Yesterday Subprime, Today Option-ARM

From the Wall Street Journal:

Countrywide’s New Scare
‘Option ARM’ Delinquencies Bleed
Into Profitable Prime Mortgages
October 24, 2007; Page C1

Subprime mortgages aren’t the only challenge facing Countrywide Financial Corp., the nation’s biggest home-mortgage lender. Some loans classified as prime when they were originated are now going bad at a rapid pace.

These loans are known as option adjustable-rate mortgages, or option ARMs. They typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow — a phenomenon known as “negative amortization.”

Countrywide first offered these loans in 2003 and quickly became a leader in this profitable and growing part of the mortgage market. Mortgage brokers liked the higher commissions and borrowers were drawn to low payments. As lending standards loosened, more of these loans included less-than-full documentation.

An analysis prepared for The Wall Street Journal by UBS AG shows that 3.55% of option ARMs originated by Countrywide in 2006 and packaged into securities sold to investors are at least 60 days past due. That compares with an average option-ARM delinquency rate of 2.56% for the industry as a whole and is the highest of six companies analyzed by UBS.

The increase in overdue payments partly reflects a decline in home prices in much of the U.S., which has made it more difficult for borrowers to refinance or sell their homes. In addition, at Countrywide, “they were giving these loans to riskier and riskier borrowers,” says UBS analyst Shumin Li.

Among option ARMs held in its own portfolio, 5.7% were at least 30 days past due as of June 30, the measure Countrywide uses. That’s up from 1.6% a year earlier. Countrywide held $27.8 billion of option ARMs as of June 30, accounting for about 41% of the loans held as investments by its savings bank. An additional $122 billion have been packaged into securities sold to investors, according to UBS.

The problems with option ARMs have been dwarfed by those in the subprime market, with 20% of nonprime loans serviced by Countrywide at least 30 days overdue as of June 30. Losses also are mounting on home-equity lines of credit and second-lien mortgages, of which Countrywide held $22.6 billion as of June 30.

The deteriorating performance of option ARMs is evidence that lax underwriting that led to problems in subprime loans is showing up in the prime market, where defaults typically are minimal. Challenges could grow, as from 2009 to 2011, monthly payments on some $229 billion of option ARMs will be adjusted to include market-rate interest and principal, according to Moody’s

In a recent interview, Countrywide Chairman and CEO Angelo Mozilo acknowledged that delinquent payments are “bleeding” into prime mortgages. He nevertheless reaffirmed his longstanding pledge that the company will survive the current mortgage turmoil and thrive, as many smaller lenders are forced out of business.

Mr. Mozilo told investors in September 2006 that he was “shocked” so many people were making the minimum payment. He called a sampling of borrowers to find out why. The “general answer…was that the value of my home is going up at a faster rate than the negative amortization,” he said. “I realized I was talking to a group…that had never seen in their adult life real-estate values go down.”

The temptation to use these loans was strong. A borrower with a $520,000 mortgage at a 30-year fixed rate of 6.05% would pay $3,134 monthly. With an option ARM carrying a 1% introductory rate, the minimum payment in the first year plummets to $1,673.

But after a specified period, often five years, when borrowers must start repaying principal and meeting full interest payments, monthly payments can more than double. If the balance outstanding gets too high — the ceiling generally is 110% to 125% of the original amount borrowed — borrowers can face sharply higher payments even sooner. Some borrowers could find themselves in the painful position of owing more than the value of their home.

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