Here Comes The Option ARM Mortgage Explosion

Subprime is done. All the teaser rates are over, the interest rates have reset and the writing is on the wall.

But in the coming quarters, the scenario will play out with other exotic mortgages, Option ARM (pick-a-pay), Alt-A, etc. The homebuyers may have had better credit, but they had the same strategy: Get a low interest rate upfront, and then deal with the reset down the road, by either refinancing or selling the home. But, whoops, home values are way lower and the economy sucks. Plan derailed.

Zacks analyst Dirk van Dijk warns of the troubles ahead:

The vast majority of the homeowners with these ‘pick a payment’ mortgages pay only the minimum payment. When it exceeds a set level, or at a set date in the future (whichever comes first), the mortgage holder has to start paying the fully amortizing payment of the now much larger mortgage. This can cause huge jumps in the monthly payment, with increases of over 50% not uncommon.

These are the ultimate in ‘exploding mortgages.’ The number of these recasts is relatively small right now — at about $1 billion per month — but that number is set to grow dramatically over the next few years, exceeding $8 billion per month in the fall of 2011. If the equity in your house is gone and your monthly mortgage payment suddenly jumps from $2000 per month to over $3000 per month, what do you think is going to happen? How about if one or both of the people in the household has been laid off?

This is going to be a huge problem, particularly for Wells Fargo (WFC).  The biggest writer of these abominations of housing finance vehicles was Golden West, which was bought by Wachovia, which was then absorbed into WFC. Unlike sub-prime mortgages, these were for the most part targeted at more upscale homeowners. The next wave of foreclosures will be in gated communities, not on the ‘wrong side of the tracks.’

The chart shows that the sub-prime problem is largely behind us (dark grey part of the bars), as most of those teaser rates have now expired. As long as people have some equity in their houses or are less than 5% underwater, it is possible for them to refinance their mortgages as long as rates stay low. The refi of up to 105% is part of the Obama housing relief plan. If people are further underwater than that they are out of luck (and increasingly out of a place to stay).


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