Option Arms About to Bite Builders

 | Jul 02, 2013 | 5:00 PM EDT
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There are still about $500 billion of first trust "option arm" mortgages in existence that were originated between 2002 and 2007. These loans are not eligible for the Federal Housing Finance Agency's (FHFA) new streamlined modification initiative I wrote about last week. Nor have they been eligible for the 12 government sponsored loan modifications programs that have been made available to mortgagors with loans made through Fannie Mae or Freddie Mac programs over the past five years.

Now that real estate values and transactions are rebounding, especially on the West Coast where the option arms are concentrated, it's a good time to review the status of the issue.

There are two basic kinds of option arms with one kind concentrated in Bank of America (BAC) and the other at Wells Fargo (WFC). Of the $500 billion of these loans outstanding, about half are at Bank of America and the other half are at Wells Fargo.

To put this number in context, the value of all residential sales in the U.S. annually is about $400 billion. So, it's a lot of properties. About half of these are in California with the other half spread around the rest of the countries urban coastal centers, including Boston, Washington D.C., Miami, and others.

Wells Fargo inherited its option arms when the company took over Wachovia. Wachovia acquired them when it bought Gold West Financial, which was commonly known as World Savings. The World Savings option arms were all portfolio products with 10-year resets. That means that the loans are owned and serviced by Wells Fargo and can be modified unilaterally by Wells Fargo without interference from the government or the mortgage backed securities investors.

The group of option arms at Bank of America, acquired as a result of its purchase of Countrywide Financial, is where the problems are. These loans have five-year payment resets and all were used to collateralize mortgage backed securities. That means that Bank of America has legal restrictions on its ability to modify these loans.

The vast majority of these loans were originated as "no income verification" loans, with borrowers claiming inflated incomes to qualify. This also means that even if the values rise so that the negative equity situation goes away, the mortgagors still can't qualify to refinance because their incomes would most probably be too low for the new standards.

In the past 12 months, the value of residential properties in California has retraced about half of the nominal value lost in the preceding five years. At the current rate of appreciation the price point will return to 2007 levels within 12 months.

The important point for investors in homebuilders is that the lack of inventory that has primarily driven rising prices in California and new home construction is about to be reversed. This will probably happen abruptly, as the option arm mortgagors have the ability to sell.

Although this situation is most acute in California, it is also a big issue for the all of the large coastal urban centers -- with the exception of New York City, where they were disallowed all along. As these homes start coming to market, it should provide a competitive alternative to the new homes being constructed by homebuilders for several years.

Both the SPDR S&P Homebuilders (XHB) and the iShares Dow Jones U.S. Home Construction (ITB) have declined from recent highs because of the rise in mortgage rates. However, there is little concern being expressed by the builders or investors in them concerning the potential of the lack of inventory becoming a glut in short order.

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