Toomre Capital Markets LLC

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Pay Option ARMs Continue To Worsen

Back in January 2008, Toomre Capital Markets LLC ("TCM") penned the post Option ARMs Spur New Worries. That post highlighted a number of other ticking credit bombs that were going to be effecting the Capital Markets in the coming months. Its chief focus was on the most toxic mortgage credit "bomb" of all: the Pay Option ARMs.

On Saturday December 6th 2008, The Los Angles Times and its writer E. Scott Reckard yet again return to this toxic subject in the article entitled Record 10% of U.S. Homeowners In Arrears Or Foreclosure. The subtitle of the article is "California, with 19% of new foreclosures in the third quarter, is a big contributor to the worsening picture." The prime culprit of this rise in the combined delinquency foreclosure rate are those Pay Option ARMs, given primarily to what were known as Prime borrowers and to a lesser extent to Sub-prime borrowers.

One might remember from the earlier TCM post: "Typically, 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."

Remember too 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." It has been said that "This is not a sub-prime crisis. This is a stated income crisis." In short, where Pay Options ARMs were most issued (Florida and California), evidence is accumulating that a significant portion of the spectacular rise in residential housing prices earlier this decade was driven by people who stated that they more financial income and assets than was truly the case.

From the above article, according to Jay Brinkmann, chief economist for the Mortgage Bankers Association, "California represents 13% of the loans in the country, but is recording 19% of all new foreclosures." One why might wonder why California is having so many more problems than other parts of the country. It is visible in the so-called "roll rate, which is defined as when one compares the number of newly delinquent loans in one quarter with the number of loans entering the foreclosure process in the subsequent quarter.

As Brinkman explained, That foreclosure "roll rate" was about 10% to 12% nationally in the 1990s and ran from 12% to 15% for most of this decade. The percentage is now 30% nationally but has reached 79% in California and 65% in Florida. "This is nothing like anything we've ever seen before," Brinkmann said. "We were shocked when we saw the California roll rates."

"Prime and subprime ARMs continue to have the highest share of foreclosures, and California and Florida have about 54% and 41% of the prime and subprime ARM foreclosure starts, respectively," Brinkmann said. "Until those two markets turn around, they will continue to drive the national numbers." The above figures are as of September 30th 2008. If the figures are correct, they indicate that almost four out of five California mortgages that were delinquent in the second quarter entered the foreclosure process during the third quarter.

And this was before the economy fell off the proverbial cliff around the start of the fourth quarter. The last three monthly employment reports have indicated that employment is falling sharply. No doubt the pull-back by both businesses and consumers will add to further employment pressure which in turn will lead to yet further residential house price reductions.

The real ticking credit bomb is that most of the Pay Option ARMs do not begin to reset until the latter portion of 2009. Combined with California residential real estate prices that are down as much as 40%, this quarterly report indicates that if a Pay Option ARM turns delinquent, it extremely likely in time to turn into a foreclosure which in turn will lead to realized losses for those who hold either the mortgage notes or the securities that are backed by those notes. Many of such securities are often referred to as Alt-A pass-throughs or ARMs. Many have also traded down very significantly in the secondary market. The very interesting issue will be "Have they become cheap enough yet to reflect the actual delinquencies and foreclosure losses that will occur among these homeowners who took out 'liar loans'?"

2nd Wave of Foreclosures on 60 Minutes Overlooked This Aspect

I would like to bring a very important NASE survey finding to the attention of all. I have been trying to bring this to the attention of Washington because they must address the following topic as quickly as possible.

This relates to the upcoming wave of Foreclosures in 2009 that are due to the resetting of the “Toxic” mortgages.

Many fail to realize that there are millions of self-employed smaller businesses, who employ from 1-10 employees, that are holding these risky mortgages. So, here we have a major problem… Not only will these small business owners lose their homes, but there will be the resulting JOB LOSSES on their business failure. Note, although President-Elect Obama is stressing the need to create 3 million new jobs, we must understand that “JOB RETENTION IS AS IMPORTANT AS JOB CREATION”.

Our priority should be to be PROACTIVE in addressing these small business owners’ need to avoid defaulting on their mortgages. They require “Immediate and Specific Financial Guidance” to weather this storm.

The 2nd Wave of Foreclosures has made it to the mainstream Media. CBS’s 60 Minutes had a segment on 12/14/08, but they missed a very important point. Here is a post which may have merit for your blog…….

I would like to bring a very important bit of information to your attention that relates to this economic crisis that was overlooked until now.

On Sunday, 12/14/08, CBS 60 Minutes aired a segment “The Mortgage Meltdown”.

Scott Pelley’s piece on the 2nd Wave of Foreclosures overlooked a critical fact.

The segment missed the fact that this next wave of Foreclosures in 2009 Will Take Self-Employed and Smaller Businesses who have these TOXIC mortgages. In fact, ALT-A, Option ARMS, Interest-Only, the TOXIC Mortgages that are considered the “Troubled” assets in TARP were specifically marketed to the self-employed who fell prey to them.

The upcoming defaults on these risky “Toxic Mortgages” will result in an increase in foreclosures. But worse, once these small businesses fail, the resulting loss of jobs will cause millions to add to the ranks of the unemployed. Note that self-employed business owners (16.2 million according to the SBA) employ between 1-10 employees.

An NASE survey at , was the first to provide compelling evidence of small business involvement in the upcoming toxic mortgage crisis. The survey was created by Prof. Samuel D. Bornstein and Jung I. Song, CPA of BornsteinSong Consultants in Oakhurst,NJ,and was conducted by the National Association for the Self-Employed (NASE) which issued a Press Release on November 21, 2008.

According to this survey, it is estimated that 3,709,800 small business owners hold Alt-A and other toxic mortgages, and 1,279,800 are already delinquent as they have missed one to three or more monthly mortgage payments at mid-November, before the expected Resets that are scheduled to begin in 4th Quarter 2008 through 2012.

These small business owners will be at-risk of payment shock and default as their monthly mortgage payments skyrocket. Small business owners were especially targeted for these Alt-A loans which required little or no documentation of income which appealed to many small business owners who previously were unable to qualify.

The resulting defaults will be the cause of the upcoming second tsunami wave of foreclosures that will dwarf the subprime crisis and will take many homeowners, small business owners, and their employees at this critical time when our economy can ill afford it.

Thank you,

Samuel D. Bornstein
Professor of Accounting & Taxation
Kean University, School of Business, Union, NJ