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The Death of the Option ARM and Negative Amortization

By Shailesh Ghimire, June 30, 2008 at 8:00 pm

Negative amortization was always controversial. Option ARMS (Pick-a-pay) always have had a negative amortization feature. In fact this loan has always been World Savings bread and butter. For the financially savvy person this loan makes complete sense. It has features which allows you to lower your taxable income, decrease your cost of funds over the long term and if used with a carefully calibrated investment strategy allows you to maximize returns to the max. Within this context negative amortization is a well accounted for risk and balanced by high returns. Even if on a short term basis you ended up with some negative amortization, over the long term, you would come out ahead.

The problem is the average consumer is not tremendously financially savvy. And therein lies the problem. When option arms were marketed to the average Joe as a financial vehicle, loan originators who themselves are not tremendously financially savvy saw an opportunity to sell more house for lower monthly payment. I’m not trying to put the onus solely on the originator here either. I am of the opinion that the head of every bank in the United States fully knew what they were selling to the average borrower.

I remember a borrower a few years ago who insisted beyond any reasonable persuasion that he wanted to be in such a loan. He said that the payment on the 5/1 ARM I was proposing was to high and he wouldn’t’ be able to afford the house after a few years. However, with the option ARM a different lender had proposed he would be “comfortable”, so if I didn’t give him a similar option he was going to go with the other lender.

This borrower had no business being in an option ARM. Not only was he relatively financially unstable, he was trying to live way beyond his means, counting on future income and future equity to compensate for the short term loss. This was never the market for the option ARM and these types of borrower had no business being in this type of loan. In fact I wrote a post back in 2005 warning borrowers about the dangers of the option ARM. I wanted to remind folks that despite how things were being advertised as a borrower you are still obligated to pay back the full loan amount with any accumulated interest.

And it is because of stories of such borrowers over the past few years that today we sit where we are. Today, Wachovia, one of the largest underwriters of option ARM’s pulled the plug on these negative amortization loans. Here is the news clip from Fortune magazine:

Wachovia (nyse: WB - news - people ) announced Monday that it is pulling the plug on it’s Pick-a-Pay program. The pay-what-you-will exotic loan offerings weren’t exactly subprime –the borrowers were a bit better-heeled Alt-A types– but the default rates on the loans have been much higher than expected and have been driving the lender’s losses.

The loans gave borrowers the option of paying several amounts each month, including low payments that led to an increase in the principal amount of the loans.

Not only did they stop the program they also have said they’ll waive the prepayment penalties on these loans as well. Most option ARM included three year hard pre-payment penalties. So whether you sold or refinanced the loan within the first three years you had to pay a prepayment penalty. With the fall in home prices adding to negative amortization more than they had figured things are not looking good that the banks can make money on these. So, Wachovoia took a long hard look and decided to cut their losses. According to Housing Wire:

Wachovia also said it will waive all prepayment fees for borrowers looking to refinance out of an option ARM, a clear indication of the stress borrowers in such loans are now facing; the bank recently hired Goldman Sachs Group Inc. (GS: 174.90, +0.19%) in an effort to help it figure out what it should do with the Option ARM loans on its books.

As you can tell it’s not just the consumer who is in pain here, Wachovia is hurting too.

Mortgage Blogs, News and More… Weekly Roundup

By Shailesh Ghimire, March 27, 2008 at 1:53 pm

Today I begin my weekly Thursday series rounding out the weeks major mortgage related events and stories from around the mortgage blog-o-sphere and beyond. This is where I try to make reading about mortgages more exciting than watching two female teachers fight in front of their students! So, let’s begin…

Polls and People

A recent poll by Rasmussen finds that 53% of Americans are opposed to a Federal bailout for homeowners. Last December Rasmussen had found that 54% of Americans blamed the individual borrowers for the mortgage crisis.

With those numbers on my mind I found it hard to watch a video on Mortgage Ciceron’s blog of a woman who lost her home because she was talked into one of those exploding ARM’s. Truly a sad sad story and a very heart wrenching vlog.

Back to the Future… Lisa Simpson’s Nightmare

Remember the Enron story and how Arther Anderson disappeared because of it? Well in an eerily similar story we have an investigator accusing KPMG of allowing, New Century Financial (subprime darling until 2006), to report a profit, rather than a loss. Will they never learn? Reminds me of Lisa Simpson’s confusion when Homer became a Springfield police officer “… if you’re the police, who’s going to police the police?” (Homer the Vigilante)

Down But Not Out

Of course the big news maker this week was the home price index showing record declines, Alex Stenback argues there is no such thing as a national real estate market. He breaks down the media headlines with great clarity. In the mean time, CNN Money has a great article on why now could be the best time to buy reale state.

Campaign 2008 Watch: Who wants to fix what, and how!

All three Presidential candidates had something to say this week about the mortgage industry and financial markets. McCain seeks common sense solutions with minimal politics and government involvement. Obama wants tighter regulation and blamed Bill Clinton among others for the mess we’re in. Hillary wants direct federal intervention.

I’d hate to close this post with a Hillary piece so let me tell you an engineer joke. To the optimist, the glass is half full. To the pessimist, the glass is half empty. To the engineer, the glass is twice as big as it needs to be.