Option ARMs: Performance and Pricing

Abstract

This article establishes that defaults on Option ARMs will be quite high because 1) borrowers have self-selected this mortgage to achieve the lowest possible payment, allowing them to stretch to be in a house they could not afford; 2) negative equity is a large issue for this market; and 3) payment shock still looms. However, the poor collateral performance is fully reflected in the low asset prices. Putting together the high default rates with our expected severities and current market prices, we establish a methodology to compare option ARMs to alternative MBS investments. We conclude, based on market prices when the article was written, that better value can be found in the option ARM market than alternatives—the subprime market or the market for Alt-A hybrid floaters.

TOPICS: Volatility measures, downside-only measures