Defusing the Option-ARM Time Bomb

Next: Defusing the Option-ARM Time Bomb

As if enough shoes hadn’t already fallen on the beleaguered national housing market, there is still one, very big one left: the option-ARM bomb, er, shoe.

To recap, first came the now-infamous, sub-prime “Liar Loans”: low or no-doc loans to borrowers with poor credit, putting nothing down, to buy homes in overheated housing markets. Such loans were characterized by low teaser rates and payments that quickly re-set much higher, typically within 2-3 years.

Sure enough, 2-3 years past the housing market’s 2005 peak, the double whammy of negative equity and zooming payments sunk many of the sub-prime borrowers.

Now come the option-ARM borrowers — apparently, legions of them.

The specialty of banks like Washington Mutual and Wachovia, these loans are literally financial time bombs: instead of amortizing principal, or even just paying interest, option-ARM borrowers can “opt” to make payments so low that they don’t even cover the interest due.

What happens to the shortfall? It’s added to the principal, a phenomenon innocuously known as “negative amortization.” Lenders I’ve spoken with put the amount of outstanding option-ARM loans at about the same size as sub-prime loans, around $1.5 trillion.

Wanted: ‘Financial MacGyver’s’

So why haven’t we heard more about them?

Three reasons.

One, it’s hard to be heard in a Category 5 financial hurricane.

Two, they’re heavily concentrated geographically. In markets like Florida, Southern California, and Las Vegas, they accounted for a significant percentage of all loans originated at the peak. In more staid markets like the Twin Cities (my focus), reputable lenders wouldn’t touch them — and now don’t have exposure to them.

Third, and perhaps most significantly, the option ARM’s have long fuses: five years, to be exact.

Yes, that’s right: at the height of the housing market in 2004-2006, aggressive lenders, in their infinite wisdom, gave their shakiest borrowers five years to start making real payments (and you thought the local furniture store’s “no interest till 2009” pitch was generous!).

That makes fallout from the biggest wave of option ARM’s due to hit in 2010-2011.

Two Ways to Disarm

So what do you do now? There are really only two options, er, choices.

One. Re-float the housing market. Higher prices mean more homeowner equity. More homeowner equity means more wherewithal to refinance, and less incentive to default.

Unfortunately, to truly disarm the option-ARM bomb, housing prices would not only have to revisit the 2005 peak, they would have to substantially exceed it. That’s because all those option-ARM borrowers now owe a lot more than they originally borrowed (thank you, negative amortization).

The odds of housing prices suddenly going up 50% or more in today’s environment are about the same as NASDAQ hitting 6,000.

Two. Make sure the banks have lots and lots of capital.

Clearly, that appears to be the approach embraced by the Fed, the Treasury, and the banks themselves.

How else do you explain the otherwise anomalous behavior of a bank like Wells Fargo, Wachovia’s purchaser, saying it’s well-capitalized on Monday, “accepting” $25 billion in federal money on Tuesday, and selling $11 billion in stock on Wednesday?

Sure it’s well-capitalized. Just like Fannie Mae, Freddie Mac, Bear Stearns, Lehman Bros, AIG . . .

About the author

Ross Kaplan has 19+ years experience selling real estate all over the Twin Cities. He is also a 12-time consecutive "Super Real Estate Agent," as determined by Mpls. - St. Paul Magazine and Twin Cities Business Magazine. Prior to becoming a Realtor, Ross was an attorney (corporate law), CPA, and entrepreneur. He holds an economics degree from Stanford.
2 Responses
  1. Anonymous

    Thank you for your post! I’ve been watching this ever since I stumbled upon articles on the Motley Fools and BusinessWeek websites about this issue. Nobody seems to comment regarding the toll this could take on the economy considering the fact that we are already in a recession and things are expected to get worse as it is. Would the stock market take a big hit and find another bottom once this gets into the mainstream media? Are we possibly headed for a depre_ssion? Or is the cost of this problem possibly already factored into the Bailout plan? Surely, if a simple person like myself knows about this runaway train of Option ARMs; the so-called economic experts in Washington must have been made aware about this problem far earlier.

  2. Josh

    If the banks have learned anything during this debacle, hopefully it is to be proactive with issues on the horizon. In a perfect world banks like Wells Fargo will take the $25B and use it to approach option ARM holders and restructure their existing loan so that the bomb does not explode. I believe that is the intent of these dollars to seemingly “healthy” banks. If it actually happens that way, though, is another thing. One can only hope. I agree with Anonymous, Ross – thanks for this post. It is an important one.

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