Toomre Capital Markets LLC ("TCM") has previously written about the other ticking credit bombs that will affect the Capital Markets in the coming months. TCM posts to review include Estimated Investment Bank Fourth Quarter Earnings??, Where is Value in Structured Mortgage Products? – Early December 2007 edition and Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies.

On Monday January 14th 2008, The Los Angeles Times published yet another excellent article written by E. Scott Reckard. This one is entitled Adjustable loans spur new worries and has more details on the most toxic mortgage credit "bomb" of all: the Pay Option ARMs. Typcially, these Pay Option ARMs present the mortgage borrowers with a choice every month during the first five years of the loan: pay the interest due and some of the principal; pay interest only, leaving the loan balance untouched; or pay less than the interest due, making the loan balance rise. Then, at the end of the five year option period, the loan is reset to fully pay-off with a fully indexed adjustable interest rate.

Since many of the mortgage borrowers elect to pay less than the amount that will fully amortize the mortgage and the effect of fully indexing the interest rate from the typical more "teaser" initial rate, when Pay Option ARMs are reset, they almost always require a higher principal and interest ("P&I") payment than initially was required. Sometimes these reset P&I payments are as much as two or even three times what the borrower was originally paying on the mortgage each month. If the borrower elects only to pay interest only during the initial months and the balance rises above a set percentage of the original loan amount, the reset process can occur earlier as soon as three years.

This LA Times article suggests that the second tide of the mortgage defaults are about to start. After reviewing data from mortgage industry data trackers, the author concludes that Pay Option ARM borrowers -- "most of whom boast respectable and often top-tier credit scores and appear to have substantial incomes and home equity" – are having severe delinquency problems that are tied to the loose lending practices that inundated the sub-prime business. Pay Option ARM loans often were granted on the basis of stated income, not proof of a borrower's income, giving rise to their nickname, "liar's loans."

"This is not a sub-prime crisis. This is a stated income crisis," said Robert Simpson, chief executive of Investors Mortgage Asset Recovery Co. in Irvine, which works with lenders, insurers and investors to recover losses related to mortgage fraud. "Simpson said loan officers routinely inflated earnings of workers with regular paychecks. On some written requests to confirm a borrower's employment, officers would specify that an employer should not provide a salary figure, he said." As a result, borrowers often overstated either their income or their assets.

The article references Mortgage Asset Research Institute in Reston, Virginia, which investigates lending fraud. Apparently one of that firm's customers checked one hundred stated-income loans against tax documents and found that nine in 10 of them overstated income by at least 5%. "More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%," the institute reported, saying the Pay Option ARM mortgages clearly deserve their "liar's loan" handle.

The LA Times secured mortgage delinquency data compiled by mortgage researcher First American Loan Performance regarding Pay Option ARM delinquencies in California. As the article states, the results are rather stunning. "The percentage of option ARMs with payments behind by at least 60 days in California is in double digits in the Inland Empire, San Diego County, Santa Barbara County, Sacramento, Salinas and Modesto [as of October 31, 2007]." That is right folks, the sixty day delinquency rate is already in double digits and this is before the full effects of the economic slowdown and hike in energy prices hit the consumer market!!!

The article continues with details that "The more recent loans appear to be faring the worst, reaffirming the conclusion that lending standards had become overly lax throughout the mortgage industry in the middle of this decade, as competition for fewer good loans intensified amid skyrocketing home prices. In Yuba City, north of Sacramento, 15% of option ARMs made in 2005 were delinquent at the end of October, the Loan Performance tally showed, and in Stockton-Lodi the delinquency rate on option ARMs from both 2005 and 2006 was over 13%."

Toomre Capital Markets LLC finds most interesting the following facts: "Loan Performance's study, which looked at loans bundled up by lenders and Wall Street firms to back mortgage bonds, found that 8.8% of such option ARMs made nationally in 2005 were 60 days or more in arrears as of Oct. 31. In California, the 60-day delinquency figure for securitized 2005 option ARMs was 9.5%, compared with only 2.1% of the option ARMs from 2003." [Emphasis Added]

What does all of this mean? To TCM at least, it suggests several things, including:

• Pay Option ARM delinquencies, defaults and eventually losses are going to be stunning and likely far worse than many expect.
• Since something like 45% of all mortgages made in California since the start of 2004 were Pay Option ARMs, California real estate (both residential and then commercial) is going to go through a very rough patch, probably lasting three years or even more.
• The Pay ARM Option problem will be focused primarily in the Prime and Alt-A sectors (i.e. among borrowers with good credit ratings when the loans were originated and likely to come from the middle class and higher portions of the economic spectrum), since sub-prime borrowers generally did not qualify for these types of mortgages.
• California real estate needs to correct significantly to get the affordability of prices back in line with historical income and rental payment levels.
• Bank of America is going to go through some amazing losses with the Countrywide acquisition. One has to wonder just how bad the Washington Mutual Option ARM losses will be as well.
• We would be prefer being late rather than early in putting on "spread" or going "illiquid" investments. No doubt there will be many attractive opportunities and plenty of volatility as the markets work through this credit crisis. However, many people forget how long and slow the process of working out real estate truly is. In a market environment where people seem to want instantaneous gratification, the resolution of this crisis is going to something akin to "water-boarding." And the crisis effects are going to continue to turn up in the most unexpected places further unsettling investment professionals.

As always, reader comments and thoughts are welcome.