Over $100 Billion Dollars in Option ARM Mortgages Set To Be Recast in 2011

If you thought that the bottoming out (or so we hope) of the economy meant that the real estate market was fully out of the woods, think again.

A massive recasting ($134 billion dollars worth in 2011, according to Fitch Solutions) of Option ARM mortgages is set to take place over the next year or so, and the results won't be pretty.

First off - what is an Option ARM mortgage?

Option ARM (Adjustable-Rate Mortgages) mortgages were popularized at the height of the real estate boom (2004-05) in the United States, and were intended to get people into homes that they were desperate to buy.

The "option" part of the Option ARM mortgage refers to the choice that homeowners are presented when they take out an Option ARM mortgage.

The homeowner can choose to:

1) Make a full mortgage payment that includes principal and interest
2) Make a payment that will cover the cost of the interest and nothing else
3) Make a "minimum" payment that won't fully cover the cost of interest

Most people (94% according to Fitch Solutions) choose option #3.

So what happens when people choose option #3?

Well, first off, you encounter something called "negative amortization".

If you aren't making a big enough payment to cover the interest on the mortgage, then any unpaid amount is tacked on to your amount owing.

This means that your principal increases with each passing month.

There is always a pre-set cap on these Option ARM mortgages.

For instance, if you had a 110% cap on your original loan balance, then this means that your mortgage is "recast" when your original principal amount increases by 10%.

When an Option ARM mortgage is "recast", the payment amounts change.

I mean, these mortgages have to be paid somehow.

When these mortgages are recast, the new payment becomes the amount that is required to cover the principal AND the interest.

The Option ARM mortgages recast automatically after 60 months if the cap hasn't been hit.

Now, here is where it starts to get scary.

As I said earlier, 94% of Option ARM mortgage holders choose the minimum payment amount. They were likely given an extremely low interest rate (initially). Many of these people bought homes that they couldn't afford in the first place, but the minimum payment option and initial low interest rate made it manageable. I'm sure that many of these people figured that they would be able to flip their homes for a healthy profit due to the real estate boom.

According to Fitch, the average payment increases 63% when Option ARM mortgages are recast, with some payments increasing by as much as 100%.

Some other interesting info for you:

-88% of the Option ARM mortgages written between 2004-2007 (the real estate boom years) have not yet been recast

-37% of the mortgages written during this period are at least 90 days delinquent, or worse

-46% are at least 30 days delinquent.. keep in mind that the vast majority of these people are only paying the minimum payment as it is!

You can see the looming issue - if people are having this type of trouble keeping up with their minimum payments, then what happens when the payments increase 60-100%?

The answer - a wave of defaults. This seems unavoidable at this point, even if lenders try to slightly modify the terms of the mortgages in favor of the homeowners. I mean, the mortgages have to be paid out eventually.

The average Option ARM mortgage holder in the United States is already far underwater on their mortgages, which makes the situation even more difficult. How many people are going to be able to resist the temptation to simply walk away from their homes when the mortgage recasts?

$134 billion dollars is a very large amount of Option ARM mortgages to be recast, and it will be interesting to see how the real estate market stomachs this development in 2011.

Source: The Business Insider - Fitch Ratings expects ARM performance to decline

Filed under: Real Estate News