| Interest-only and negative amortization payments | | | | also recast as a conventionally amortizing loan. Since |
| cannot go on forever. At some point, the loan balance | | | | many borrowers were qualified based on their ability to |
| must be paid in full. For all adjustable rate mortgages, | | | | make the minimum payment at the teaser rate, when |
| there is a mandatory recast after a fixed period of | | | | the loan recasts and the payment significantly |
| time where the loan reverts to a conventionally | | | | increases (double or triples or more,) the borrower is |
| amortizing loan to be paid over the remaining portion of | | | | left unable to make the payment, and the loan quickly |
| a 30 year term. | | | | goes into default. |
| A recast is not the same as an interest-rate reset. A | | | | The natural question to ask is, "Why would lenders do |
| reset is a change in the interest rate being charged on | | | | this?" There is no easy answer. Most simply did not |
| a particular loan. The amount of the payment may go | | | | care. The lender made large fees through the |
| up or down (although it usually goes up) when a reset | | | | origination of the loan and subsequent servicing, and |
| occurs. A recast is a change in payment necessitated | | | | the loan itself was sold to an investor. The investor |
| by a change in the amortization method. This recast | | | | bought insurance against default, and many of these |
| eliminates the options for negative amortization and | | | | loans were packaged into asset backed securities |
| interest-only payments and requires the fully amortized | | | | which were highly rated by ratings agencies due to |
| payments on an accelerated schedule for what is | | | | their low historic default rates. Nobody cared to |
| often an increased loan balance. The payment after a | | | | examine the systemic risk likely to result in extremely |
| recast is always higher. | | | | high future default rates because the business was so |
| For instance, if an interest-only loan is fixed for 5 years, | | | | profitable at the time of origination. Most assumed this |
| at the end of 5 years, the loan changes to a | | | | would go on forever as house prices continued to |
| fully-amortized loan with payments based on the | | | | appreciate. It was envisioned that most borrowers |
| remaining 25 year period. The longer interest-only or | | | | would either increase their incomes enough to afford |
| negative amortization is allowed to go on, the more | | | | these payments or simply refinance into another highly |
| severe the payment shock is when the loan is recast | | | | profitable Option ARM loan. |
| to fully amortizing status. Also, in the case of negative | | | | In hindsight, the folly is easy to identify, but for those |
| amortization loans, the total loan balance is capped at | | | | involved in the game during the Great Housing Bubble, |
| a certain percentage of the original loan amount, | | | | there was little incentive to question the workings of |
| typically 110% but sometimes higher. If this threshold is | | | | system, particularly since it was so profitable to |
| reached before the mandatory time limit, the loan is | | | | everyone involved. |