Option ARM Recasts

This is a fascinating article that the NYT has written about World Savings and its Option ARMs. It allows you to draw some fairly perverse conclusions.

I assume you know what Option ARMs are all about. If not here is the link to Wikipedia, I’m not going to explain it again. And you may know about World Savings but if not the cliff notes version is that it was a big lender in California, Arizona, Nevada and Florida (you know what that means) most of its loans were Option ARMs and it was bought by Wachovia several years ago. That means it’s now Wells Fargo’s headache.

Now before we get into the really crazy implications here you need to review this from the NYT article:

In a mortgage market gone crazy with generous loans, no one was more generous than World Savings.

Lots of banks offered mortgages that allowed borrowers to pay less than the amount of interest being charged, but World was virtually alone in making loans that let the borrower continue to make small payments for a decade, rather than two or three years.

Most banks forced the borrower to start making much larger monthly payments if the amount owed — an amount that could rise each month if the borrower made the minimum payment — rose to 110 percent of the appraised value of the home when the loan was made. World saw that as stingy. It did not force the payments up until the amount owed was 25 percent greater than the original value.

You can’t get loans like that anymore, of course. But World’s old mortgage loans live on. Other banks, where escalating monthly payments are either here or on the immediate horizon, are facing the need to foreclose or renegotiate many loans. Within a year or so, most of those loans will have vanished, for better or worse for the homeowners and for the neighborhoods those homes are in.

Few of the World borrowers face such imminent disaster, however. And that is why it is fascinating to follow the progress of World’s mortgage portfolio.

Some of those homeowners may end up all right, being able to wait out the depressed housing market.

And if the local housing market fails to recover? Homeowners there may still be able to wait out the process, making monthly payments that could well be less than the cost of a comparable rental. If such an “owner” thinks prices are unlikely to ever come back, he or she could rationally decide to stay in the home while doing little to maintain it.

OK, a couple of other facts you need to know. 

1. Wells says that the amount owed on this portfolio was $115 billion in March and they estimate that is 107% of current market value of the underlying properties and much higher — for example 132% in California’s central valley — in select areas.
2. More than 70% of the mortgages are in California, Arizona and Florida. Wells says it thinks that 61% of these loans will not be paid as agreed.
3. All of the loans World made on this program were for 80% LTV or less. The average LTV was 71%.
4. Less than a third of 1% of the loans will reset by the end of 2012.
5. Wells has written down the portfolio by 20%.

Now here’s how I see all of this. 

First, forget the numbers about how far these loans are under water. That’s only a factor if the homeowner needs to sell. It’s based on current estimates of market value not the actual mortgage balance versus the original purchase price. If these owners were starting with an 80% LTV, given the extremely low interest rates that have prevailed since they were made they most likely haven’t even accumulated enough negative amortization to bring them within shouting distance of the original loan balance. 

Second, if you’re going to do neg am loans then do it big time like this. Giving a borrower the option to run up the balance to 125% builds a lot of flexibility into the loan. It’s not at all impossible that these borrowers can wait out the housing market. If they’re isn’t some life event that causes them to have to sell then it might eventually be a sweet deal. Lord knows they’ve currently got mortgage payments that most of us would kill for. 

Third, Wells may be laying in the weeds on this. They took some heat for buying Wachovia and as you probably recall stole it from Citi which was set to get a lot of assistance from the FDIC. Did they and maybe even Citi realize that the Option ARM portfolio was unique and not that much of a time bomb? According to the article they contend the portfolio has some big embedded losses but they’ve not reserved all that much. I have a lot of respect for Wells analysis, conservatism and particularly savvy when it comes to real estate finance. If you buy bank stocks and have been discounting theirs because of this portfolio you might want to reconsider. 

I guess the lesson here is that if you’re going to do Option ARMs either as a lender or borrower, make sure that you have plenty of room to run up the balance. If you do, you might just be able to ride out a lot of problems. At the very worst, you live dirt cheap for a long time and if the dance doesn’t work out right you just give back the keys like everyone else.