Option-ARM payment shock

Via Calculated Risk, a report by Amherst Securities which reaches more or less the same conclusions Credit Suisse did (and reported in March here and again in June here by yours truly).

The conclusions, more or less, are that while the first wave of mortgage defaults in the "Subprime" category has subsidized subsided in recent months, a second wave is about to hit the shores in the Option-ARM category as the payments on these mortgages are recast higher (in the 100% to 150% range).

The current state of the economy

From John Hussman:

One possibility, which is clearly the one that Wall Street has subscribed to, is that the recent downturn was a standard, if somewhat more severe than normal, post-war recession; that the market's recent strength is an indication that it is looking forward to a full “V-shaped” recovery, and that the positive print for third-quarter GDP is a signal that the recession is officially over. Applying the post-war norms for stock market performance following the end of a recession, the implications are for further market strength and the elongation of the recent advance into a multi-year bull market.

The alternate possibility, which is the one that I personally subscribe to, is that the recent downturn was the initial phase of a more prolonged deleveraging cycle; that the advance we've observed in recent months most likely represents mean-reversion – qualitatively and quantitatively similar to the large and often abruptly terminated “clearing rallies” of past post-crash markets; that major credit losses are continuing quietly but are going unreported thanks to changes in accounting rules by the FASB this past spring, which allowed for “substantial discretion” in accounting for loan losses and deterioration in the value of securitized mortgages; that a huge second-wave of mortgage losses can be expected from a reset schedule on Alt-A and Option-ARMs that has just started (following a lull in the reset schedule since March) and will continue into 2010 and 2011; that intrinsic economic activity remains abysmal; that recent GDP growth is an artifact of massive fiscal stimulus that is unlikely to have sustained follow-through; and that recent market valuations are not representative of those observed at the end of most post-war recessions, but are instead similar to those observed at major market peaks prior to the mid-1990's.

Accrued Int on Option ARM recasts

http://accruedint.blogspot.com/2009/08/smackdown-week-interlude.html

CR: Option Arms

First post in a long time... CFA exam and all that. From CR:

And here is a repeat of the most recent reset / recast chart from Credit Suisse.


Credit Suisse is using recast dates for Option ARMs and reset dates for all other loans.

As Tanta noted: "Reset" refers to a rate change. "Recast" refers to a payment change.

Resets are not a huge problem as long as interest rates stay low, but recasts could be significant. There are some questions about how the Wells Fargo pick-a-pay portfolio fits into this chart, since Wells Fargo doesn't expect significant recasts until 2012 (see A Bank Is Survived by Its Loans )

Mortgage resets

From Hussman:

Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures. . . .

As the recent housing bubble progressed, the profile of mortgage originations changed, so that at the very peak of the housing bubble, new originations took the form of Alt-As (low or no requirement to document income) and Option-ARMs (teaser rates, with no required principal repayments).

A broader profile of mortgage resets is presented below (though even this chart does not include the full range of adjustable mortgage products).

This reset profile is of great concern, because the majority of resets are still ahead. Moreover, the mortgages to which these resets will apply are primarily those originated late in the housing bubble, at the highest prices, and therefore having the largest probable loss.