Now that we have motivated how severe the payment shock from option arm recasts can be, we tackle the problem of approximating the magnitude and timing of their recasts. The first step in estimating option ARM recasts is to break down the outstanding loans by origination quarter and factor.

There are a couple of reasons we do this to estimate when loans will be recast. Option ARM loans recast when either they reach their negative amortization limit or five years after origination, whichever happens first. Breaking the loans down by factor allows us to see how many have negatively amortized and how close they are to reaching their negative amortization limit. In addition, breaking them down by origination tells us how close we are to the five-year mandatory recast date.

Figure shows the current distribution of option ARM loans by origination quarter and factor and reveals a couple interesting attributes about outstanding option ARM borrowers. For instance, the data show that the vast majority of borrowers have elected to negatively amortize. For recent vintages, approximately 95% of borrowers have loan balances that are higher than their original balance. Furthermore, many borrowers have negatively amortized significantly (108-112% of original balance), which makes it likely that their loan will recast prior to five years. The most prevalent negative amortization limit is 115% of the original balance (although 110% and 125% limits are common, as well).

Forecasting Option ARM Recasts Step 2: Projecting Negative Am

Now that we have broken down the extent to which borrowers have negatively amortized, we focus on projecting how they will do so. In order to calculate this, we need to know: 1) the minimum payment of these borrowers; 2) the accrual rate on the loan; and 3) the payment that they borrowers choose to make on their loans.

We can simplify the problem by making a couple of assumptions. First, we assume that borrowers either prepay or make the minimum payment. Judging from the amount of borrowers who have negatively amortized, we find this assumption plausible. Second, we project all future accrual rates on loans based upon forward curves from today's term structure. The majority of option ARMs are indexed off of 1yr MTA. Thus, using the forward treasury curve and the margin, we project the interest accrual rates for option ARM borrowers.

The minimum payment can be calculated easily, given the initial note rate of the loan. Usually, the initial note rate for option ARMs is set as 1% and the minimum initial payment is based off a 1% amortizing loan. Every subsequent year, the minimum payment is increased 7.5%.

Now that we know the minimum payment and the interest accrual rate, we can determine the rate at which the loans negatively amortize. This, in turn, allows us to figure out when loans will recast. We illustrate the calculations in Figure 29. In this instance, we calculate the rate of negative amortization for an option ARM loan originated in February 2006 with a current factor of 107% and a negative amortization limit of 110%.

In this example, the loan experiences an interest accrual rate of 5.15-7.63%, which leads the loan to negatively amortize $145-670 per month. By June 2009, we estimate that this loan will have reached its negative amortization limit of 110%, and thus will have recast prior to reaching its five-year limit.