Interesting Times

By Jody Shenn, Bloomberg, 7/27/09

The wave of “option” adjustable- rate mortgages recasting to higher payments, projected by some economists to represent a looming source of foreclosures that will hurt housing markets over the next few years, will be smaller than “feared” because many borrowers will default before their bills change, Barclays Capital analysts said.

Option ARMs offer initial minimum payments that fall below the interest borrowers owe, creating growing balances and potential spikes in monthly bills. Payment resets occur after five years or when the debt grows to a preset amount, typically 110 percent to 120 percent of the original principal.

About 40 percent of borrowers with option ARMs are already delinquent, and “many” of the others will start missing payments before their obligations change, the Barclays mortgage- bond analysts wrote in a July 24 report. Recasts of securitized option ARMs will peak at about $6 billion a month in mid-2011 and include “volumes lower than feared” overall, they said.

“The additional risk really will only be for borrowers who manage to stay current over the next couple of years and might default due to a payment shock,” the New York-based analysts including Sandeep Bordia and Jasraj Vaidya wrote.

Whitney Tilson’s hedge fund, T2 Partners LLC, in a presentation dated July 3 said option ARM recasts may peak in the second half of 2011 at more than $16 billion a month, citing Credit Suisse Group data. While the lower number from Barclays analysts suggests an earlier end to the foreclosures contributing to record home-price declines, investors and some analysts including at Barclays and JPMorgan Chase & Co. have said the U.S. government’s effort to have more bad mortgages reworked will delay some defaults.

Super-Senior Securities

The Barclays analysts, who wrote that about 88 percent of option ARMs packaged into securities in 2007 will eventually default, said that after a rally in prices they no longer suggest owning related bonds, “a trade we have been recommending for months.”

Typical prices for the most-senior option ARM bonds from 2007 have jumped about 40 percent from March lows to 46 cents on the dollar, according to their report. JPMorgan analysts in New York including John Sim and Chris Flanagan wrote in a July 24 report that prices for so-called super-senior securities may reach the “mid-to-high 50” cents on the dollar.

The bonds “still represent one of the last double-digit yielding assets (for even bad scenarios) in the resi mortgage space,” Jesse Litvak, a mortgage-bond trader for Jefferies & Co. in New York, wrote in an e-mail. “One of the biggest risks” will be the size of losses per foreclosure, he said.

Lower short-term interest rates are benefiting option ARM borrowers in two ways, the Barclays analysts added.

Lower Payment Increases

They have lessened balance growth, allowing more recasts to happen only after five years. They also have reduced payment increases to a projected 30 percent to 35 percent for loans recasting over the next year and an estimated 50 percent to 80 percent for later recasts, compared with a more than doubling of payments under calculations last year, their report said.

More than $750 billion of option ARMs were originated between 2004 and 2008 as borrowers used their low initial payments to afford higher-priced homes, according to newsletter Inside Mortgage Finance. Outstanding U.S. home loans totaled $10.5 trillion on March 31, according to Federal Reserve data.