Resetting Option ARMs

The country’s most problematic states — California, Nevada, Arizona and Florida — remain at the top of the “seriously delinquent” mortgages and foreclosures list. For those areas, this overshadows a 17 basis point quarter-to-quarter decrease in the fourth quarter overall residential loan delinquency rate that brought it to 9.47%.

And the main culprits no longer are subprime or resetting adjustable-rate mortgage loans, but prime fixed-rate loans 90 days or more past due. Delinquency rates for these loans closely follow the long-term unemployment curve. The Mortgage Bankers Association fourth-quarter delinquency data show the highest percentage of loans already modified and performing are option ARMs. The anticipation that option ARMs at reset will keep delinquency rates up appears to have been a false alarm, similar to expectations that subprime ARM resets would turn into a default rate issue, MBA’s chief economist Jay Brinkmann said during a conference call. And that’s because option ARMs most likely to default at their reset date “probably have been taken care of.” His expectation is that going forward option ARMs loans would feature the same patterns as subprime borrowers that already defaulted before the reset, or never defaulted after the reset.

A Royal Bank of Scotland report on the performance of U.S. nonagency residential mortgage-backed securities maintains that there is concern among RMBS market insiders related to how option ARM loans will perform when their payment is reset but so far some have performed better than expected. There are about $50 billion in outstanding securitized loans from the 2005 vintages that already have started to recast or will do so this year.

There is fear that the ongoing economic crisis increases the probability that the expected 15% to 20% average increase in payment, or payment shock at recast, will affect delinquency rates going forward.

But the report stresses that while the performance of the 2005 vintage notes “could vary significantly depending on shelf,” Washington Mutual 2005 paper so far “has performed much better than other shelves of the same vintage, experiencing serious delinquencies that are currently 24% (including foreclosures and REOs) vs. 40% for other option-ARM shelves of the same vintage.” Similarly, its rates of serious delinquencies are lower. The reason, according to the report, is because WaMu’s 2005 paper was better underwritten, with low first-lien LTVs and a smaller percentage of silent seconds compared to other 2005 option-ARMs and some prime 5/1 ARMs, so WaMu’s payment shock at recast is expected to be in the 5% to 10% range.

Outside of the option ARM sector, where more concerns currently lie, long-term unemployment is more and more turning what seemed like a subprime credit issue into a prime fixed-rate loan problem due to the direct correlation between long-term unemployment and 90-day-plus delinquency rates, Mr. Brinkmann said.

The number of 90-day past due loans is at 50% of all delinquent loans, far exceeding the industry’s average of about 20%, which is directly affected by “the changing nature of unemployment,” said Mr. Brinkmann, noting that the rate of over six-month unemployment, or long-term unemployment, is higher now than it has ever been since 1948. He did, however, try to cast a positive light on the overall delinquency rate, calling the slight quarter improvement the possible beginning of the end of the unprecedented wave of mortgage delinquencies and foreclosures that originated with the subprime defaults in early 2007.

In fact Mr. Brinkmann was not the only one who highlighted improvements. Michelle Meyer, an analyst for Barclays Capital, called the decline in new delinquencies and foreclosures “encouraging,” but she also had some words of caution.

Using MBA’s fourth-quarter data, the analyst estimates the quarter-to-quarter decline in the percentage of foreclosures fell to 1.2% from 1.42% of outstanding mortgages. This is the lowest since the fourth quarter of 2008. MBA’s figures for the number of mortgages outstanding translate to just over 600,000 foreclosures started in 4Q, down from roughly 760,000 in 3Q.

Ms. Meyer added, however, that despite the decline in foreclosure starts the percentage of mortgages in some stage of foreclosure increased to 4.58% from 4.47%, “there is clearly still a very large foreclosure pipeline, with a record number of mortgages in some stage of foreclosure.”

One fact is nonetheless consistent: the same four states are driving the national delinquency average.

Overall, California, Nevada, Florida and Arizona still dominate the number of foreclosure starts, even though their share has dropped from the mid-40% range to 39.2%, mainly due to performance improvements in California’s prime ARM loans, Mr. Brinkmann said. Florida leads in problems with prime fixed-rate mortgages. There, up to 26% of all mortgages are late by at least 30 days or more.