Friday, May 29, 2009

Reset Chart from Credit Suisse has a Major Error

Versions of the Credit Suisse reset graph have been featured in the Financial Times, used by the International Monetary Fund, and are a staple of web sites like these that are dedicated to the housing bubble. It’s fairly shocking then to see what appears to be a major error in their calculations.

Last week (here and here) I noted that something didn’t make sense about Wells Fargo’s estimates that only one third of one percent of their Option-ARM loans would recast before 2012. Reader’s comments and an email from CalcualtedRisk helped me to get my head around what was going on. In fact, Wells Fargo’s numbers are technically correct.

First for some background, when Wells Fargo purchased Wachovia it acquired about $120 billion of Option-ARM loans originated by a Northern California company called Golden West. These Option-ARMs, or “Pick-A-Payment” loans, allowed borrowers to literally pick their monthly payment from four options: 1) a payment that would pay off the loan in 15 years, 2) a payment that would pay off the loan in 30 years, 3) a payment that only covered the interest, and 4) a minimum payment that was less than the interest only payment.

The last option allowed for “deferred interest” or “negative amortization”. In essence, since not all the interest due was being paid by the borrower, the principal balance on the loan would grow each month. This was an extremely popular choice for borrowers at the peak of the real estate bubble, as Golden West noted in their 2005 year-end filing with the SEC:

In 2005, the initial monthly payment selected on almost all new loans was lower than the amount of interest due on the loans.

For obvious reasons this has been of particular concern. If the amount one owes on a loan goes up while the value of the home is decreasing, there is a heightened risk the borrower might walk away from the home leaving the bank to deal with the loss.

As the housing market has continued to deteriorate, the question on everyone’s mind is when will borrowers have to face the reality that they can't make a minimum payment forever? The Credit Suisse chart has been a guidepost for that reality check.

But interest rate resets don't pose much a problem for those with Option-ARMs when rates are low. They can continue making a minimum payment that only adjusts upwards by 7.5% once a year. The real "payment shock" comes when the loan is recast (i.e. becomes fully amortizing over the remaining term of the loan). This occurs after a contractual time limit (normally 5 or 10 years) or, if due to negative amortization, the loan value increases to 110-125% of the original principal of the loan.

For this reason Credit Suisse used the recast date in their chart above for Option-ARMs as stated by Mathew Padilla of the Orange County Register:
Credit Suisse, an analyst told me, used resets in the chart for all loans except option adjustable-rate mortgages, when borrowers can choose a minimum payment that may be less than interest owed (option ARMs are in yellow on the chart… see how they are rising!). For option ARMs it used recasts, which can happen either when the loan amount expands to a maximum allowed — often 115% or 125% of original principal — or a set period, such as five years.

If you’re paying close attention you'll notice that something doesn't add up. Wells Fargo, who holds more Option-ARMs on its books than any other institution, states in their last 10-Q filing:
Based on assumptions of a flat rate environment, if all eligible customers elect the minimum payment option 100% of the time and no balances prepay, we would expect the following balance of loans to recast based on reaching the principal cap: $4 million in the remaining three quarters of 2009, $9 million in 2010, $11 million in 2011 and $32 million in 2012... In addition, we would expect the following balance of ARM loans having a payment change based on the contractual terms of the loan to recast: $20 million in the remaining three quarters of 2009, $51 million in 2010, $70 million in 2011 and $128 million in 2012.

In short, Wells expects $56 million in Option ARMs to recast due to the loan balance reaching 125% of the value of the original loan and another $269 million to recast based on the terms of the loan. Given that we’re talking about a portfolio of over $100 BILLION of these loans, this means ESSENTIALLY NO LOANS WILL RECAST due to the negative amortization limits or contractual terms before 2012.

Both assumptions seemed suspect, yet, they are in fact true. Looking at page 55 of the Golden West 10-K from 2005 we read:

...most of our loans are scheduled to have a payment change without respect to any annual limit in order to reamortize the loan over its remaining life at the end of the tenth year or when the loan balance reaches 125% of the original amount. We term this reamortization a “recast.” Historically, most loans in our portfolio have paid off before the loan’s payment is recast.

History doesn’t look like it will be a good guide going forward but this at least clearly spells out what we are facing. If recasts don’t happen contractually for 10 years this means that the $49 billion of Golden West Option ARMs originated in 2004 will recast in 2014, and the $51 billion originated in 2005 will recast in 2015.

But take a look at the chart. Credit Suisse shows NOT A SINGLE OPTION-ARM RECAST IN 2014 (nor any in 2013 or the first three months of 2015).

Maybe Credit Suisse moved the recasts up based on the loans hitting their 125% balance caps as they state in their footnote? But again, the numbers don’t add up to what Wells states in their last 10-Q: virtually no recasts due to "reaching the principal cap" before 2012.

They also don’t add up if you model this out in excel with some actual numbers. Take a look at the table to the right (click for larger image):

Here we look at a hypothetical $500,000 Option-ARM mortgage originated by Golden West in January 2004 that now sits on Wells Fargo’s books. In order for the loan to recast before 2014 it needs to have enough negative amortization to hit the 125% limit. Wells Fargo assumes a "flat rate" environment in their calculations, but I assumed that today the CODI index (used for a majority of Golden West loans) plus margin jumps to 7% from its current level of 4.875%. At the end of the year I assume it jumps another 100 basis points to 8% and stays there until 2014.

Even with the assumption of higher rates the loan never hits its 125% cap. The loan currently has accrued about $40,000 of negative amortization. By 2014 it would accrue another $45,000, making the final balance $585,388 (115% of the original loan). In order to get the loan to hit the 125% cap by 2012 the accrual rate would need to jump today to 10% and say there for the next 3 years.*

In short, the Credit Suisse chart above looks to be incorrect. Contractually, these recasts won’t happen until 2014 and given the generous 125% cap it is unlikely negative amortization makes these loans hit that limit unless we have a major spike in interest rates. As mind boggling as it may seem, recasts for Wells Fargo’s giant Option-ARM portfolio won’t take place for another 5 years.

Of course, none of this is to say that Wells Fargo is out of the woods. They are essentially stashing away on their balance sheet tens of billions of neg-am loans that will recast into 20-year fixed rate mortgages in 2014 and 2015. Talk about a payment shock. (Although, it is important to note that the minimum payment automatically increases by 7.5% a year. If rates were to stay low this could mean that borrowers would eventually start paying more than their interest only payment and paying down their loans. My guess though is that these automatic increases will get people walking away from their homes before the recast date. Who wants to pay $3000 a month on a home that's underwater? Any way you look at it, it’s a mess.)

Also worrisome is that we’ve heard from readers that WaMu/JP Morgan is notifying Option-ARM borrowers that they are extending their minimum payments out another 5 years. Are they pushing off recasts into 2014/15 as well?

The bottom line something doens't add up when Wells Fargo predicts virtually no Option-ARM recasts before 2012, while Credit Suisse predicts no recasts after 2012. While I would guess Wells Fargo is underestimating recasts assuming a flat rate environment, the bulk of recasts do look like they will be pushed out to 2014/2015. Surely, some of these recasts need to be reflected in the Credit Suisse chart. I’ll leave it to others what this means for the housing market, but what is clear is this needs more attention.

* [To verify these numbers download this spreadsheet from CalcualtedRisk, update the index with the CODI series, and plug in your own home values.]

Update: Regarding the 125% cap, to clarify, this was for loans with a LTV of less than 85% at origination. This represents the structure of "almost all" the Option-ARM loans according the the Golden West 10-K:

A 125% cap on the loan balance applies to loans with original loan-to-value ratios at or below 85%, which includes almost all of the loans we originate. Loans with original loan-to-values above 85% have a 110% cap.


  1. Here's another thing the CS chart doesn't take into account....okay, let's say I have a 10-year Option ARM. I'm still within my first 10 years on the loan, and have made an artificially low payment for some or most of the time. So, my loan balance is getting bigger.

    I look around my neighborhood and know other "homeowners" are stressed, and foreclosures & short sales are popping up. Very few houses are selling that aren't distressed sales.

    I decide to re-finance into a fixed rate loan before my Option Arm becomes impossible to pay. I see my mortgage balance getting bigger on my statement, and the MSM is full of stories about record low interest rates.

    So, I go to re-finance and officially find out that I do not qualify for fixed rate financing because my house is worth less than I paid for it, and I either have insufficient equity or am underwater on the loan.

    Will these folks start to walk away? I read a really interesting post on one of the mortgage sites that the blogger thought all the hoopla about super low rates and easy re-financing, blah, blah would actually speed up the collapse. Once these Option Arm folks try to re-fi, the rose colored glasses come off when they find out what their house is worth in black & white. And they find out they are stuck with their toxic loan.

    So, do these loans blow up in large numbers before the 10-year recast hits?

  2. I definitely think they will. The payments increasing 7.5% a year will get people thinking twice about hanging on.

    BTW Lisa, in our last discussion on Option-ARMs I was incorrect when I said a recast was triggered by a loan-to-appraised value ratio of 125%. For the Golden West loans a neg-am loan can get to 125% of the original loan principal.

  3. According to the Mayan Calendar our world comes to an end in 2012.If CS is taking that as gospel it could explain the chart...

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  5. SO - RE bears - what this means to me is that while RE might fall, panic selling won't happen due to recasting for the next 5 or more years. I believe that homedebtors will hang on until they are forced out - the overwhelming majority will not walk away and will not plan ahead in fear of what will inevitably come their way. Sheep.

  6. Anonymous above,

    You have it wrong. The Mayan Calendar actually says that after 2012 the Calendar is blank and the world will see a major change. "Blank" is often confused to indicate "end", which is not the same thing! :)

    Whether this change will be for the better or worse is to be seen.

  7. There seems to be another glaring omission from al of these charts. Having been a mortgage broker for the past 15 years, I can tell you that all 'good' borrowers wanted 30 year fixed interest only loans during the bubble. It was a very high percentage of our business. These interest only loans, even though the interest rate is fixed, recast after the 10 year interest only period to a 20 year loan. Payments on these will increase 35% 10 years after the date the loan was taken out. I think this could be the biggest pool of foreclosures we've seen yet. No one mentions it.

  8. One key issue here might be the amount of the minimum payment required. I have a client whose minimum payment was about 1/2 of the interest only payment. Every payment made was at the minimum amount. This resulted in a $300,000 loan hitting the 125% cap in about 2 years and 4 months. I have a hard time believing that a $500,000 loan issued in 2004 has accumulated only $40,000 in neg am in 5 years.

  9. No doubt there will be variances - not the least of which will be banks shuffling their losses to hide them - extending terms, etc. The bottom line, however, is that foreclosures are certain to continue to increase over the next few years and very likely for the next decade, as knife-catchers cut their losses and walk away from their "great buy" today.

    Lisa makes a good point about people being shocked back to reality. I know that many people are overly optimistic when it comes to evaluating how underwater they actually are - as soon as they know the truth, we'll have an avalanche of foreclosures, as these people "stick it" to the banks.

  10. Anon @ 8:59

    The minimum payment could be lower allowing for more negative-amortization but I used 1% which was typical (30-year mortgage, 1% rate, = $1608 for the first payment).

    It could be the margin. I used 2.5% which was also common. But if the borrower had a margin of more than that you could reach the cap more quickly.

    You could download the spreadsheet above from CalculatedRisk and play with the numbers. For my chart I updated all the interest rates through last month with the CODI Index so historically this is what would have happend to a $500,000 loan with these parameters.

  11. For those of you charting with the Mayan calendar, the other noteworthy event happening in 2012 is the expiration The Mortgage Forgiveness Debt Relief Act (click on my name for the link). I imagine Christmas will be a time of deep reflection where people have to figure out if they want to continue servicing their oversized (or soon to be oversized) mortgages or take advantage of the government's largess ("Don't 1099 me, bro"). Jingle mail, jingle mail, jingle all the way...

  12. The question you have to ask yourself, and I know this sounds weird, but so what? What if Wells earns $200B of pre-provision earnings before the recasts? That's a LONG time from now and housing could certainly stabilize before then.

    But you have a nice piece of analysis here, good work.

  13. HHB, nicely done.

    I had forgotten about the annual rise in minimum payment, 7.5% in your example.

    I think maybe this accounts for CS's mistake, they were assuming no rise in minimum payment. It also explains the jump in late payments/foreclosures these loans are seeing even if recast is years off. In three years the minimum payment is 25% higher, even if interest rates are flat, or fall.

  14. Anonymous,

    Yes, they may do OK earning-wise, and housing may stabilize by then.

    But value of the house in HHB's example could have fallen to $350,000 now. Maybe in 2014 it recovers to $400-450,000. But the borrower owes $585,000.

    This person is underwater and just stays underwater for maybe 10 years.

  15. My recollection is that here in MI, it's illegal to issue a mortgage that results in negative ammortization- that is to day, you've got to at least pay the interest. That may be ONLY for individuals, but as I've not heard of these "minimum payment" mortgages here, I believe I'm correct.


    We don't need any more issues to tackle. We're just starting to gain traction on the ones we've got.

    Great analysis HHB. Kudos to you.

  16. Ultimately, every one is buying time with the help from the Obama Administration, especially when with 125%LTV loan mod.

  17. Isn't this assuming that people can afford the annual rise of 7.5% each year? A 1,500 -> 4,000 monthly payment is bad, but so is a 1,500 -> 2,500. Seems to me that people can't afford the annual rise, and so they are getting foreclosed on before the recast. Wouldn't explain much about the CS chart, but it would point to foreclosures coming before 2014/15.

  18. "You have it wrong. The Mayan Calendar actually says that after 2012 the Calendar is blank and the world will see a major change. "Blank" is often confused to indicate "end", which is not the same thing! :)"

    And you have it wrong still. The Mayan calendar's start date was arbitrarily set. It was set so that certain celestially significant events would align with the start of certain reigns. Thus, the end date is also arbitrary.


  19. Update .Sept 18 th .2010.


    Pictet & Cie Bank.

    Ivan Pictet.
    Nicolas Pictet.
    Charles Pictet.
    Jacques de Saussure.
    Jean – Francois Demole.
    Renaud de Planta.
    Philippe Bertherat..

    Pictet & Cie.- claim they are the “Rolls Royce”of swiss banks.

    Swiss Banks or more correctly Swizz banks.

    Swizz. ---- “ a great disappointment.” or a “ fraud.”

    Fraud. ---“ an intentional deception or dishonesty.”— “a crime.”

    Crime. ---“ an act committed or omitted in violation of a law.”

    Serious Crimes .
    Conspiring to pervert the Course of Justice.
    Perverting the Course of Justice.
    Contempt of Court.

    Pictet & Cie.

    Pictet & Cie Bank –Partners –(1996—2010)-liable.
    Peters &Peters – Partners.—(1999----2010)-liable.

    The bank and it’s officials/lawyers deliberately withheld crucial documents requested under a High Court order. The bank and it’s officials/lawyers deliberately withheld evidence from the Police, and one of it’s account managers Susan Broadhead gave a false witness statement .
    Another one of it’s managers Nicholas Campiche ( Now Head of Pictet – Alternative Investments.) concocted a letter pretending to be a client and closed his account. The senior partner (Ivan Pictet.) sought to have numerous documents destroyed,along with those copies held in their London office’s of Pictet Asset Management. Initially stating that they were forgeries then their lawyers Peters & Peters – Monty Raphael –and the barrister Charles Flint.Q.C. later had to admit in Court that the documents were genuine.

    British Parliament. Hansard .29th March 2007.
    Barry Sheerman .M.P.—quote.

    ---------“ Constituents of mine have lost £2 million through fraud. The fraudster used Pictet & Cie - - a French Bank - - and Pictet Asset Management to back the fraud being perpetrated.””

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