During the past year, many investors and policy makers have been grappling with the risks posed by resetting subprime ARMs. Many investors feared that loans resetting at substantially higher rates would lead to sharp increases in foreclosures, which would further weaken the housing market and drive down home prices. In addition, there were fears that this could potentially spill over to the consumer, thus driving the economy into a recession. However, the Fed has largely eliminated the problem in the near term through aggressive rate cuts.

Another risk still remains, though, which has been less talked about: recasting option ARMs. Many of the payments on these loans will increase 50-100% over the next several years. Undoubtedly, this will put tremendous pressure on these borrowers and will likely lead to increased foreclosures. In this article, we aim to quantify the risks posed by the recasting of these loans. In particular, we estimate the balance and timing of loans that will recast, the payment shock borrowers will experience, and the loan-to-value ratios when the loans recast. Based upon our study, we arrive at the following conclusions:

• Between 2008 and 2012, $312bn in option ARM loans will recast to become fully amortizing loans. The majority of these recasts will come in 2010 and 2011 when $109bn and $118bn will recast, respectively.
• Upon recast, most option ARM borrowers will experience significant payment shock. When the majority of existing loans recast in 2010-11, their monthly payments should jump 60-80%. To put this into perspective, most subprime resets should cause only an 8-10% payment shock.
• As a result of declining home prices and the negative amortization of these loans, most borrowers resetting in 2010-11 will have loan-to-value ratios in excess of 100%.
• Given the number of the loans outstanding and inability of these borrowers to refinance, we expect option ARM recasts to be significant catalysts in increasing foreclosures and further driving down home prices in the near future.

While much focus has been placed on the risks posed to the economy and housing market by subprime ARM resets, few have looked into the risks posed by option ARMs. As it turns out, given the current level of interest rates, option ARM borrowers face a much more severe payment shock at loan reset (or recast) than 2/28 subprime borrowers. To illustrate this, we look at the expected payment shock for two hypothetical borrowers facing reset in 2008 - a 2006 subprime 2/28 borrower and a 2004 vintage option ARM borrower.

In Figure , we explore the expected payment shock for these borrowers. First, we look at the 2/28 subprime borrower who took out a $250,000 loan in 2006. For subprime ARMs originated in 2006, the average initial WAC was 8.39%, which translates into a monthly payment of about $1903. At reset, the loan becomes indexed off of 6mth Libor plus a margin of about 6.05% for 2006 loans. Given a 6mth Libor of 2.97% on February 15, 2008, these borrowers will face a new rate at reset of 9.02%. The new monthly payment comes out to about $2,044 - an increase of only 7.4%.

Next, we look at a payment shock experienced for a 2004 vintage option ARM. Most option ARMs have an extremely low teaser rate (1-2%) that is used to set the initial minimum monthly payment. Assuming an original loan balance of $250,000 and a teaser rate of 1%, the initial monthly payment would be about $804. Each year, the minimum monthly payment is allowed to rise 7.5%, and the current minimum payment is $1074.

If the option ARM borrower only makes this minimum monthly payment, the loan will negatively amortize as the interest accrual rate is much higher. In our example, we assume the loan recasts as the borrower reaches the 115% negative amortization ceiling. At recast, the loan balance will have increased to $287,500, a maturity slightly under 26 years, and a gross WAC of 7.05% (1yr MTA plus 2.75% margin). As the loan recasts to become a fully amortizing loan, the monthly payment balloons to $2,027, which represents an 89% increase in borrower payment!

While this is a slightly stylized example, since not all option ARM borrowers will hit their negative amortization limits, it is not out of question that many of these borrowers will be in this exact situation. 95% of outstanding option ARM loans have negatively amortized to some extent. Thus, at recast, most option ARM borrowers will have to make an amortizing loan payment on a balance that is greater than their original loan.

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