You Worry About ARM Resets, I'm Worried About Recasts!
A: For a while now, most of the credit indicators that traders like myself use to determine the level of stress in the lending world, have come in. A good sign. But you must understand that these indicators came in because of the ginormous policy actions taken by our Fed and our Treasury. If you take a step back you will know that strong economies don't need this level of interference to prevent a systemic financial collapse. Yet I continue to hear words of hope from attorney's (you know who you are), agents, and anyone else I run into that the government is solving all of our problems and the world in the near future will be filled with candy canes and roses. Keep dreaming. While LIBOR and other indexes that are tied to Option ARM resets have come down greatly, its NOT the reset I worry about; its the RECAST! Let me explain for those who think every Option ARM is about to reset lower and help borrowers meet debt requirements.
First, let me define the difference between these two real life forces for anyone with an Option, Pick-A-Pay, NegAm ARM loan product:
LOAN RESET - when the RATE on your loan adjusts from an initial teaser level
LOAN RECAST - when your loan is re-calculated with the new principal amount, to fully amortize within the previously agreed upon term; a.k.a, re-amortization of outstanding principal at the fully indexed rate. When the loan is recast, the payment required to fully amortize the loan over the remaining term becomes the new minimum payment, and the payment cap no longer applies.
It's the NEW PRINCIPAL AMOUNT that is the worry here, because of all the borrowers out there choosing the negative amortizing monthly payment option that causes the original loan amount to rise over time! There are two main reasons why your Adjustable Rate Mortgage will re-cast:
1) the loan reaches it's balance cap
2) the first scheduled re-cast date, usually 5 years from origination
This makes me especially worried about Wells Fargo, who acquired World Savings Bank (aprox $122Bln of option adjustable mortgages) - which was acquired by Wachovia in 2006; both with huge holdings of Option Arm, Pick-A-Pay, and other NegAm loans on their books. Now Wells has it all.
Rolfe Winkler, who publishes OptionARMageddon.com, chimes in:
When recast happens, the interest rates may or may not be more favorable but all of a sudden you're forced to make a FULLY amortizing payment on a loan balance that's 15-25% larger than the one you started with!Rolfe isn't the only one talking about this. The late, great Tanta of Calculated Risk discussed the recast problem in depth a number of times, in her attempt to educate readers of the dangers lurking in our future. Here is one of Tanta's discussions from AUG, 2008:
90% of Option ARM borrowers make the minimum payment, which doesn't even cover interest. Regardless of where interest rates are, the recast to a fully amortizing payment will be much higher than the minimum payment the borrower has been making.
Payment shock = instantaneous toxicity. Can't refi because loan balance is higher than when you started and the home price is WAY below what you originally paid. These things default like none other.
As far as I'm concerned, a large part of the confusion here is that our friends in the media are not very careful about using the terms "reset" and "recast" consistently, like us UberNerds do. "Reset" refers to a rate change. "Recast" refers to a payment change.So, how many loans are set to recast? Look at this Barclay's report displayed in the WSJ last year to see the wave about to hit, right as the banks lie wounded on the ground:
On a normal fully-amortizing ARM, the interest rate resets on what is called the "Change Date" (five years out for a 5/1 ARM, three years out for a 3/27 ARM, each year thereafter for the 5/1 and every six months thereafter for the 3/27, etc.). The payment recasts exactly one month after the rate resets. Mortgage interest is paid in arrears, so first you reset the rate, then the following month you recast the payment. "Recast" is really just a shorter word for "re-amortize": you take the new interest rate, the current balance, and the remaining term of the loan, and recalculate a new payment that will fully amortize the loan over the remaining term.
By and large, the biggest danger for Option ARMs and IO ARMs is the recast date, not the first or subsequent rate reset dates.
Think of all the borrowers, with Option Arms/NegAm/Cosi/Cofi/Pick-A-Pay loans, that chose to pay the bare minimum monthly payment in order to buy the house that otherwise they couldn't afford, and saw their original principal rise over time; and now the recast is near! You worry about the loan resets, I'm worried about the loan recasts!
Posted by AvUWS
Tue Feb 17th, 2009 11:11 AM
Please move along, there is nothing to see here... Congress will find a way to make it all better for the poor home owners who had no idea what they were being offered and got hoodwinked by banks and mortgage brokers.
(Tongue now no longer planted firmly in cheek...) A lawyer friend of mine did a lot of extra work helping lawyer friends at closings and said that they absolutely tried to explain the details and risks of what the borrowers were signing. He said they couldn't close without signing half a dozen or more state and federally mandated documents detailing the terms and risks. But for the most part they all just ignored the details and signed to get the money.
Posted by Noah
Tue Feb 17th, 2009 11:24 AM
AvUWS: I guess you liked the line: "Yet I continue to hear words of hope from attorney's (you know who you are), agents, and anyone else I run into that the government is solving all of our problems and the world in the near future will be filled with candy canes and roses."
I agree, the consumer had a large role here. Sure there was predatory lending and misleading and that has to have consequences, but in the end, nobody puts a gun to the borrowers head to sign for that loan.
Posted by AvUWS
Tue Feb 17th, 2009 11:47 AM
Not just isn't a gun put to their head, but a couple of decades of regulation has required that the scary parts of these contracts not be in the small print. They have to be large, up front, and often reiterated in separate term sheets with all the scary bits (like resets and recasts) in bigger letters.
Eventually, like with our tax code, it just becomes layer upon layer of "simplification" and "information to the consumer" that just ends up obfuscating the issues. Just another instance of "we are the government and we are here to help".
Posted by UWS
Tue Feb 17th, 2009 11:48 AM
Off point, but I thought I'd share some front line weekend openhouse reporting. I went to see a relatively smallish new build condo building below midtown on Sunday. Developer had cut 20% off the mid to late late 2008 ask for the last few remaining units. I counted 46 people on the sign-in sheet, and as of this morning 4 contracts are out for some of the remaining units.
Posted by ben byrnes
Tue Feb 17th, 2009 11:49 AM
WFC wrote down $25 Billon of the Golden West/Wachovia $122B of pick-a-pay mortgages by $25B before consolidating Wachovia's balance sheet. WFC is assuming a further $10-$11B of eventual losses that will run through the income statement over time (peaking in 2010).
So WFC's assumptions is 30% loss rates on this book.
I have been trying to decide if WFC is a buy or a sell. Please share your experiences with WFC as a customer/ex-employee/etc. The discussion board is here:
http://tinyurl.com/acmgb5
Posted by Noah
Tue Feb 17th, 2009 12:02 PM
UWS - thanks for update. Im hearing reports of packed OHs for properties that are priced right? So what does that mean? Well, if you price around 20% below peak, you should get traffic.
I'm curious to see traffic for my new 1,400sft listing at 152 E 94th Sunday. Getting many calls already and first showing is Sunday OH. Will report here back on this comment thread, as I dont like to discuss traffic reports as a separate discussion on UD. Too salesy.
Posted by Rob
Tue Feb 17th, 2009 01:18 PM
I wonder if a large number of these loans have already been foreclosed. In my experience the people that took these loans were on financial shaky ground as of the closing date. Given the current environment many of these people may have already defaulted. Are there figures available for how many of these loans are still actively being paid? Maybe there are not too many of these noxious loans left...
(wishful thinking?)
Posted by truthteller
Tue Feb 17th, 2009 01:41 PM
Zombie banks.
Zombie Condos
Now, zombie mortgages.
We are moving at breakneck pace into very unchartered waters.
Cheney, Bush, Greenspan, Bernanke, et al, ought to be behind bars for the catastrophes they created.
Deceitful brokers ought to follow.
New York City is in for some rough days and years.
Posted by A Reader
Tue Feb 17th, 2009 05:15 PM
I thought that Urban Digs readers might be interested in this precis of the thinking of former IMF chief and MIT economist Simon Johnson. The first link provides a terrifically useful overview. The second is to Simon Johnson's blog, which is for real econo-heads. It is sobering reading.
http://www.economicprincipals.com/issues/2009.02.15/385.html
http://baselinescenario.com/
Posted by lars
Tue Feb 17th, 2009 05:42 PM
A Reader,
Thanks for the links.
Posted by Noah
Tue Feb 17th, 2009 06:22 PM
A Reader - THANKS for the links.
After reading the first link, I wondered to myself if you read THE CREATURE OF JEKYLL ISLAND?
I think you would enjoy that book.
Posted by jeff
Tue Feb 17th, 2009 07:07 PM
Noah - great piece thanks for the work on recast vs. reset. As we discussed earlier this has been gnawing at me for some time and I knew there was still a ticking time bomb here despite the lower LIBOR rates. Thanks for clarifying it....now I can add one more thing to my list of worries and maybe get motivated to take some more of my stock market losses before they get worse.....really was hoping the big ease + big stim could put a bottom under stocks, but I am still worried about a total meltdown being possible. Thanks goodness I put on some Gold in early Q4.
Posted by A Reader
Wed Feb 18th, 2009 07:58 AM
Noah: Thanks for the rec on CREATURE OF JEKYLL ISLAND -- I had not read it!
Here's the specific piece in BASELINE SCENARIO that discusses the global economic outlook for 2009 and 2010 and comments on the various policy options. It's the one I'd meant to post: Short version: the bottom is not yet in sight; there's no basis for current forecasts for a recovery in Q4 2009; any recovery will be anemic and L-shaped. A long piece, but reasoned & thought-provoking.
http://baselinescenario.com/2009/02/08/baseline-scenario-2909/
Posted by OT
Wed Feb 18th, 2009 09:13 AM
A Reader - thanks for sharing. Fantastic reading, if chilling. What I take from it is keep your head down, stay employed, and stay in cash until late 2010.
Posted by Noah
Wed Feb 18th, 2009 11:00 AM
A Reader - wow, very chilling but the story is basically the same if you read CR, Mish, BR, UD, Roubini, Yves's site, etc..
The savings part is what few are talking about and starting to now.
And the blurb about households, which in my opinion, have not yet fully develered:
"Perhaps the most fundamental barrier to economic recovery in the US is the weakness of balance sheets in the private sector. Households did not save much since the mid-1990s and reduced their savings further this decade, in part because of the increase in house prices"
Posted by Michael Oliver
Wed Feb 18th, 2009 01:55 PM
I think you're right on here. However a lot of the option ARM's have had the "negative am" option taken away over a year ago. I haven’t yet had one seller come to me that had an option arm and want to sell (via short sale or otherwise) that had the option to do "negative am". Once the property gets to 110% of value that option evaporates. I think that’s getting lost and the resets wont be as bad as predicted because most option arm borrowers are already losing their homes do to going past the 100% LTV.
Posted by julia
Thu Apr 23rd, 2009 07:47 PM
OMG, i'm loving it! i really pray for a total collapse as it's such a great news finally for those youngsters on the sidelines.
this bubble was hell on earth for us. finally, some justice.
Posted by Josh
Thu Sep 2nd, 2010 12:19 AM
A question I've got is how many of these loans are still being paid. I think it would skew things knowing this information.