Denninger points out that the looming problem with Option-ARMs is not interest rate resets, it's the fact that once the outstanding balance hits 110% of the loan value (remember, an option ARM allows folks to make payments that are substantially smaller than what would be required by amortization, adding the shortfall to the principal), the loans convert to fully amortized. All the folks that could just squeak by paying only the interest (or less) then are massacred by a huge hike in the monthly bill.
But if you think those numbers are a horror show, the real ugliness isn't found there. It is in fact found in all the foreclosed-but-unsold and not-yet-foreclosed "but will be" housing stock. Through the nation I am getting reports, some hard and some anecdotal, that lenders are sending out NODs (default notices) and then sitting on the process intentionally.
Why would they be doing that?
Simple: Most lenders who have these notes either in a security or as "whole loans" they were unable to pawn off on someone when the securitization market collapsed are holding them at "par" - the total amount outstanding.
If they sell they are forced to realize the loss; so long as they have a "reasonable belief" it will perform or be bought out (e.g. a government-sponsored and funded refinance) they can carry it this way if it is held to maturity. This of course makes their books look much better than they really are when you've got $500,000 in cash out against collateral that the market values at $150,000!
Then there is the Option ARM inventory and, most troublesome, the HELOC's (mostly seconds used for purchase and cash-out transactions) behind them.
There have been opinions floated that the "ARM" decimation is mostly a nothing, since short-term rates are so low and will remain that way for a reasonable amount of time.
This is true but misleading - with Option ARMs the nuclear destruction does not come from a reset of the interest rate but rather the recast when the loan ages or reaches (typically) 110% of the original principal value.
At that point what was either an interest-only (or even not a full interest) payment is forced to a fully-amortizing payment on the balance of the original time. For many of these loans this is set to happen at either three or five years post-issue, which means we're just starting to see the loans written in 2006 turn into many-headed hydra about now.
The importance of this event is that the increase in payment is absolutely insane - it is not at all unusual for payments to double, and there are few if any of these loans where the jump will not be at least 50%.
The IMF says there's roughly double the embedded loss in the system compared to what has been recognized and written down. I think they're conservative - my original estimate for housing market losses was somewhere around $2.5-3 trillion for residential alone.
So far the tally is up in the high hundreds of billions, meaning that there are a lot more cockroaches still to be found in the banking system - and they're doing their best to hide from the light.
Can that succeed? Not a prayer in Hell.
Those Option ARMs and any seconds behind them are doomed. There is no possible way to refinance them as most are over $100,000 underwater. The seconds written on top to get around conforming limits or avoid PMI are in fact worth nothing as the first has priority in a foreclosure action and there's not enough there to even satisfy the first!