If you had to create a mortgage that was more toxic and more destructive than a subprime loan, you would have a very hard time creating that product. Yet leave it to creative finance to spawn a devilish product with the unique name of option ARMs. The option ARM is a 30-year adjustable rate mortgage which offers borrowers four different monthly payments. You have the 30-year fully amortizing payment, a 15-year fully amortizing payment, the interest-only payment, and the most popular last option of “negative amortization.” The illusion and Orwellian language of this loan gave the impression that borrowers would have tremendous options in paying off their mortgage.

The facts are disturbingly different for this Jekyll and Hyde mortgage. Over 80 percent of option ARM holders elected to go with the smallest payment. The option ARM is a subset of the Alt-A toxic mortgage universe. In the midst of the major bank failure circus Washington Mutual, Wachovia, and Countrywide Financial all were swallowed up with their option ARMs into the belly of JP Morgan, Wells Fargo, and Bank of America. The three firms are now gone but their option ARMs linger creating banking indigestion.

In California these loans were highly popular with the decade long housing bubble. Imagine paying only $1,479 a month for a $460,000 loan. Things are good with the teaser payment and then the mortgage transforms into a toxic giant that’ll eat you alive. Take a look at a Countrywide loan example given to us in a suit brought on by the California Attorney General:

Things increase little by little until you hit the fifth year. At that point, you run out of options and your payment jumps up to $3,747 and your balance has gone up to $523,792 because of the negative amortization. The adorable little mortgage has turned into a ferocious lion ready to devour your monthly income. Many here in California now find that they are in this situation. They have an overvalued loan with a home that is off by 40 or 50 percent from the peak. You have certain prime locations like Culver City that are loaded up with Alt-A loan products including option ARMs. These will start recasting in mass later this year and into 2010.



In light of the “stellar” earning being reported by financial institutions, the reality is the balance sheet for many is still riddled with toxic assets. The commercial real estate bust is going to force many regional banks under. These option ARMs are going to provide continued losses for each of the major banking players on Wall Street. The only exception would probably be Goldman Sachs who didn’t drink the poison they were selling.



As it turns out, option ARMs are even more toxic than subprime loans. Here are some facts to chew on:

Option ARMs

36.9% of loans are 60 days past due

19% in foreclosure

Subprime

33.9% of subprime loans 60 days past due

14.5% in foreclosure

To add fuel to the fire, most of these loans are in the states with the biggest bubbles. Let us take a look at Wells Fargo and glance at the Pick-A-Pay portfolio:

68 percent of the balance is in California. Another large portion is in Florida. These loans are toxic and will be major losses for the bank going forward. Yet there is a surprising trend going on. Even though notice of defaults are sky high, you are not seeing the foreclosures hit the market. I have heard from many that have gone past 6 months without making a payment and they are still waiting for that notice of default. Why are banks not moving fast? Hard to say but it is probably because they are waiting for the public-private investment program to dump this stuff off to taxpayers or are simply overwhelmed by the amount of foreclosures they are seeing.

Many of the option ARMs will recast in 2010 with the peak being reached in 2011. If you look in the treasure chest of JP Morgan, you will find the artifacts left by WaMu:

These loan products were only useful in a gigantic once in a lifetime housing bubble. They do not serve any other purpose. I remember someone telling me that most of these loans were for “doctors, lawyers, and those who don’t want to document their income.” At least they got one of the three right.