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Option ARMs: The Most Misleading Mortgage Product Ever Devised. Worst Than Subprime? You Bet. Looking at Wells Fargo, JP Morgan, and Bank of America.
If you had to create a mortgage that was more toxic and more destructive than a subprime loan, you would have a very hard time creating that product. Yet leave it to creative finance to spawn a devilish product with the unique name of option ARMs. The option ARM is a 30-year adjustable rate mortgage which offers borrowers four different monthly payments. You have the 30-year fully amortizing payment, a 15-year fully amortizing payment, the interest-only payment, and the most popular last option of “negative amortization.” The illusion and Orwellian language of this loan gave the impression that borrowers would have tremendous options in paying off their mortgage.
The facts are disturbingly different for this Jekyll and Hyde mortgage. Over 80 percent of option ARM holders elected to go with the smallest payment. The option ARM is a subset of the Alt-A toxic mortgage universe. In the midst of the major bank failure circus Washington Mutual, Wachovia, and Countrywide Financial all were swallowed up with their option ARMs into the belly of JP Morgan, Wells Fargo, and Bank of America. The three firms are now gone but their option ARMs linger creating banking indigestion.
In California these loans were highly popular with the decade long housing bubble. Imagine paying only $1,479 a month for a $460,000 loan. Things are good with the teaser payment and then the mortgage transforms into a toxic giant that’ll eat you alive. Take a look at a Countrywide loan example given to us in a suit brought on by the California Attorney General:
Things increase little by little until you hit the fifth year. At that point, you run out of options and your payment jumps up to $3,747 and your balance has gone up to $523,792 because of the negative amortization. The adorable little mortgage has turned into a ferocious lion ready to devour your monthly income. Many here in California now find that they are in this situation. They have an overvalued loan with a home that is off by 40 or 50 percent from the peak. You have certain prime locations like Culver City that are loaded up with Alt-A loan products including option ARMs. These will start recasting in mass later this year and into 2010.
In light of the “stellar” earning being reported by financial institutions, the reality is the balance sheet for many is still riddled with toxic assets. The commercial real estate bust is going to force many regional banks under. These option ARMs are going to provide continued losses for each of the major banking players on Wall Street. The only exception would probably be Goldman Sachs who didn’t drink the poison they were selling.
As it turns out, option ARMs are even more toxic than subprime loans. Here are some facts to chew on:
Option ARMs
36.9% of loans are 60 days past due
19% in foreclosure
Subprime
33.9% of subprime loans 60 days past due
14.5% in foreclosure
To add fuel to the fire, most of these loans are in the states with the biggest bubbles. Let us take a look at Wells Fargo and glance at the Pick-A-Pay portfolio:
68 percent of the balance is in California. Another large portion is in Florida. These loans are toxic and will be major losses for the bank going forward. Yet there is a surprising trend going on. Even though notice of defaults are sky high, you are not seeing the foreclosures hit the market. I have heard from many that have gone past 6 months without making a payment and they are still waiting for that notice of default. Why are banks not moving fast? Hard to say but it is probably because they are waiting for the public-private investment program to dump this stuff off to taxpayers or are simply overwhelmed by the amount of foreclosures they are seeing.
Many of the option ARMs will recast in 2010 with the peak being reached in 2011. If you look in the treasure chest of JP Morgan, you will find the artifacts left by WaMu:
These loan products were only useful in a gigantic once in a lifetime housing bubble. They do not serve any other purpose. I remember someone telling me that most of these loans were for “doctors, lawyers, and those who don’t want to document their income.” At least they got one of the three right.
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The Whitney Tilson housing presentation compiles a lot of info, and arrives at the typical conclusions. They state the following as the second of only 2 reasons for the bubble:
“2. The entire system – real estate agents, appraisers, mortgage lenders, banks, Wall St. firms and rating agencies – became corrupted by the vast amounts of
quick money to be made.”
To include real estate agents, appraisers, and loan originators for the bubble is now a cliché joke. It’s like blaming stock brokers for the stock market bubble, or the blackjack dealer because a gambler lost everything.
Brokers and originators do not make loan products or underwriting guidelines. Appraisers cannot fabricate comparable houses that have sold. Real Estate agents cannot force a person to buy a home they do not want, especially on a scale to affect the national housing market. No, you have to look at reasons with much wider impact.
They completely missed the reasons that led the FED (a cartel of banks) to lower rates so far for so long without which there would be no bubble. Remember these late 90's buzzwords? - downsizing, outsourcing and rightsizing, dot com bust and 9/11. Exceedingly low interest rates triggered everything afterwards, then as rates started thier ascent in mid '04 until march '06 the average home price was out of reach for the average consumer. Buying, then appreciation slowed and the bubble began to burst. You see it wasn't the cost of the house, but the cost of the money that mattered. But now we still have the same problem that existed in the late 90's, namely jobs, that was masked in the 00's by all the cheap money that kept the economy going, making our current situation all the worse for the additional debt.
The presentation states typically that regardless of the underwriting standards used to make loans, the loans would simply be sold into the market. In actuality you need a ready and willing buyer to buy a product. Without demand, there would be no creation of that product. It was really greedy investors trying to maximize returns (that's their job) that created a huge demand for mortgages. This led to less quality via reducing underwriting standards in order to make more borrowers who were lining up to bid up the prices of housing in order to get in on a piece of the action. Also check out The CRA for more on that. Of course the rating agencies were looking at past performance instead of actual quality to rate subprime products – another big problem.
This post could be a supplement to the Whitney Tilson housing presentation. I would highly recommend looking over this--it's long but a very, very good macro shot of the housing situation.
http://www.moremortgagemeltdown.com/charts/index.html
Unfortunately this is the typical article that demonizes the industry for offering choices – which I am all for since this is still America.
Although I never liked Option ARMs, these loans were popular with end users for a reason, borrowers just wanted the lowest payment possible. Contrary to most of what is written nearly all the people who took one of these was not forced into it but asked for it.
We live in the land of no personal responsibility. In every thing Americans do, it is always something or someone else’s fault and articles like this continue to reinforce that thinking.
I had a customer that no matter how many hours (literally) I spent explaining why the 30 year fixed was a better loan for her than an Option arm, she took the option arm (from another lender!), even though it had a higher start rate and a 5%(!), 3 year prepayment penalty, she just wanted the lower payment!
Statements like this are simply ill-informed and do a great disservice to in perpetuating wrong thinking;
"These loan products were only useful in a gigantic once in a lifetime housing bubble. They do not serve any other purpose."
I am not for doing away with these loans because there may be an instance, however infrequent, where it may suit a borrower well. I suggested the use of one for one borrower and it worked out perfectly for her needs. How? This borrower was looking to downsize and found the home of her dreams. She needed to buy it quickly or risk loosing it. She refinanced her existing home to get cash out with an Option ARM, which got her the 20% down payment for the purchase of the new smaller home as well as qualify for the additional 30 year fixed rate payment on the new home. The lower option ARM payment allowed her to make both payments until the old house sold, which it did, and she lived happily ever after.
During the boom, people commoditized mortgages and were only shopping for the lowest rate and payment when they should have been shopping for a mortgage professional.
I hate to be critical of the writer and I hope this is posted because it is so important - using absolutes is never a good thing. The pendulum is swinging too far the other way. Like anything else you can buy, if used incorrectly it can be dangerous. Consumer education and personal responsibility is the key to safely using any product. Whenever there is a reduction in choices the consumer suffers. Having the government dictate what is 'right' for you is wrong unless you are willing to give up your freedom.
Joe six pack has the right perspective.
You fail to mention that Option ARMS were the products that were written to people buying houses with nothing down; it wouldn't matter what loan they were "given", they would have gone bad. If, instead of option arms, people putting nothing into a house got a fixed rate instead and the loans all went bad, would you drag out all the loan verbiage of the fixed rate product and say fixed rates are the reason for all the toxic products? The answer is no. Option arms are just a convenient excuse. However, when lenders required 20% or MORE down, and gave clients an option arm (or, more accurately, the clients insisted on an option arm), they VERY rarely went bad. Period, end of story. People use statistics like a drunken sailor uses a lamppost - for support. You have to be careful painting such a broad brush on a single product - if you separated option arm products with zero down and 20% down, your argument that option arms were bad would have much more creedence. However, if you in fact did that, you would not have such a salacious story.
A good strategy for people on the brink, is to stop paying your mtg and save it in a savings account. If you'll lose the place anyway, why throw cah down the drain?
When/if the bank comes to collect the house, take the cash you've saved and use it to rent a place and pay off other debts.
That is if these people can act responsibly with money, some will, others have proven they can't save and have no willpower.
What if, by the time the bank comes to take the home, the other bank (where you stashed the cash that you saved by not paying the mortgage) has failed and the FDIC/Federal government is insolvent/not paying insured deposit claims? A (hopefully) highly unlikely scenario/outcome but if you consider it an impossible one, you are kidding yourself. The policy response over the last 30 years to decreasing national production of goods and services (borrow your way to national prosperity) is as unsustainable as the housing/CRE booms were. Eventually, the piper will be paid. Just the two cents of your friendly, paranoid, but fiscally responsible fellow citizen.
Good artice, but you failed to mention one of the most toxic aspects to these mortgages. The banks thru the magic of our crazy accounting rules were able to book the profits from these loans as if the mortgagee was making the full interest and principal payment, regardless of how little they were paying. Of course at some point, the fake profits will disappear and have to be accounted for.
"My neighbor - solid nighborhood 3000sq ft + houses...hasn't paid her mortgage in a year...no big deal...countrywide won't change anythjng for her, and won't take the house, no notice of forclosure or anything...she doesn't even stay there anymore, but thank god she keeps it up"
Interesting, we have some friends in the exact same situation. They have a McMansion in a newer subdivision that they purchased for about double what it is worth today. They celebrated one year of not making payments July 1, 2009. NO FORECLOSURE, no attempt to collect. Again around 3k sq ft. 3 Car garage etc. This is twilight zone stuff to watch, because if the word spreads the entire mortgage system is in trouble.
Very good post Mr. Durden. I do agree that it was problematic trying to read the right side of the legal document accompanying the post but the gist of the post was not difficult to follow. Folks, we've got a very serious problem ahead of us. As the post correctly points out, the Option ARM/Alt-A storm clouds gathered on the horizon represent a VERY serious problem.
But I would like to add that, apparently the lending/borrowing behavior that got us into those storm clouds has not vanished in its entirety. I met a young woman today who is in the process of buying her first home. Paying about $260k in the northeast for a home on about .4 acres. That is not the problem. When I asked her how much she put down, the answer astounded me. What's your guess? 20%? 25%? 30%? 15%? Brace yourselves.
$3,500! It's an FHA mortgage. Perhaps she is the only person buying a home with so little down, but I highly doubt it. So, apparently the overleverage in residential real estate loans which helped get us here has not gone away. The lesson has not been learned. If this is occurring on a widespread basis, we are screwed for a VERY long time.
Anon9798 - I know of a near identical situation (also in the Northeast). FHA program+$8k Fed credit+$10k grant (payable upon refi or sale but I'm unsure if it's forgiven over time). I'm told that the program requires something on the order of no more than 3% of your own funds into the deal and the kicker was that you had to little to no liquid reserves. This particular property is $220k and the loan is $202k with about $2,500 cash to close. I heard this in a passing conversation so I don't have all the details firmed up but you hit it with your comment - the can just continues to get kicked down the road.
JSP,
Thank you for your reply. I failed to mention, I do not believe that this nice young lady obtained this loan solely under her credit. She is delinquent/in default on student loans and her first car loan. She stated that the car she is driving now was purchased by having her mother co-sign on the loan. So, the mortgage may not have been obtained using her credit (hopefully) or may have (in which case I am more horrified). After what has gone on to see this lack of personal accountability/responsibility be so widespread up and down society is what concerns me most. Most folks have not learned their lesson. So, when this all blows up (a year or two or five or ten), it is going to blow up VERY badly.
Again, thank you for your reply.
Again, very similar details to what you've mentioned in the situation I'm familiar with: extensive unsecured debt with much of it on limited time promotional rates. I asked, 'were you approved based on those promotional terms?' and was told 'yes'. When I asked what the solution was when these debts recast to a standard APR and the reply was simply, 'roll them onto another card at a low/zero rate'. The problem (or at least, one of the problems) is, those seem to be getting more and more rare.
My feeling is that yes, you are correct in that the next 2-5yrs or so will experience another similar event to that we're experiencing now with mortgages but I believe this time the reason for it will be a little different. Everybody knows the RE market is down. People know and/or are finding out that (for the most part) lending has become more strict than it has been over the past 5yrs. We all hear about how bad the foreclosures are and how high unemployment is. I see the entitlement/bailout mentality taking over and those who are getting into homes may just become another number. Default on the unsecured, file Chap 7, skip a year or so of mortgage payments before getting an NOD. Become another 'victim of the economic downturn'. The more government programs made available to backstop, shore up, prevent, 'level the playing field', etc will stretch out the inevitable a little further each time until there truly is no going back.
My fingers are crossed that personal responsibility will make a comeback sometime during my lifetime.
No more 0 rate CC...read the fine print...3% min. on any $ trans.
The word will spread. Happening all over the place. Have a friend in Sunnyvale, CA who stopped paying mid to late last year. Just received default notice a week ago.
BTW, the financial system is broken/melted down already. It's just been papered over for the last (by now) 12+ months with taxpayer fiat dollars. Most folks don't seem to comprehend the magnitude of what's coming down the pike either as the result of ignorance or pollyanna-ism. It's very sad.
My neighbor - solid nighborhood 3000sq ft + houses...hasn't paid her mortgage in a year...no big deal...countrywide won't change anythjng for her, and won't take the house, no notice of forclosure or anything...she doesn't even stay there anymore, but thank god she keeps it up....been for sale for 18months and has lowered the price by 30% to 20% below county tax appraisal...
When that house sells, things are turning, screw the bs numbers from ws et al..
Hey Zerohedge, this column is too skinny to read easily, all these columns on your new blog are too skinny. My eyes hurt having to zoom back and forth. Your blog is hard to read now. Consider this, please.
Resize Browser and Text. -no eye strain!
Among many other things (patience please) we are working on an iPhone friendly version of the website.
yay!
I want a blackberry link.
I wish I could read this article properly, easily.
This new website SUCKS!!!
The blog site was plain and simple. Easy to read.
Hard to tell what is new here and what is old.
This website is a clusterfuck.
Make the window wider.
(Hey. That sounds like I have some kind of speech impediment)
Lenz Crafters can fix that problem in about an hour....
Yeah this was a product you would not give to your worst enemy, I never sold it. But Countrywide was the first lender pushing it to the max, as World/Golden West & Wachovia I'm sure started lowering their teaser rate to compete. Everyday you would see the ridiculous 1% flashing on the CWBC site. It truly makes me sick, hopefully Mozilla will see some time off the streets. I did worry how a more conservative lender at one time like World, which did reamortize their loan everytime you made a payment so realitistically you could reamortize every 15 days and have interest calculated on a new balance and recasted every 5 yrs and had the 7.5% payment cap (also had their own inhouse conservative apprsl dept); how they were going to ever think of competing against 1% opt Arm. I thought they might have had a chance since they lasted for over 100 yrs. I've lived thru many bus cycles and knew there was something more sinister about this market. Never like any of the subprime lenders either unless they were a bank like Staten Island (SIB) and for awhile liked Fremont til they did away with the 60 day window on their ppp. I just wish these LO's that did the wrong thing and put ppl in these programs for highest yield spread and % of sales price commissions when they knew they could have put them in something stable, conservative and best for their financial future, as well as something they could afford, I hope they have trouble sleeping at night or what goes around comes around. I think I would get great enjoyment help putting them behind bars.
No one in authority wants your assistance. Too many prople made too much money refusing to offer stable mortgage products for which the applicants were qualified because the commission structure made offering stable products a money losing proposition. I jumped for joy when the New Century's of the world imploded and I will do the same when these loan books take down a TBTF institution or two. Sooner or later the Fed & Treasury will have exhausted the means of the nation in the futile attempt to keep the ponzi game rolling along. Until they have we are left with little choice but to stand back and break out the popcorn
Great post paul! I'm investing in plenty of popcorn
I think they'd rather own the land now that they've realized there is no market per se for paper. It's too bad....they're poor losers. I prob did only a handful of subprime, I was actually counted myself blessed. And now I am understanding why we couldn't show rate sheets and give out cr reports, oops, sorry! That's how I taught my clients, how they're ripped off and how the money's made. Guess I didn't know where the big money was made. What pisses me off is I made one loan and one fee and they made multiple commissions, slicing up my loan is a billion pieces in trusts, bonds, and multiple alphabet soup and they were paid on the transfer of hands many, many times, on the way up and on the way down, making bets on bets, covered or not. Guess I was in the wrong business. Gotta find a new profession, but I feel brainwashed.
I may be reading this wrong, but it sounds like you're saying a lot of homeowners were taken advantage of with these products. Sure, these loans are absolutely insane and as the article states, they were a product of the bubble, but the homeowner/speculator/end-user for one reason or another thought this might be a good idea for them. I know of MANY borrowers who were advised NOT to take these loans and they did anyway. Countless numbers would walk away from a sensible loan and go to another firm to get buried with an OARM. Only when prices began to fall did the tune begin to change and you'd start hearing a lot more about 'I didn't know', 'I didn't read what I was signing', 'I thought the value of my house couldn't go down'.
For all refi's, these borrowers had at least 3 days to review the paperwork before it was official. How many did? How many still justified to themselves that it was still the right thing to do? How many projected out 6+yrs to see if they could even come remotely close to making the payments? How many looked at the amortization schedule and sh*t themselves?
I wouldn't have touched these docs with a ten foot pen if it were on my property. The program didn't make sense to me but it was an option available to those who thought they may benefit from it. I know, I know, there were plenty of corrupt of brokers out there who pushed these on people unwittingly and possibly committed outright fraud with the docs, but I firmly believe they were the exception and not the rule.
For anybody buying a home, selling loans, or involved in real estate in general from 2003 - 2007, they knew that it couldn't sustain itself over the long term. Those who say otherwise either weren't sophisticated (read: smart) enough or wanted to disillusion themselves to believe that it could go on and on. It always comes to an end...
Read Manias, Panics & Crashes by Kindleberger. We've been pumping and popping bubbles for hundreds of years and will continue to do so.
JSP
I'm just saying the minute I saw this product I thought whoever created it should have gone to jail. The product was dangerous. I 'grew up' with adjustables (Home Savings) and was not afraid of the adjustable product, as mine & World's was portfolio, we also had our own conservative in-house aprsl dept and required a large downpmt. True, it was the subprime at the time and manually underwrote. There were certain adjustables you definitely wanted to stay away from like 1% int cap=29% increase in payment, 10 yr recast, no reamortizations w/pmts and such. As with usual market cycles, what goes up must come down, neg am usually ate itself off in those times. Corruption and greed mixed into this whole financial mess, and you have subprime lenders and derivatives totally unregulated to the degree of regulating risk is something different. Yeah, many fall into that category. I just wish it didn't start at the top because now it's harder to prosecute. The takeover has started, ball has been rolling and I see no end in site. And I was a processor for 20 yrs and saw first hand, rarely did my bor know what the prod was or how it worked, they thought they were getting a fixed rate, and when I explained it to them, were very upset. When I would go to the CEO and explain the illegalities of this, who lost their job, I did. I was not considered the money maker in the mix. I became a LO in 2000 to try to make a difference, teach ppl the TRUTH. 50% of all mtg bkr's in FL were convicted criminals, they didn't have time past 2006 to do background cks, I've always been fingerprinted and federally bonded working at Chase, etc. If we don't clean house from within we'll never catch the crooks on the outside.
i guess green shots will be coming in waves, it's ironic that they chose the 5 th year before the huge leap forward (in the USSR those were magic numbers as well ..)
Wachovia acquired the biggest option ARM portfolio in the world when it acquired Golden West Financial in 2006 to get their hands on the Golden West Pick-A-Pay product. Nice move, G. Kennedy Thompson.
I shorted loads of the stock when the news broke, which was a nail biter, but I held and it paid off. Wish I had puts, but the point is, I think I'll get another crack at making money on that same loan portfolio.
Wachovia didn't stop offering these option ARMs until mid 2008 -- I'm dead serious. Now Wachovia is owned by Wells Fargo, and Wells may very well be destroyed by this toxic ball of radioactive waste that buried the fifth largest universal bank in the country. Obviously, Wells hasn't paid back any TARP, and I firmly believe it's because they're going to need it, and more. And this may be the first time in recent history that Warren Buffet gets his ass handed to him on a big investment, and I bet it sends him to the grave. I hope not, though.
I agree with this, but you have to be careful because WFC is unloading these loans privately and thus the transactions aren't hitting the market which would force repricings on whole portfolios. Now they can pick and choose what they are writing down without impacting the rest of their portfolio. This was quietly reported recently.
When I saw the article, my first thought was that it would mention the Sandlers and Golden West Financial. I believe they pioneered the option ARM. I have vivid memories of advising clients NOT to enter these "traps."
I sadly concur with the WFC and BRK-A comments. I have had some success with covered call strat on my WFC position. Will bail soon as the CRE will hit the fan in short order.
this sh*t is not going anywhere...
Still doesn't sound too scary, actually! Here in South Africa we pay around 1% of the property price per month, and a common mortgage is 20 years. So $500 000 house would be around $5000 a month. Some of us try to put in as much extra cash as possible in order to pay it off sooner. I pay the credit card off each month, or leave it in a positive balance because the interest is better than my current account.
I mention that because it's obviously a different universe. The future for America probably lies between the two extremes.
Wow, here in Canada, a 6.5% mortgage with a 20-year
amortization would cost you about $3,700/month. Over
the course of 20 years, you pay $1.2 million and I'd
pay less than $900,000. Plus I get to watch hockey.
Great post - appreciate the guest contribution
Great post. Thanx a ton. And thanx to Chris Martenson, i put my vegas house up for sale literally the day after watching his crash course presentation. the day after. done and out dec 2007. whew, just barely.
Did those who knew you call you reactionary or irrational?
Just b/c you act quickly on new data, often contradictory to the current paradigm, it doesn't mean you are a flake. Au contraire.
Caongrats on getting out.
Yeah, still remember that loan officer telling me I could afford a house nearly 12x my annual base. Good thing I ignored him or I'd be living in a three-bedroom cardboard box right now.