Option ARMs Get Some Breathing Room

It looks like the day of reckoning for Option ARMs has been pushed out.

Business Week cites a Credit Suisse study that says the wave of resets for Option ARMs which had been forecast to begin this year and accelerate through 2010 has probably been delayed by about a year. The reason? Low interest rates.

Recall that Option ARMs reset generally on the five year anniversary of the loan or when the deferred interest reaches 110% or 115% of the original balance of the loan. Due to extremely low interest rates, the deferred interest on many of the newer vintage loans has been accumulating at a slower rate. Hence, the can gets kicked down the road.

Here is the old projection for resets:

And here is the new projection:

Now none of this alters the fact that these loans are perhaps the worst financial product ever conceived. Even with the additional breathing room, their performance continues to be horrible.

Option ARMs typically reset after five years, at which point the monthly bill increases 65% or more. About 37.5% of option ARMs originated in 2005 are still outstanding, 63% of the 2006 vintage are outstanding, and 82% of the 2007 loans remain, according to Barclays Capital (BCS). And about a third of the outstanding loans in these years are deeply delinquent.

In a given month, between 4% and 5% of borrowers who are current on their option ARMs taken out in 2006 and 2007 default in the following month, says Sandeep Bordia, Barclays’ head of residential credit strategy, who also expects resets to be delayed until next year. “These things have been performing horrendously,” Bordia said. “I don’t know how much of it will last into the recast.”

Option ARMs are devilishly hard to refinance. The combination of falling home prices and negative amortization puts most of them significantly under water. Additionally, most Option ARM borrowers are heavily reliant on low interest only payments so attempting to move them to fixed rate amortizing loans often results in significant payment increases. Put simply, these borrowers bought homes that were seriously beyond their reach and no modification short of gifting them significant amounts of equity is going to solve their problem.

I guess one less problem to deal with at this point in time is a good thing. On the other hand, as issues like this hang around, it’s hard to envision a truly robust recovery.

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