean nothing in relation to the option ARM disaster. It seems those that write the articles may not have any firsthand experience with these notes or investing in real estate. Any successful real estate investor understands that price is the most important thing in buying a home. Why? First, a good price gives you wiggle room even if you have a high interest rate. With a high interest rate, you always have the option of going lower through other financing. If you are at 3% or lower there isn’t much a drop to 1 or 2 percent is going to do. Let us look at a quick example to highlight this. And I’ll exaggerate simply to drive the point home:

Here we have the lower rate argument taken to the extreme. You’ll notice the monthly payments are practically the same yet one mortgage is $200,000 and the other is $105,000. As an investor, the rate is negotiable. You want a lower price because it gives you more flexibility:

(a) A lower price means you can sell the place much easier

(b) You can always refinance a very high rate

(c) You have the option of paying the note down faster. Any extra payment will take care of more principal on a lower mortgage

I think these misconceptions and the focus on the monthly payment or lower rates is one of the primary reasons so many people are losing their homes. Those dealing the loans didn’t understand that having a rock bottom rate leaves no wiggle room and borrowers are paying with losing their homes. If your rate is 1 percent for example, you have nowhere to go but up. Any future buyer is constrained to the same mortgage environment. But say you buy a home at a rock bottom price with a high interest mortgage, say rates drop then your home is more lucrative because when you are selling, all you care about as the seller is the final amount paid. As a seller do you really care if a borrower buys a home with a 4.5% new FHA loan? Of course not.

I hope this helps to clear up some of the confusion surrounding option ARMs. I felt it was necessary to clear up some of the details of these mortgages to put an end to any notion that lower rates are somehow going to buffer $500 billion in option ARM recasts over the next few years. It won’t. It is all about the price.

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Southern California is only $32,500 Away from Seeing Housing Prices Fall by 50 Percent from the Peak: The Precipitous fall from $505,000 to $285,000.

The Southern California housing market still shows significant signs of distress. It is rather obvious that the Federal Reserve is going to do everything it can to weaken the dollar and try to strong-arm interest rates until they scream uncle. During this same historic week that we are now in zero interest rate policy Ben Bernanke helicopter (ZIRP) world, another milestone occurred in Southern California. The median price for an area with more than 20 million people has now breached the $300,000 mark. This is significant because the peak of $505,000 was reached only last summer.

The market has deteriorated so quickly and with such devastation, it gives me pause to think what is going to happen when the $300 billion in pay option ARMS (POA) recast in 2009 through 2012. For many long time readers you know that my “crash scenario” meant prices falling 40 percent from their peak. The median price for the region is now off by 43.6 percent. Keep in mind that last month 55 percent of buyers exercised their bargain shopping right to purchase repossessed homes. You have to take that into context when looking at the median price. However, let us go through our monthly analysis of one of the most expensive and diverse housing regions in the country:

*Click for sharper image

This chart gives a very clear picture of what has occurred in Southern California. You’ll notice that most counties reached their peak in the summer of 2007 only to fall precipitously over the next year. Southern California is a micro view of what has occurred in many metro areas across the country. You have your prime locations in Laguna Beach, Santa Monica, and La Jolla that will remain resistant simply because of their locations. Yet you have areas like the Inland Empire that have seen unrelenting price drops similar to those in Florida or Arizona. Aside from the Southern California median price dropping below $300,000 we have our first county dropping below $200,000 since 2003. The median price for a home in San Bernardino is now $185,250. San Bernardino hit a peak of $380,000 in November of 2006. Guess what? We’ve just had our first county drop by 50 percent from the peak.

Now there are many things pushing prices lower. Market confidence is shattered and it doesn’t help the public to hear that a Ponzi scheme run by Bernard Madoff has been going on for probably a decade and has put at risk nearly $50 billion. That isn’t the boost in the arm we need right now. First, to simply think that the housing market collapsed out of nowhere is a mistake. Let us look at the sales pattern in conjunction with median price for Southern California over this decade:

The first warning sign we had came with the major pattern dislocation in the summer of 2006. The normally robust bounce in sales did not occur. Yet prices kept going up for another year. This is where the bubble stepped it up to another level. This graph from a technical perspective gives you a better understanding why looking at price alone is not a good predictor of future trends. What you’ll also notice is the steady sales increase from January of 2008. Normally, winter is the weak selling season and you’ll notice the seasonal dips in the chart followed by the healthier summer selling seasons. Keep in mind that our recent ascent upwards was fueled by these strong price drops.

The recent sales increases should be taken in context. If you look at the decade, we are still well under even the weakest winter trough from 2000 to summer of 2007. You’ll also notice that last months sales are now reflecting the typical fall and winter weakness.

Some argue that the median price is a poor indicator. Yet this is what the average family on the street is most likely in tune to. It is also the average family that will be buying homes so yes, it is important. It is fascinating that during the boom, those in the real estate industry kept championing robust median price numbers and now that the numbers don’t suit their purpose, they choose to knock them down. Okay, let us look at the Case-Shiller Index for the Los Angeles and Orange County area:

The Case-Shiller Index measures repeat sales on the same home. So this is arguably a more accurate reflection. The index doesn’t give us a price per se but gives us an overall measure of price increase from a baseline point. For example, the baseline year is 2000 and has a number of 100. At the peak, the LA/OC measure jumped to 273.94. That is nearly a tripling of price in less than a decade. This measure is now converging with the median price. How so? Let us look at the median price of a home in L.A.

December 1999 median price: $192,000

August 2007 median peak price: $550,000

550,000 / 192,000 = 2.86 times

Nuts. The median price of Los Angeles is now $340,000. Let us run the numbers again:

December 1999 median price: $192,000

November 2008 median price: $340,000

340,000 / 192,000 = 1.77 times

What is the current Case-Shiller number? 184.54. Keep in mind that the Case-Shiller Index looks at L.A. and Orange County. The 184.54 number takes us back to where we were in February of 2004. The median price in Los Angeles county in August of 2003 was $338,000. The index and the median price are converging with a trend and are only separated by 6 months in Los Angeles. Bottom line? You can choose to look at the Case-Shiller Index or the median price and the story remains the same.

Yet California is facing challenges beyond just the housing market. Some people forget that you actually need good employment to buy a home. They have become so laser focused on interest rates or monetary policy that they forgot one thing. A large number of Californians were employed in the real estate industry! I talked in great detail about the rise and the fall of the Southern California housing empire in a previous article. We benefited the most from the housing bubble and are paying the price during the bust.

Have you noticed that the bailouts have gone into the black hole of crony capitalistic banking wonderland? Wasn’t the main purpose of the bailout to keep the market from collapsing as it currently is? The truth of the matter is the bailout was never for you. The bailout was to keep the world of the bankers and those on Wall Street from collapsing. Even floor brokers now realize that they aren’t part of the private club as we have seen the many pictures of entry level workers walking out with their boxes from Lehman Brothers. It is the Titanic and only a few lifeboats are available. Who will get a piece of the bailout lifesaver?

California is also in a budgetary mess. While our politicians get paid to literally do nothing, our employment base is getting shattered to pieces:

It is stunning how little focus has gone into sustainable job growth. Here we are, nearing the end of 2008 and having committed over $2.2 trillion and what can we say we have accomplished with all this? My main question is how can we as a public simply not care where this $2.2 trillion went? Think if we only dedicated half the time from the bread and circus theater of the auto industry to asking the Fed to open up their books. $15 billion for the auto industry. $2.2 trillion for the banking industry. Hmmmm. You know how many jobs that $2.2 trillion could have created? I’m not for government meddling as long time readers know but I would rather have that $2.2 trillion go to rebuilding roads, schools, focusing on healthcare, and maybe getting our budget in order. If it is a choice between banks, hedge funds, and our buddy Madoff I’d rather see the money go to the average American taxpayer who is already being taken to task while watching the Fed and U.S. Treasury destroy their currency.

I still stand by my prediction that the bottom for California housing will not be reached until 2011. I know in our nano-second driven world, it is hard to imagine 2 or 3 more years of this. But we only have 2 roads we will follow. One road takes us down our current path. Price destruction and massive market corrections to fix the misallocation of a bubble decade. Otherwise known as deflation. Or if the Fed and U.S. Treasury have their way hyper-inflation. Their actions hope for a 1970s style inflation were they can prime things up and then get it under control. Anyone that looks at data from that time realizes that bringing down high inflation is no easy task.

The Southern California housing market operates with all these multiple forces pulling at it. Before you start looking at a bottom ask yourself the following questions:

(a) Is the employment situation good for the state?

(b) Are wages increasing?

(c) Is there a lack of inventory on the market?

(d) Are prices going back up?

I would answer no to all the above and if someone asked me whether Southern California has hit a bottom, my answer would be no.

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