Why Option ARMs Are Different

Megan McCardle and Ryan Avent have posts up about the coming recast of option ARM mortgages. Both contend that the issue isn’t the payment shock but some other factor or combination of factors that might make borrowers with option ARMs default.

Here is Ryan’s analysis:

Since the housing bust began, people have approached the problem of rising defaults as being principally about payment shocks, but that’s not really borne out by the data. In his long and fascinating look at the unfolding of the financial crisis, Phillip Swagel discusses how the Bush Treasury’s initial approach to the foreclosure crisis focused on interest rate resets, but he says they quickly discovered that wasn’t the main problem. He notes that if you chart 2/28 and 3/27 mortgage defaults over time, you don’t see the kink at the 24 or 36 month mark you’d expect if the reset was doing most of the work in generating foreclosures. What they found was that defaults were happening surprisingly quickly — basically, underwriting standards were so terrible that borrowers couldn’t even afford the initial payment.

As the bust has proceeded, by contrast, defaults have mainly resulted from the combination of negative equity and some kind of income shock — job loss, death or illness, divorce, and similar. A recent paper from economists at the Boston Fed found evidence along these lines and concluded that policymakers would have better luck reducing defaults through, say, fully funding unemployment insurance programs than through trying to reduce payments.

Megan is also of the opinion that the main problem is that homeowners experience an income shock, not that they can’t adjust their expenditures to deal with a 1% interest rate increase.

To the extent they are talking about option ARMs, they misunderstand the effect of the extent of an interest rate recast on a monthly payment. A short example will demonstrate how severe it is.

Assume someone bought a $600,000 house with an option ARM. They elect to pay the minimum payment which for our example we’ll assume is interest at 3%. Their monthly payment would be $1500. Assume at the end of five years they are subject to a recast and that they have amassed 10% negative equity and that the new rate is going to be 5%, Now they no longer have the option of paying just interest, they have to start amortizing the loan and to make matters worse the monthly payment is going to be calculated on the remaining life of the mortgage — 25 years. Their new payment is $3858, more than two and a half times their current payment. Oops, that’s a payment shock!

Negative amortization ARMs are a completely different animal. They don’t conform to our normal understanding of adjustable rate mortgages and frankly never work if a housing market isn’t appreciating smartly. It’s a flipper’s product that was fraudently marketed as a viable loan for homeowners.

The payment shock embedded in option ARMs is real and for most holders untenable. Figuring out how to deal with the them probably has to start with an admission of this fact.

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