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Friday, May 01, 2009 10:31 AM


ARMs Reset Crisis Revisited


Just over a year ago I took a Close Look At The ARMs Reset Problem.

Inquiring minds may be asking "What's Changed?"

The answer is: there has been much improvement across the board, but especially for 5-1 ARMs. In addition, those in ARMs tied to the Cost of Funds Index (COFI), will be pleased to note that on April 30, the COFI sank to an all time low.

The History of COFI shows the March 2009 index value at 1.627, a record low. A year ago index value was 3.280. Last month it was 2.003.

COFI is the weighted average of the cost of funds (CDs, savings deposits, checking deposits, etc) for member banking institutions of the Federal Home Loan Bank of San Francisco (the 11th District). COFI is a lagging index. The index value for a given month is typically reported on the last day of the following month. For Example: At or after 3 p.m. on the last business day in September, the bank announces the August COFI.

The most common indices used to compute ARMs are COFI, 1-Year Constant Maturity Treasuries (CMT), 1-Year LIBOR, and 1-Month LIBOR.

Rate Comparisons - COFI, 1-Yr CMT, 1-Yr LIBOR



Those in interest only loans are frequently tied to 1-Month LIBOR.

1-Month LIBOR



All charts courtesy of Money Cafe.
Click on any chart to expand.

ARM Index Rates

COFI - 1.627%
1Yr CMT - .64%
1Yr LIBOR - 1.97%
1Mo LIBOR - .41%

ARM rates consist of an index rate (typically one of the above), plus a margin component (e.g. 1 Month LIBOR + a spread). The amount of the spread is based on credit risk and other factors at the time the loan. Regardless of what index rate is, ARMs that are now resetting are likely to be coming in at lower rates, perhaps even much lower rates.

1 Year CMT Table



One Month LIBOR Table



One Year LIBOR Table




COFI Table



Across the board, those in 3-year ARM rates that have recently reset or are about to reset, will do so at a much lower rate unless there is a floor. Moreover, with the specific exception of 1-Year LIBOR based loans, there will also be a reduction in 5-Year ARM rates when those loans reset. Looking ahead just one month, even 5-Year ARMs tied to 1-Year LIBOR are likely to reset lower.

Thus, even homeowners ineligible to refinance now because they are underwater on their homes, have already (or soon will) see a significant reduction in mortgage interest rates (assuming there is no floor that prevents rates from going lower). I do not have stats on the percentage of loans with and without a floor, but even with a floor, rates should not rise.

Principal Payments Need To Be Factored In

There is still one more issue to address, and that is higher payments when the interest only period ends. For example, a 5-year ARM loan typically goes from interest only payments to interest + principal amortized over 25 years on the first rate reset. Likewise a 3-year ARM loan typically goes from interest only payments to interest + principal amortized over 27 years on the first rate reset. Some ARMs have a 10 year interest only period which postpones this particular problem.

Across the board, those in 3-Year ARMs with principal and interest payments will likely see their total mortgage payment drop. However, those paying interest only, especially those in 5-1 ARMs, may see their total payments rise. Even so, the situation has hugely improved from a year ago.

Pay Option ARMs Still A Problem



The problem with Pay Option Arms is over 80% of POA mortgagees only make the minimum payment. Given that minimum payments typically do not cover interest owed, the loan balance increases every month. This is called negative amortization, and it has been going on for years.

Negative amortization is compounded by falling home prices. At some point, typically 110-125% of the mortgage, an enormous gotcha kicks in. That gotcha requires a fully indexed fully amortized principal and interest payment, amortized over the remaining years. People who could only afford the minimum payment will be forced to pay principal, plus interest, on top of a loan balance that has been growing monthly. Good luck on lenders getting all their money back on those loans.

The second problem in regards to POAs is that a huge portion of these loans originated if the least affordable, biggest bubble areas, like Florida, California, Las Vegas, etc. From a lender's perspective that hugely increases the likelihood of default as well as the size of the problem should default occur.

Conclusion

Other than the ticking time bomb of Pay Option Arms (which is still a huge problem, especially for California), the ARM reset problem has vanished for as long as rates stay low, or permanently if ARM holders roll over into affordable fixed rate mortgages.

Unfortunately, reset issues are not the only problem. The economy is still losing 600,000+ jobs a month and for every job lost there is another person who might be shoved into foreclosure as a result.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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