Option ARMs are the gift that keeps on giving this holiday season. As it turns out, these pesky toxic mortgages are still sitting waiting to hit recast periods. Like a street vendor taco these things went down nicely and appeared cheap but came with a hefty aftermath. The last option ARMs were made in 2007 yet they are still causing much pain in the housing market. Attorney General Jerry Brown has requested data from the top 10 issuers of option ARMs with a deadline date of November 23. It’ll be interesting to see what is released from the AG’s office. However, Standard & Poors issued a report on option ARMs last week and found that much of the problems with these loans are still to come.

One of the stunning points found was that 93 percent of option ARM borrowers decided to go with the negative amortization option otherwise known as the “minimum payment” option. This is something we have established from many fronts and data sets. The bottom line is the vast majority went with negative amortization and this grew the actual balance owed. Yet one of the new findings in the report was that 78 percent of all outstanding option ARMs have yet to hit major recast points. Given that 58 percent of option ARMs are here in California, this is a one state wrecking ball:

In total, some 350,000 option ARMs are still active nationwide. Over 200,000 of these loans are here in California. The most risky option as we have established with option ARMs is the negative amortization payment:

Now why was this payment such a poor choice? Well as the California housing market fell by 50 percent from its peak, the actual balance on many option ARMs was going up. So not only is the home underwater from the initial starting point, the loan taken out on the home has increased on 90+ percent of these borrowers. This is like negative equity squared. So deep are these loans in negative equity territory that not even HAMP can save them. Oh, and speaking of HAMP, it is turning out to be a colossal failure as expected:

“(NY Times) Capitol Hill aides in regular contact with senior Treasury officials say a consensus has emerged inside the department that the program has proved inadequate, necessitating a new approach. But discussions have yet to reach the point of mapping out new options, the aides say.

“People who work on this on a day-to-day basis are vested enough in it that they think there’s a need to do a course correction rather than a wholesale rethink,” said a Senate Democratic aide, who spoke on the condition he not be named for fear of angering the administration. “But at senior levels, where people are looking at this and thinking ‘Good God,’ there’s a sense that we need to think about doing something more.”

I know many delusional folks in California were thinking that somehow the quiet on the option ARM front had to do with the masterful success of HAMP. Of course, these loans never qualified for HAMP but that is beside the point. HAMP is failing because of a simple reason. Negative equity. Here in California, we have millions underwater. Those with option ARMs are not only underwater, they are going to have massive spikes in their monthly payments at a time when the California unemployment rate is the highest in record keeping history. The problem is Wall Street has sucked up all the taxpayer bailouts and for what? To keep the crony welfare investment banks ticking? Trillions of dollars out the door and the real economy is still troubled. HAMP had the naïve premise that the only problem was high interest rates and the problem with the housing market was toxic mortgages. Well, the actual problem is thousands of homes are still valued at bubble prices and with stagnant wages for a decade, people can’t afford homes without going massively into debt. Prime, near prime, and subprime means little when you have no income and that is why even prime defaults are spiking. The option ARM had such an allure for the gold rush California home speculator because it sidestepped that tiny little caveat of income. It allowed maximum leverage without the valid income support. 80 percent of option ARMs went stated income. In other words, people made crap up like saying they made $200,000 when they were pulling $75,000 to qualify for that $600,000 home:

“(CNN) There is another little problem that many option-ARM borrowers seeking refinancing would face: “Upwards of 80% of were stated-income loans,” said Westerback.

These are the so-called “liar loans” in which lenders did not verify that borrowers earned as much money as they said they did. Lenders may not be able to modify mortgages because many of the borrowers’ income could not stand up to the scrutiny. Borrowers may also not want to go through underwriting again because they could be held legally liable for deliberate inaccuracies on their original applications.

Add to those conditions the still fragile economy and high unemployment rates, and you have a recipe for disaster.”

As people chime in about stabilization, California is still hovering near the bottom in terms of prices. The only reason we have seen prices move slightly up is because the massive jump into foreclosed homes, the home buyer tax credit, Fed buying securities to lower mortgage rates, and all these phony moratoriums that we are now seeing are basically delaying reality for many. Inventory is artificially low because of the shadow inventory.

People ask for a solution. Here it is: We should have (and still should) break up the banks into pieces that are small enough to fail. Bring back Glass-Steagall with some teeth. Commercial and investment banking should be put into silos that don’t even come close to one another. Banks that need to fail should. After all, the government now backs 90+ percent of all mortgages so why do we even need them? A quick assessment should have been made from day one on housing. Those that couldn’t afford their homes should have gotten assistance into rentals. Here’s a thought. Why didn’t we create a program where those who had no way of paying on an overpriced home were given a tax break to rent a place in an empty commercial real estate development? Right there you kill two birds with one stone. Of course, those on Wall Street and those in our government are two sides of the same coin. For the past three decades they have systematically neutered our government to the point of it being a bread and circus spectacle.

You think the 200,000 option ARM borrowers in California are sitting in a good spot? Let us look at negative equity rates for a few metro areas since this is the largest predictor of future foreclosures:

If you look at the Inland Empire and the Phoenix metro area, they virtually reflect one another. In fact, both areas have negative equity rates of 54% of all mortgage holders. This is incredible. Half of all borrowers are underwater in these big regions. But look at the largest block of mortgages in California clustered in the Los Angeles-Long Beach area. 1.5 million mortgages and 400,000+ are underwater. You think this is going to bode well for home prices as option ARMs hit their recast dates in stride from 2010 to 2012? I put in a more normal area of Dallas above and you can see what a normal market looks like. Even there, you can see that negative equity is still an issue. But compare that to California and it is another story completely. What does this mean? The middle market is certainly going to take major hits once these loans hit their recast dates. If they don’t qualify for HAMP, then what? S&P in their report gives an example of a hypothetical $400,000 mortgage:

The payment flat out doubles at the recast date. Do you think people are going to be able to come up with an extra $1,200 per month with no problems? You know what the typical mortgage payment for a home bought last month in California totaled? $1,097. That is the price of the hypothetical increase in the priciest state in the U.S. So yes sales are happening but at a much lower end. How is this going to help those in negative equity on more expensive homes? Take a look at the raw numbers for the state:

34 percent of all California mortgages are underwater. You can rest assured that 80+ percent of those option ARMs are underwater. As the above highlights, those mortgages are still here and they are still toxic.

Option ARMs fall under a bigger umbrella of Alt-A loans. California has over 700,000 active Alt-A loans. The bulk of the 200,000+ California option ARMs fall under this category. But the bulk of these loans are also toxic mortgage waste. These will go off as well. These are actually part of the shadow inventory including those who simply stop paying but banks sit back and do absolutely nothing. Is that really a solution? Take a look at where the Alt-A loans are in California:

Los Angeles and Orange counties hold the biggest number of Alt-A and option ARM loans. Do you really think this is a bottom? It might be for a home in the Inland Empire selling for $100,000 or $150,000 depending on local area dynamics. But many cities in Los Angeles and Orange County are vastly overpriced. The above dynamics look similar to how subprime was building up in 2006 and 2007 before the market imploded. Yet somehow things are now different.

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