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Here is an interesting scenario:

A person buys a house for $185,000 in 2006 and keeps paying his mortgage month after month.  Now, in early 2008, he owes the bank – $192,000!

What’s wrong with this picture?  Well he did a payment-option adjustable rate mortgage.  He owes $1300 every month, but can send in $565 – the rest ($735) is added back to his total debt.  When the debt reaches $212,000 or after 5 years, his monthly payment will rise to $2800 a month!  He has an Option ARM.

The rub: Once the option ARM loan balances reach a preset limit (negative amortization cap – ~ 110-120% of mortgage amount) their payment rates immediately increase.

Of course, if he was a desi (Indian) he would have sold the house very early (or not even bought one) and gone to live in an apartment to start saving money.  But that is a cultural thing, maybe. If these homeowners ever want to move house but are finding it difficult to sell their home because of its value, it’s likely that they’ll need a bridging loan. This bridging loan example can offer more information if needed, but in simpler terms, a bridging loan helps homeowners buy another property whilst their property is on the market. This can help the homeowner avoid ARM and find a more suitable mortgage type.

There are about 1 million homeowners with a total owed money of $500 billion in option ARMs.  These people are beyond the help that interest rate cuts from the Fed bring!

If you are a homeowner who pays a monthly fee towards your mortgage, then you could have a sufficient amount of funds, (not all), to owe towards these ARMs. In particular, using your property wealth after you have released it from your house in the form of equity release, can help you to get one step closer to paying the money back.

So, these option ARMs are worse than the normal ARMs where the increase in interest rate will be just 8% or so.  For these option ARM folks the adjustment will be almost 100%.

These Option ARMs come under different names: PayOption ARM, CashFlow Option Loan, 1-Month Option ARM, Flex 5 Home Loan, Pick-a-Paymentsm Loan, 12 MAT ARM, Option Power ARM, FlexPay® 12 MAT, FlexPay® 3/1 LIBOR ARM, OptPAY ARM, etc.

While these option ARMs were used as the financing mechanism by speculators – who bought a property for short term only, these were also used as affordability product.  THAT is where it gets dangerous!

One example from Businessweek on how the payments progress in these mortgages:

Example given by S&P: The monthly payment goes up between month 48 and month 49 by 88%. On a $500,000 loan, using S&P’s assumptions and my multiplying skills from fifth grade, that would be as follows:
Month 1: $1,665
Month 48: $2,070
Month 49: $3,900
“Payment shock” is what S&P calls this.

Here is a primer on Option ARMs from the Federal Reserve Board.

Now these option ARMs affect the economy even more deeply.  These are bundled as Mortgage backed Securities bonds.  The problem is that their origination was so fraught with mess that the payments – which form the revenue on bonds – are in jeopardy.

Almost 20% of these option ARMs required < 10% down payment (remember those real estate riches schemes?), and no proof of borrower's income!  That puts these MBS's in jeopardy.  The funny part is that initially the delinquency rates are low thus giving the investors in these MBS that they are very safe investments, which explains their proliferation. This has affected another area that is critical to the entire investment market - the bond insurers.  These companies (with GIlt Edge ratings) insure that the bonds issued by Municipals and other authorities will be paid, so they have almost perfect ratings.  Now these bond insuring companies have in the past few years invested in these MBS which are themselves suspect.  So, they are in the danger of experiencing huge losses and therefore shortfall in their capital - which means that their guarantee which was the foundation behind the bond market suddenly falls off!  It is a small but critical part of the entire edifice of financial markets.  Here is an example:

On Friday investors learned that Fitch Ratings had placed 87 classes of residential mortgage-backed securities guaranteed by MBIA  on a negative ratings watch.
The prospect of downgrades threatens to fuel a continuing negative spiral for investment banks, with analysts warning that plunging values of billions of dollars of unsold leveraged loans held by the banks could force them to make more write-downs.
Friday’s warning by Fitch on MBIA comes one day after the bond insurer announced that it had boosted the size of its public stock offering to $1 billion from the $750 million it announced Wednesday. The company has been trying to raise capital to maintain its crucial AAA financial strength rating.
Fitch placed MBIA’s AAA rating on negative watch on Tuesday. If the bond insurer’s rating is cut, it would lead to a downgrade of the bonds it insures as well.