Option ARMs and the "Time Bomb"

December 7, 2009

Fears are growing of a renewed surge in defaults on option ARMs (OAs). Investors have increasingly expressed concern that a spike in defaults driven by mandatory payment recalculations (the recast "time bomb") is building for the roughly $100 billion unpaid balance of 2006-issue loans, and question whether modifications under the Home Affordable Modification Program (HAMP) can be used to help significant numbers of troubled OA borrowers. A review of this complex product's features will be helpful. The initial payment is calculated to fully amortize over the loan's term at a low "start" rate (typically 1.5%). Accrued interest is subsequently calculated at a fully-indexed rate of 12-month MTA plus a margin (usually 300-350 basis points). For a pre-designated period of time (either 60 or 120 months after issuance), the borrower can make a minimum payment, i.e. the initial payment subject to 7.5% annual increases. If a monthly payment is less than the interest-only payment (based on the fully-indexed rate), the difference is added to the loan's balance (i.e., "negative amortization"); otherwise, the difference is treated as amortization. The loan is recast either at the end of the minimum payment period, or if its balance increases to a negative amortization limit (typically 115% of the loan's original balance). After the recast, the loan becomes an annual-reset ARM, with payments determined by the fully-indexed rate and remaining term.

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