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The Coming Wave of Option-ARM and Alt-A Mortgage Resets.

Have you ever been body surfing in California or
Hawaii? You can immediately tell the difference
between the locals and the tourists by where they
swim in the surf. The locals are outside the breaking
waves waiting to catch them and the tourists for some
inexplicable reason always stay in the impact zone as
though the shallower water is somehow safer.
Each time the tourist gets pounded by a wave they
pop back up, the waters momentarily calm, and the
tourist stays in the same spot, as though suddenly the
ocean had stopped doing what it always does. Of
course the local knows there is another wave just
behind the first, shakes his head and laughs as the
tourist, yet again, gets pummeled by a wall of water
the local joyfully rides.
Executive Summary: There is not one,
but two different waves of resetting
mortgages. The subprime resets that led
to the wave of foreclosures we’ve
experienced and the Option-ARM and
Alt-A wave that is just starting.
Publications have noted a decline in
the supply of foreclosures and firming
of prices, however this is artificially
created and temporary.
We presently find ourselves in the
relative calm between two waves.

Below you’ll find a chart from Credit Suisse showing monthly mortgage resets. The reset
date is when the artificially low teaser rate on a mortgage expires and the mortgage
payment “Resets” to a new, typically higher amount.

This chart does a great job of showing where we’ve been and what’s coming next. The
bright blue arrow is today, April 2010.

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Where we’ve been: Subprime

The light green area represents Subprime loans. You’ll see that Subprime resets
dominated 2007 and 2008 and then began to markedly decline in 2009. About 60% of all
subprime loans have defaulted as of 1/12/2010.

What’s coming next: Option-ARM and Alt-A

The yellow and light yellow areas represent both Option ARM and Alt-A mortgages that are
starting to reset. You’ll notice these two types of mortgage resets grow dramatically in 2010
and 2011, and then fall off rather steeply in 2012. Present default rates are very high
for these products as well. Option-ARM’s about 50% and Alt-A about 40%. And regardless
of mortgage type, well over 90% of defaults become foreclosures.

These are Prime borrowers who wanted to get into more home than they could afford by
using an exotic and dangerous product they felt they could manage. Whereas some
subprime borrowers can argue that they were duped into using the product, these
borrowers were typically buying more expensive homes and theoretically should have
been more sophisticated borrowers who can’t make that “I didn’t know what I was getting
into” argument. It’s also why we find a great deal of these mortgages in the states that had
very high rates of appreciation CA, FL, AZ and NV.

Option-ARM:
Option-ARMs have alternative payment options where the mortgagor can make
significantly smaller payments in the early years.
Unfortunately, once the short-term teaser rates expire, the rates of interest are returned
back to those similar to conventional mortgages.
For those who chose to make minimum payments, the principal owed on their mortgage
has actually increased because the value of minimum payments did not cover the
mortgage's interest. The uncovered interest would then be added to the mortgage's
principal.

Alt-A:
Typically Alt-A mortgages are characterized by borrowers with less than full
documentation, lower credit scores, higher loan-to-values, and more investment
properties. These loans are sometimes referred to as “liar loans” because of the lack of
documentation. Many believe a large percentage of these borrowers bought far more
home than they could afford and will therefore default once the teaser rate expires.

Summary:
So we basically have two different waves of resetting mortgages. The subprime resets that
led to the wave of foreclosures we’ve just experienced and the Option-ARM and Alt-A
wave that is just starting.

Looking for green shoots of hope in the real estate market, some publications have pointed
to a decline in the supply of foreclosures hitting the market, and some firming of prices.
Unfortunately what they fail to note is that this slowing of supply is artificially created by: a)
laws enacted at the federal and state level which have forced mortgage servicers (banks)
to reexamine their entire portfolios to determine the relative few who are eligible for these
programs thus delaying by months the inevitable foreclosure process for hundreds of
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thousands of homes, b) understaffed mortgage servicers who simply could not handle the
massive increase in defaulting mortgages again delaying the inevitable and c) the organic
ebb of subprime defaults prior to the last wave of Option-ARM and Alt-A that is still on its
way.

So, we presently find ourselves in the relative calm between two waves.

The difference between the last wave and the next is that a larger percentage of Subprime
mortgages were written on entry-level homes and Option-ARM and Alt-A mortgages on
relatively more expensive product. This means there’s a good chance we’ve found, or are
close to, the bottom at the low end of the market, but we’ll probably see further price
declines in mid and upper priced homes.

Best regards,

Bruce & Tim

PS. Stay out of the impact zone

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