Contributed by Patrick Pulatie, CEO, Loan Fraud Investigations
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For the last year and one-half, there have been projections regarding the coming implosion of Option ARM loans. So far, it has yet to materialize on the scale that was projected. What happened to the implosion? When can it be expected? In order to answer these questions, an understanding of the mechanics of the Option ARM must first be acquired.
What is an Option ARM mortgage?
The Option ARM (sometimes marketed as “Pick-a-pay” or known as “neg-am” loans to industry insiders) was a very specialized mortgage loan program, designed originally to be used only under very specific circumstances. The primary beneficiaries of the Option ARM would be borrowers who had difficulties in documenting income as self-employed persons, or borrowers who had income streams that fluctuated monthly or with the seasons. Such borrowers would include contractors, sales persons, etc. The rationale for using such a loan was that when business was slow, the borrower could make the minimum payment, and when the borrower was busy with greater income streams, then the borrower would “catch up” on the loan by making principal reduction payments.
The Option Arm featured four different methods of payments. They were:
- The Minimum Payment – This payment was based upon the Start Rate of the loan. The Start Rate was a “discounted rate” for usually one month, though it could be three months, six months or a year, depending upon the program.After the end of the one month starting interest rate, often one percent, the loan went to its Actual Rate, which will be explained shortly. However, the borrower would still be able to make the minimum payment at the one Start Rate (often something like 1%). Since the Actual Rate of interest for second month might be something like seven percent, the loan would become a Negative Amortization (neg-am) loan, where each month that the minimum payment was made, the loan balance would actually increase.
- Interest Only Payment – The Interest Only Payment would allow the borrower to only make the Interest due monthly on the loan. The loan balance would remain the same, never increasing or decreasing.
- 30 Year Fixed Rate Payment – This is the traditional payment on a mortgage loan, which allows for the loan to be paid off in 30 years.
- 15 Year Fixed Rate Payment – This is a payment amount that would allow for the loan to be paid off in 15 years.
The borrower had the option of determining which payment that he would make on the loan each month. He simply wrote out the check for whatever payment he desired, and mailed out the check.
Actual Interest Rate of the loan
The loan had a very specific methodology for determination of the Actual Interest Rate after the first month at one percent. There were two elements necessary for determination of the rate:
- Index – The Index for a loan could be the LIBOR Index, COFI, CODI, COSI, or the MTA Index. The MTA, or Monthly Treasury Average, was the most popular of the Indexes used. It took the Monthly Yield on 1 Year Treasury Notes and averaged them out over a year. The Index Value to be used for each adjustment would always be the value for 45 days prior to the interest rate change date. The Index changes monthly.
- Margin – The Margin was the “markup” on the loan interest rate, which would be similar to marking up goods for purchase in a store. The Margin could be from 2.2% up to 4.5%. It was the loan officer who would determine the Margin for the loan, and not the lender.
The Margin would be added to the Index to determine the Actual Interest Rate of the loan. If the Margin was 3.7% and the Index was 2.2%, then the sum of the two would be 5.9%. However, most Option ARM Notes called for the rate to be rounded to the nearest .125%, so the effective rate for the month would be 5.875%.
Yield Spread Premium
As mentioned above, the loan officer, or broker, determined the Margin on the loan. The loan officer could provide a Margin of 2.2%, 3.00%, or whatever he wanted. One would think that the loan officer would simply give the borrower the 2.2% Margin to keep the interest rate low, but this seldom happened. That is because the higher the Margin that the broker gave a borrower, the lender would “reward” the broker with a Yield Spread Premium. On a $500,000 loan, the broker might charge a Loan Origination Fee of 1 point, or $5,000, and then receive the Yield Spread Premium of up to 4 points. For a $500,000 loan, the broker might receive a total commission of up to $25,000 per loan.
The sad fact is that most borrowers never knew this was occurring. That is because the broker seldom disclosed the Yield Spread Premium on the Good Faith Estimate. When it was revealed, and the borrower asked about this “unknown” Yield Spread Premium”, then the broker would tell the borrower, “Don’t worry about that. This is a bonus I “could” receive, once I reach a certain dollar volume with the lender, if it happens, and it seldom does. I just have to disclose the potential for it. Either way, you do not pay for it.” This was simply a lie by the broker.
Another little stunt that the broker would pull would be to charge no Loan Origination Fee and call the loan a No Point Loan. The borrower thought that the broker was being a “stand up guy”. It was never properly disclosed that the Yield Spread Premium would be paid to the broker by a higher interest rate and payment.
The end result of the broker or loan officer receiving the Yield Spread Premium would be the borrower’s payment going up considerably. On a $500,000 loan, it is common to see the payment being $500 per month or greater than what the borrower actually qualified for.
How the Option ARM really worked
When the Option ARM mortgage was being presented to the borrower, the borrower was usually told that the Interest Rate was 1%, and the Minimum Payment would last for five years. This was a blatant misrepresentation of the terms of the loan.
The truth was that the Minimum Payment would be allowed for the first year of the loan. At the end of that year, the payment could (under typical terms) increase 7.5% of the payment amount. If the monthly payment was $1,000, the second year the Minimum Payment would be $1,075. The third year of the loan, it could go up to $1,151.52, and so forth for the first five years. Usually, at the beginning of the 6th year, the Fully Amortized Payment would be required, unless it had a 10 year period of minimum payments, as did World Savings loans and a few other special loans.
The borrower was almost always never told what the Actual Interest Rate or payment was on the loan, unless they were aware of the loan and asked.
In addition to requiring the Fully Amortizing Payment after some fixed number of years, each Option ARM loan had a “cap” on how high the loan balance could go above the initial loan amount. The cap could be from 110% of the loan balance up to 125% of the balance (for World Savings or WaMu). What this meant is that:
$100,000 loan amount X 110% = $110,000 maximum loan amount or Negative Amortization (neg-am)
When the loan would hit $110,000, then the loan would “recast,” which meant that the Fully Indexed Rate Payment would then be required. Depending upon the Index and the Margin, the loan could recast in two years or it could recast at the five year mark, or any time in between. As the Index increased in value, the quicker the recast occurred.
Note that the term “recast” is not the same as “reset”, which is often used when discussing normal ARM loans. Resets are scheduled increases in payments based on Index or Margin. Recasts are based on hitting the neg-am ceiling, or otherwise reaching the scheduled end of the non-Fully Indexed Payment phase.
On most Option ARM loans, the original projections on the Truth In Lending Disclosure would show that the loan would recast in from 3 to 4.5 years. Any increase in the Index value (assuming the borrower’s payments stayed the same) necessarily meant that recast would occur much earlier. As a result, the Truth In Lending Disclosure, though accurate, never told the full story.
Minimum Payment vs Fully Amortized Payment
I have mentioned several times about the Minimum Payment and the Fully Amortized Payment. However, for most people, the differences in each mean nothing unless it can be shown by example. So I shall take the $500,000 loan with a Start Rate of 1% as an example.
- 1% Start Rate
$1,608.20 monthly payment
- Index of 4.00%
Margin of 3.80%
7.75% actual Interest
Rate rounded to nearest .125%
$3,582.06 Fully Amortized Payment
- $1,973.86 Deferred Interest added to the loan balance (at start).
- $4,027.96 Monthly Payment at Recast
- Recast occurs at the 31st month
These are the numbers that the Option ARM borrower was almost always never made aware of when taking out the loan. The first Minimum Payment would add $1,973.86 to the loan balance, and each future payment would add even more due to the increasing loan balance.
Refinancing out of an Option ARM
Once the payment on an Option ARM does recast, as shown above, the payment can easily double. At that time, most borrowers will desire to get out of the loan because they cannot afford the payment. However, this is easier said than done since the approval guidelines for getting a loan have become much more stringent.
90% of the Option ARMS in California were stated income loans. Borrowers were never qualified using their actual income. Instead, the broker (more often than borrower) falsified the loan application income, so as to meet Debt Ratio Guidelines for approval. This leads to loan applications like the one where the room attendant/maid for a Four Seasons Hotel made $7900 per month. (Can I have that job?)
Even worse, the broker might create employment for borrowers. Most common was landscaping companies for Hispanic borrowers, and the lenders never checked. It was just a wink and a nod.
A third issue was that credit score requirements for an Option ARM mortgage fell from a minimum of 680 in 1998, down to 600 for some programs by 2004. (World Savings would loan on even lower scores, if there was enough equity in the home.) At the same time, loan to value ratios were increasing from 70%, up to 95%. Credit quality requirements for the loans were eroding fast, and anyone could qualify for the loan.
(Ultimately, the lender only cared that the borrower could make the Minimum Payment on the loan, since the loan would be sold, “without recourse” to investors, through securitization. If the borrower defaulted at a later time, it was the investor who would lose on the loan, not the lender. Without lender “risk”, there was no concern for lender liability in event of default. Even more important, the lenders sold the loans to Wall Street for 5 to 6 points. Therefore, they could afford to pay up to 4 points Yield Spread Premium for the loan.)
If a borrower wanted to refinance out of an Option ARM mortgage, he would face numerous problems which would usually prevent the refinance:
- Low credit scores which precluded the borrower from the best loans.
- Lack of true income to qualify for the best loan.
- Lack of equity in the home. This was the result that with Negative Amortization, an 80% loan to value loan would actually be up to 92% loan to value at the time of recast (100% with a 125% neg-am ceiling). Add a second mortgage on the property, which was quite common, and the loan to value would often be over 100%.
- Three year Prepayment Penalties.
Since the borrower could not refinance, he would have one of five potential options to choose from:
- Continue making the Fully Amortized Payment, if possible.
- Not make the payment and end up in foreclosure.
- Try and attempt a loan modification (and we know how that is going).
- Short-Sale or Deed in Lieu of Foreclosure.
- File a lawsuit against the lender for fraud and other allegations.
Refinancing out of an Option ARM will be almost impossible for most borrowers, even if lenders were lending, because of deterioration in home values, loan-to-value (LTV), and people’s incomes.
The Coming Option ARM implosion
Now, the reader has a working knowledge of the Option ARM mortgage. In fact, the reader should now know more about the loan than most loan officers ever knew! After all, loan officers only cared about the Margin and what Yield Spread Premium that they could earn. Armed with this knowledge, the reader should be able to understand why the Option ARM implosion has not yet materialized, and when to expect it.
The relevant factors related to the Option ARM implosion are:
- The Index and its increases or decreases.
- The Margin, from 2.2% up to 4.0%.
- The Negative Amortization Cap, from 110% to 125%.
The Margin and the Negative Amortization Cap have been set at the time of the Closing of the loan, so these factors are fixed, and cannot be changed. The higher the Margin, the quicker the loan recasts. The lower the Negative Amortization Cap, the quicker the loan recasts. Provided that the Index does not change during the life of the loan, the Margin and Cap would result in a recast date equal to what is shown on the Truth In Lending Disclosure. If the Truth In Lending Disclosure shows a recast occurring anywhere from 3-5 years, then that would be the expected time for implosions to occur.
The Index, since it can increase or decrease, is the key to the implosion to come.
- In 2004, the MTA Index ranged from 1-2%. Therefore, it is realistic to assume that because of the low value of the Index, the loans originated during that period of time would likely recast close to the five year maximum in 2009.
- In 2005, the MTA Index was increasing. It jumped from 2% to almost 4%. The loans originated during this period of time would still recast near the five year mark. However, the loans originated in 2004, since the MTA Index was twice as high, would no longer recast in 2009, but would find them recasting earlier, in 2008, and sometimes in 007, if the loan had a high Margin and a low Cap of 110%.
- In 2006, the MTA Index increased even more. It went from about 4% up to 5%. Therefore, the result would be that the 2006 loans would have quicker recast dates than 5 years, but so too would the 2004 and 2005 vintage as well. At this point, LFI has seen loans recasting in as little time as 1 Â½ to 2 years.,
- The Index remained stable during most of 2007, until September, when the “lender implosion” began. At that point, rates began to fall. Recast dates would again be extended out.
- As of Sep 2009, the MTA Index was at .63%. At this rate, most Option ARMs would go back to the 5 year projection.
The chart below shows the rise of the Index through 2007.
Federal Reserve and the MTA Index
When the lender implosion began in Aug 07, those of us in California, Florida, Arizona and Nevada already knew what the rest of the nation would soon find out. Foreclosure activity was increasing, property values were falling, and the economy was stalling out. The Fed knew this and so did those who were buying the One Year Treasury Bonds and Notes, and as a result, the Bonds and Notes were increasing in value and dropping in rates.
By Jan 08, the Federal Reserve knew the market was in freefall. They Fed knew that the Foreclosure Crisis would only worsen. They also knew that the Sub-Prime Crisis would worsen, and then later would come the Option ARM and Alt-A Crisis. The first objective would be to attempt to deal with the Sub-Prime Crisis. Their actions drove the LIBOR Index down to .31% by the beginning of 2009. Unfortunately, that was too late for most Sub-Prime borrowers. They had originated loans from 2003 to 2006, usually fixed for two years, and by the time LIBOR rates fell to a “reasonable” level that would prevent foreclosures, it was too late. The majority of the loans had recast and people had given in to being foreclosed upon.
While the Fed was dealing with the Sub-Prime Crisis, they were also hoping that their actions would prevent the Option ARM Crisis. By lowering the MTA Index, it would postpone the recasting of the Option ARM loan to the full 5 year term. Within that time, the hope was that the “lending crisis” would end. Of course, once again, the Fed was out of touch with reality.
What the Fed failed to realize, or did not care about, was that homes were completely overvalued. As foreclosures continued to occur with the Sub-Prime Crisis, home values continued to fall. Even more short sighted, the reaction of the Servicers was not considered. The Servicers had no concern for the homeowner. Instead, they mostly wanted to foreclose (as I have detailed in previous articles).
The one action that the Fed has accomplished is to postpone the Option ARM implosion. By decreasing the MTA and other indexes, they managed to extend the period of time for when the Option ARM would recast. Now, most Option ARM loans will recast in 4-5 years. Since 2005 and 2006 saw the bulk of the Option ARM loans originated, the implosion will really occur during the next two years.
LFI (my company) is seeing increasing numbers of Option ARM loans in trouble from recasting. Most of these are the 2005 Vintage, with 2004 in second place. There have some 2006 loans, and a few from 2007. Most of the 2006 and 2007 Vintages are likely the result of financial issues related to a drop in income.
If you are behind with your Option ARM mortgage, there is hope. The good news is that many of the attorneys that LFI works with, are reporting success with getting Option ARMS modified. These modifications involve rate reductions and usually principal forbearance.
However, you must be proactive. Do not wait until you have a Notice of Trustee Sale scheduled.
If the Sale is scheduled, attorneys have limited time to work on your case, and with their current heavy workload, most will simply suggest filing a bankruptcy to stop the sale. Then they will agree to work with you.
Remember, if you have an Option ARM loan you cannot afford, in order to avoid losing your home, you must take action immediately.
Patrick Pulatie is the CEO for Loan Fraud Investigations (LFI). LFI is a Forensic/Predatory Lending Audit company in Antioch CA, and has been doing homeowner audits since Nov 07. LFI works daily with Attorneys throughout California, assisting homeowners in the fight to save their homes. He and Attorneys are constantly developing new strategies to counter foreclosure efforts by lenders.
Disclaimer: Pulatie and LFI are not attorneys and do not dispense legal advice. The purpose of LFI is to assist attorneys and homeowners in their fight.