I'm just a retail broker from Canada and I could see this coming 2 years ago.
Hmmm... lets loan somebody 100% of their purchase price with no documentation of their income... oh yeah, we'll also only make them pay back the interest... and the house has already apreciated 75% in the past few years.
I cant believe how the banks thought this was a good idea.
cariboo_kid, This seemed so obvious. I wonder why BusinessWeek and others didn't run these stories a couple of years ago? Maybe that would have helped some people.
Of course Greenspan was suggesting ARMs were the way to go:
"... many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.
...
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."
Alan Greenspan, Feb 23, 2004
It seemed like a reasonably smart thing last year to take out an option ARM - "buy as much house as you can afford" "the prices will always rise.."
Now it seems incredibly foolish to take out a large loan with small initial payments that balloon in the years ahead. A very top heavy and unstable situation.
I think the psychology has shifted..
When was it that Krugman wrote that column about how he'd refinanced to a fixed rate mortgage? 2002? 2003? Yes, he pulled the trigger too soon, but he did correctly see the gathering economic forces and responded correctly.
ousider, Krugman wrote that piece in March '03. According to Freddie Mac, 30 year rates were 5.75% then. That was pretty close to the lowest rate in this cycle (5.23% in June of '03 - maybe Krugman refi'd again!). Of course Krugman could have waited until early '05 to get a similar rate and he would have paid much less on an ARM for those two years. Still, overall, pretty good timing and great advice!
Kind of the opposite of Greenspan who suggested usning ARMs at almost the exact wrong time.
Hopefully this will inform consumers not to take such dangerous products. It is increasing clear that the lenders will do nothing to stop the easy money.
I have a question regarding mortgage based securities worth trillions of Dollars.
Who is bearing ultimate the risk of default in these products? I was puzzled by the news that the originators had to buy back these securities because of nonpayment.
If economy slows and defaults and foreclosures increases then ı am afraid we are facing a systematic risk endangering global financial system.
Dr.Roubini seems to be spot on.
The buyback period is only anywhere from the first 30-90 days. This encourages the banks to have the lowest standard possible as long as they get the first 1-3 payments in it isnt their problem anymore.
Reading some of the commentary yesterday from some Wall Street wags-
"Housing will be ok, the economy is great- we are getting a soft landing, Bernanke is a genius.....or even over at CNBC a new method of predicting the housing sector says that sales will be up for the rest of the year"
Or the percieved slowdown in the economy because of the slump in housing has been great overstated....."
I guess many of us here then are old ladies wringing our hands- go out and buy!
And yu know how most new buyers are deeply familiar Alan Greenspan's nuanced statements. Not so nuanced is the brokers and lenders, who subsequently rammed the idea of ARMs down said new buyers' throats, since often, the riskier the mortgage, the bigger the commission.
And yes, CR, all through this, the press band played on. So sad -they could have played the role of consumer advocate instead of industry bullhorn, but now it's too late. Thank God the blogs were able to get to at least some people before they made the biggest financial mistake of their lives.
Herb Sandler never disappoints me. Never. Just when you think youve heard the most ridiculous comment ever, Herb steps up to the plate and gives a mighty swing:
It's not the loan that's the problem, says Herbert M. Sandler, CEO of World Savings Bank, parent of Golden West. The problem is with the quality of the underwriting.
Uh, Herb, the Option ARM in its current incarnation was designed to get around the little problem of "quality of underwriting."
Yesterday I spent some time rooting around in WAMU's latest financial statements in response to an issue raised in another post, and I found this gem in the footnotes to the latest 10K (italics are mine):
Certain external factors have, over the last five years, contributed to a reduction in the credit risk inherent in the Option ARM portfolio. The two most significant economic factors affecting the Option ARM portfolio are prepayment rates, which operate to reduce the risk of payment shock in the portfolio caused by the 60-month recasting event, and changes in housing prices, which affect current loan-to-value ratios. The risk of payment shock is reduced because many Option ARM borrowers will prepay their loans prior to the occurrence of the first 60-month recasting event. Furthermore, credit risk usually diminishes when housing prices appreciate. Option ARM loans originated prior to 2005 have benefited from a longer period of housing price appreciation than loans originated in 2005; with such earlier originations accounting for 62% by balance and 71% by number of Option ARM loans held in portfolio at December 31, 2005, current loan-to-value ratios have generally improved in many cases offsetting the credit risk associated with negative amortization that may have resulted from the borrowers use of the minimum payment option.
Translation: "Forget all that crap we said about responsible underwriting. Cheap refis and bubbly house prices have been keeping these dogs afloat. Unfortunately, the 2005-2006 vintage appears to be screwed."
Or as someone said recently on another subject (I find news items to be largely interchangeable these days):
In retrospect, said Michael A. Sheehan, the former deputy commissioner of counterterrorism in the New York Police Department, there may have been too much hyperventilating going on.
cariboo hits the nail on the head, stating the problem as clearly as I have ever read. Well done.
And k harris, I agree that no one should use an ARM who is not financially sophisticated, but I don't buy your rationalization that Greenspan's advice was ONLY intended for those people.
I have never considered, and would never consider, using an ARM. There is simply too much risk involved for an ordinary Joe like me. Like many others how had fixed rate loans pre-2001, I instead refinanced my fixed into a lower rate.
There is a related article in the WSJ this AM: Housing Chill Begins to Pinch Nation's BanksBanks have ridden the real-estate boom over the past five years by pitching traditional loans, newfangled mortgages and home-equity loans that can be used to pay off credit-card bills or fund a new plasma-screen television.
While the banks reduce their exposure to these loans by selling some of them into secondary markets, real estate still amounts to a chunk of their assets.
As a result, real estate, including mortgages, home-equity loans and commercial loans, represented a record 33.5% of the U.S. banking industry's $9.298 trillion in assets in July, according to the Federal Reserve. The numbers represent the highest level in the Fed's database going back to 1973.
...
the mortgage market is filled with new types of loans that were far less prevalent -- or didn't exist at all -- in previous housing downturns. These products, such as interest-only loans or adjustable-rate mortgages in which the borrower can choose from multiple payment options, are viewed as more risky than traditional fixed-rate mortgages. The trade association says that fewer than 25% of all mortgages are adjustable-rate loans.
"The oldest saw in banking is that bad loans are made in good times," Keefe's Mr. Cannon says. "We have never really faced a weakening housing market with the structure of the mortgage market as it is today."
CR, HERE's a line from the Bus. Week story I wasn't aware of:
"banks don't have to report how many option ARMs they underwrite."
I don't recall seeing ANYTHING in the suggested policy changes rectifying this, do you? THIS WOULD BE ABSOLUTELY AMAZING!
Hey, Bailey. It seems like you and I are never awake at the same time lately.
Financial institutions have to report "nontraditional mortgage" information to their regulators, and the draft guidance makes the reporting requirements more detailed and stringent.
But the SEC doesn't require publicly-traded banks to report to the public everything they have to report to the regulators. And non-public banks don't have to report squat to the public.
The public institutions that have been providing optional details about their Option ARM portfolios lately--like WAMU--have been doing so because the stock analysts and rating agencies have been forcing them to answer some questions. I know I sleep better when I have to rely on stock analysts.
outsider: Timing an event that will (or just may) happen at an unknown point is always a crap shoot. That the event does not hit randomly, but the shakers and movers can bring it about at will or delay it by changing economic parameters mostly unpredictably doesn't help either.
Hey Tanta. Seems like old times, me thanking you for clearing up some of the "small" stuff very few seem to even question these days. I did read the OCC guidance (I even listened closely to a recent talk Dugan gave for hints), but I missed this. I know "the SEC doesn't require publicly-traded banks to report to the public everything they have to report to the regulators", but it's something I periodically forget. It's just too hard for me to reconcile, I guess.
I hope every day's better for you & this one's better than most.
As a former business reporter and current mortgage lender, this BW story is misleading. Or doesn't fully understand the Option ARM product. I'm not saying that there isn't a problem, but the problem is not described correctly by BW. (I've never originated an Option ARM because because I never had an appropriate borrower for this loan.)
Option ARM are no greater evil than traditional ARMs or interest only loans.
Option ARMs are complicated to explain but payments aren't about to skyrocket. The payments have been steadily going up because of rising interest rates.
Let me explain how it works. There are 2 rates in an Option ARM, a real underlying interest rate and an artificially low rate. The real rate adjusts monthly and immediately when the loan begins. The real rate is typically the moving average of the LIBOR (typically 6 month) or the MTA, the 12-month Treasury moving average. And index plus a fixed margin. The margin can be anywhere from 1.5 to 3.25%. Once chosen, the margin is fixed, and the margin is where the lender makes its profit.
The artificially low rate is offered at 1% to 3.9% depending on the lender. The fake low rate is fixed for year, then steadily adjusts.
For example, we have a home value at $375K, and a loan of $300k. (The loan is 80% of the appraised value. The same rules apply with the Option ARM as with any other loan. If you don't have 20% down, then you have PMI or a second mortgage to avoid PMI.)
Let's use 2% for the artificially low rate and the 6-month libor (today at 5.45%) and a fixed margin of 2. So today's real rate is 7.45%.
So in our example, the 4 options are:
1) a fully amortized payment with an artificial rate of 2%. The payment on a $300K loan at 2% is $1,108.85. (The payment doesn't not include taxes and insurance)
2) Interest Only payment of the real rate. Interest only is simple interest, and the payment at 7.45% is $1,862.50.
3) Fully amortized payment at the real interest rate on a 30-year term. At 7.45% fully am, the payment is $2087.38.
4) Fully am on a 15-year schedule. Payment is $2,772.52
I'm sure no one uses option 3 or 4.
If the borrower uses Option 1, then the loan will negatively amortized. Since the real interest rate is 7.45, paying $1,108.85, the loan balance will increase by $753.65 to $300,753.65. (300,000 + 1,862.5 - 1108.85). Over a year, your principal will grow by $9K at the fake rate and payment.
The fake low payment is set for a year, then increase by 7.5% each year.
1,108.85 X 1.075 = $1,192.01
If you choose to pay option 2, then your balance stays at $300K. At some point, generally after 10-years, the loan will be forced to amortized at the prevailing rate, otherwise the balance will never be paid off.
To qualify for the Option ARM, lenders use higher scores than FannieMae or FreddMac. High 600s, although the qualifying scores have dropped of late. Plus the borrower has to qualify at the real rate (7.45%) not 2%.
The benefit is if you are in a house for 2 to 5 years, then it's a great loan keeping your payment low until you move or trade up. And the LIBOR and MTA had been 2% lower two years ago.
Lenders don't do 100% with Options ARMs because they typically cap the negative amortization at 115%. The danger comes even at 80LTV (loan to value) the house drops from $375 to some lower value.
Why someone would get a Option ARM (or a traditional ARM) for their house which they expect to keep for a long term is a mystery.
Traditional ARMs have been better than Option ARMs because of low fixed rates. Why get an Option ARM where the underlying rate adjusts each month? A tradition ARM is fixed for 3, 5, 7, 10 years. And those rates have been below 6% until this year. 3-1ARM had rates in the 3s when the Fed Funds rate was at 1% at the bottom of the easing cycle.
BW says that brokers are paid more for the Option ARM. THAT IS NOT TRUE. Brokers are paid with origination or discount points like any other loan. And/or with the fixed margin. Our example used 2 as the fixed margin, the higher the margin, the more the broker is paid.
And the police officer example in the story about a prepayment penalty: that is no different than any mortgage. The prepayment penalty is spelled out and must be signed at closing. Even if you don't understand the amount of penalty, you understand that one exists and that you signed. You can't blame that on the lender.
The traditional ARMs are more the danger because they will be adjusting in the next couple of years. Even then, that's a slow growing problem. If you have a 4% 3-1 ARM, the rate typically only adjust by 1% or 2% (depends on what loan product) per year. It won't go from 4% to 8% in one adjustment.
Hue: Why somebody would get an option ARM for a house where staying put is while perhaps not the primary but a possible scenario is no mystery to me at all.
I have met people who did this precisely because this was the only way they could afford "the payment" here & now. (Well, there & then as this was some time ago.)
Hue: thanks for the detailed post. I think we agree that these loans are generally a bad idea. I still don't think most borrowers understand all this, or that most mortgage brokers and loan officers explain it very clearly. There was some guy on a CR thread not long ago who was going on about how his mortgage payment with an Option ARM was actually "negative carry," because he's convinced that his accrued but unpaid interest is tax-deductible. Let's hope for his sake he gets disabused of that before he tries to claim it on his 1040, but the point is I bet he got that idea from his broker, who got it from some goofball website. And I think we can agree that I dont think Ill stay in the house that long is right up there with Im sure Ill continue to get bonuses and stock options every year and my income will keep going up. Maybe, maybe not, but you wouldnt be the first person who didnt get a pony. It used to be the role of the underwriter to break this sad news to people. Now were supposed to use the borrowers confidence that the future will go as planned to justify making the loan.
And even if you want to take the position that the borrowers are to blame for not reading or understanding their loan documents, you have to wonder at the enthusiasm with which lenders have been making loans to borrowers who dont seem to be reading the closing documents before signing them, or who seem to put as much weight on what they read on the internet as they do on the actual covenants in their promissory note. Theres paternalism and then theres plain old watching out for your counterparty risk, and the apparent alertness and attention span of the counterparty is a relevant fact. I have no time for anyone who uses informed rational agent assumptions in their risk models and then refis someone out of a 5.25% fixed rate into an Option ARM. Either you change your risk model or you refuse to touch that sucker-born-yesterday loan, and it has nothing to do with paternalism. I didnt realize that the borrower was an idiot is no more respectable an excuse than I didnt realize my payment could go up.
I do take issue with this part of your post:
To qualify for the Option ARM, lenders use higher scores than FannieMae or FreddieMac. High 600s, although the qualifying scores have dropped of late. Plus the borrower has to qualify at the real rate (7.45%) not 2%
Higher scores than Fannie and Freddie for the same product? I don't think so. Fannie and Freddie dont buy Option ARMs. Comment continues below:
Furthermore, as you know, the credit score FN/FH will accept depends on what their automated underwriting systems think of the entire picture of the loan, including down payment, documentation, LTV, etc. Both agencies generally state 620 as the minimum FICO they accept for A quality loans in general, but its misleading to compare that to a 660 minimum on an Option ARM and say were stricter than the agencies.
What you dont mention is debt-to-income ratios. It doesnt matter if you use the fully-indexed rate to qualify a borrower if you at the same time raise your maximum DTI from 38% to 45%. Here are the guidelines from the first broker hit I got on Google for Option ARM maximum DTI:
\t95% Purchase 650 score, 40% DTI, full documentation (80/15)
\t90% 640 score, 45% DTI, full documentation (80/10)
\t90% 695 score, 45% DTI, Stated No Income Verification (75/15)
\t80% No min. score, 45% DTI, full documentation (20% down can be gift)
\t80% No min. score, Stated No Income Verification, 45% DTI (no 4506 or 8821)
\t75% No min. score, Stated No Income No Assets, 45% DTI , up to $1 Million
If my gross monthly income is $5,000 and I have no other debt, my DTI under your example is 22% on the minimum payment and 42% on the fully-indexed fully-amortized payment. And if my car and credit card payments push the DTI over 45%, I can just state a little more income, cant I?
Lenders don't do 100% with Options ARMs because they typically cap the negative amortization at 115%.
Certainly nobody Ive heard of does a 100% LTV Option ARM. But look at the random example of guidelines I just found: a 95% CLTV (80% first, 15% second). Even the broker admits thats hard to get, so lets assume that 90% CLTV is probably the realistic maximum for these things at origination. The three big problems here, which can work in combination, are: a) the value is only as good as the appraisal, and even the best appraisal has a standard acceptable tolerance of 5%; b) almost all of these programs allow the second to be a HELOC, and so even if the line is limited to the amount of the down payment, the borrower can keep it there by interest only payments or subsequent draws; and c) as you note, the negative amortization on the first mortgage pushes the original CLTV upin your example, by 2% in the first year. My point is that there are built-in reasons to think that apparent 10% equity isnt much protection even before we thrown in a softening real estate market.
Option ARM are no greater evil than traditional ARMs
I have met people who did this precisely because this was the only way they could afford "the payment" here & now. (Well, there & then as this was some time ago.)
cm, this is the part that is hard for me to understand because this person must have qualified for the loan with the real rate, higher payment. So to the underwriter, this borrower could afford the higher payment. Unless it was in one of those state income situations. But even at that, you can't state the income that is far above your salary in a particular field in a particular geographic area.
Underwriters are careful not because they care about the borrower, the company doesn't want to own the loan, it has to be legit to sell to the investor.
If that person could only afford the house with Option ARM then that is no reason to buy. But plenty of lenders are willing to originate that loan and plenty of investors are willing to buy that loan. That is the same as buying a house at 100% (with traditional ARMs and seconds)wiht interest only products. Renting a house with a mortgage!
Is it the chicken or the egg? Marketing makes people do this or people come with an idea they have to buy a house, and the lender is just willing to supply a product even if it's a short term fix that will lead to financial disaster?
In my experience, it's hard to talk borrowers out of bad loans, they come with an idea with what they want. And there is another lender whispering sweet nothings to them while you are telling them the truth. But generally I don't win those borrowers. I don't tell them what they want to hear.
And even if you want to take the position that the borrowers are to blame for not reading or understanding their loan documents, you have to wonder at the enthusiasm with which lenders have been making loans to borrowers who dont seem to be reading the closing documents before signing them.
Tanta, you won't find many lenders talking people out of loans or bad loans. And there are plenty of loan officers who intentionally deceive people and hoping they sign anyway.
It's a 100% commission business. Loan officers just originate the loan, sometimes knowing it's a bad loan and looking the other way. A lot of car salesmen went into the biz during the boom. And a lot of people from technology or investments who were forced to follow one bubble to another because of where the economic growth was, even if it's a fleeting bubble. It's a mean of survival or old-fashion greed for the lender or loan officer. They're just sales people who often don't even understand the loan product, and it's not necessary either, to successfully close loans. And thinking about the financial consequences of the borrower or economy down the road? Nah ... If a loan officer could find a comparable paying job, they wouldn't be in 100% commission mortgage sales.
My company is a LendingTree lender, meaning we get leads though LT and that means intense
My company is a LendingTree lender, meaning we get leads though LT and that means intense competition. A lot of time, borrowers go with loan officers telling them what they want to hear. If someone tells you you can get a 30-year fixed at 5.5% (which doesn't exist right now), these borrowers go for that even if the loan is different at closing. They don't back out or not signed. It has been a couple weeks in the loan process, rates may have moved, or they needed the cash, or the sales contract deadline etc. and they end up with the loan that an honest loan office pitched at the beginning.
Often times, borrowers who accept these bad loan are strapped financially at the time, like the couple in the 60s in the BW story. They needed $50,000 in cash, a low payment. Well, that loan doesn't exist, or only exists as an Option ARM. Basically, they can't afford their financial situation. Is it crazy to refinance for any kind of loan when you are in your 60s on a fixed income?
It's easier to blame the loan officer when it blows up down the road. Not to say the LO is without blame. The borrowers are like spouses of cheaters pretending they never saw the signs or saw it coming.
Faced with a situation where either it's a paycheck or telling people they should not do a loan, many loan officer will take a paycheck.
Higher scores than Fannie and Freddie for the same product?
No, I just mean it's generally harder to qualify for an Option ARM versus a vanilla Fannie or Freddy ARM or fixed product.
And that is what I meant by Option ARMs are no more evil because they are harder to qualify for. The entire system is bad, and Option ARMs are not worse. I admit I don't know the accounting issue at the investor level, when to book the payment etc. that BW described.
Higher scores than Fannie and Freddie for the same product?
No, I just mean it's generally harder to qualify for an Option ARM versus a vanilla Fannie or Freddy ARM or fixed product. It's hard to generalize on scores alone, until you run the loan through the automated engines.
Lenders use Fannie and Freddy guidelines and software even though they don't sell certain products to Fannie or Freddy.
And that is what I meant by Option ARMs are no more evil because they are harder generally to qualify for. The entire system is bad, but Option ARMs are not worse. I admit I don't know the accounting issue at the investor level, when to book the payment etc. that BW described.
I'm as apocalyptic as the next guy about housing due to the debt bubble but is anyone else concerned about the sentiment aspect of a major weekly magazine with a bearish front cover on housing? Could be a contrarian signal despite the obvious fundamental problems in the housing market.
Hue said:
"cm, this is the part that is hard for me to understand because this person must have qualified for the loan with the real rate, higher payment. So to the underwriter, this borrower could afford the higher payment."
What? In MD's new "Lifeline" program designed to bail out those who used exotic loans, the site specifically states the interest-only payment is used to qualify the borrower. There is no way that lenders used the borrowers ability to repay the whole loan when qualfiying them, or else these loans wouldn't be a problem, correct?
"cm, this is the part that is hard for me to understand."
I was talking about the original Option ARM that I'm familiar with. The investors my company used for those products required people to qualify with the real rate, fully amortized (option 3 in my earlier example). I'm not familiar with the Lifeline program, or the Option ARM where the borrower qualified with the lowest payment.
Option ARMs are different than traditional ARMs, where some programs allowed people to qualified with the interest only payment.
Because people needed to qualify with the real interest rate, it never made sense for me to originate an Option ARM since a traditional ARM was better with a fixed rate during the fixed period.
A lot of news stories that say the Option ARM payment making sudden jumps don't explain why the payment rocketed. In my experience the minimal payment only goes up 7.5% year over year. The sudden jump to a real payment must have been triggered because of the Neg Am reaching some LTV level.
The other mystery to me about Option ARM is that if people got into those in 2004, the traditional ARM rates were really really low, in the 5s or high 4s at the time. Option ARMs made no sense then either.
Looking at that site, the Lifeline program is for people who are caught in the jam with exotic mortgages. It doesn't talk about how people qualified for exotic mortgages in the first place.
There is no way that lenders used the borrowers ability to repay the whole loan.
No, not the whole loan. It's the payment and rate that is used in qualifying.
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I'm just a retail broker from Canada and I could see this coming 2 years ago.
Hmmm... lets loan somebody 100% of their purchase price with no documentation of their income... oh yeah, we'll also only make them pay back the interest... and the house has already apreciated 75% in the past few years.
I cant believe how the banks thought this was a good idea.
Further proof that not even a blind, semi-retarded donkey with exotic financing could be taken by surprise by a reset.
cariboo_kid, This seemed so obvious. I wonder why BusinessWeek and others didn't run these stories a couple of years ago? Maybe that would have helped some people.
Of course Greenspan was suggesting ARMs were the way to go:
"... many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.
...
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."
Alan Greenspan, Feb 23, 2004
Best Wishes.
Ironic, now California is the most miserable state to live in.
It seemed like a reasonably smart thing last year to take out an option ARM - "buy as much house as you can afford" "the prices will always rise.."
Now it seems incredibly foolish to take out a large loan with small initial payments that balloon in the years ahead. A very top heavy and unstable situation.
I think the psychology has shifted..
When was it that Krugman wrote that column about how he'd refinanced to a fixed rate mortgage? 2002? 2003? Yes, he pulled the trigger too soon, but he did correctly see the gathering economic forces and responded correctly.
ousider, Krugman wrote that piece in March '03. According to Freddie Mac, 30 year rates were 5.75% then. That was pretty close to the lowest rate in this cycle (5.23% in June of '03 - maybe Krugman refi'd again!). Of course Krugman could have waited until early '05 to get a similar rate and he would have paid much less on an ARM for those two years. Still, overall, pretty good timing and great advice!
Kind of the opposite of Greenspan who suggested usning ARMs at almost the exact wrong time.
Best Wishes.
Hopefully this will inform consumers not to take such dangerous products. It is increasing clear that the lenders will do nothing to stop the easy money.
I have a question regarding mortgage based securities worth trillions of Dollars.
Who is bearing ultimate the risk of default in these products? I was puzzled by the news that the originators had to buy back these securities because of nonpayment.
If economy slows and defaults and foreclosures increases then ı am afraid we are facing a systematic risk endangering global financial system.
Dr.Roubini seems to be spot on.
Best Wishes
The buyback period is only anywhere from the first 30-90 days. This encourages the banks to have the lowest standard possible as long as they get the first 1-3 payments in it isnt their problem anymore.
Reading some of the commentary yesterday from some Wall Street wags-
"Housing will be ok, the economy is great- we are getting a soft landing, Bernanke is a genius.....or even over at CNBC a new method of predicting the housing sector says that sales will be up for the rest of the year"
Or the percieved slowdown in the economy because of the slump in housing has been great overstated....."
I guess many of us here then are old ladies wringing our hands- go out and buy!
CR,
Let's remember, though, that Greenspan offered his ARM advice to those who felt they could shoulder the risk. That makes it a whole lot better.
And yu know how most new buyers are deeply familiar Alan Greenspan's nuanced statements. Not so nuanced is the brokers and lenders, who subsequently rammed the idea of ARMs down said new buyers' throats, since often, the riskier the mortgage, the bigger the commission.
And yes, CR, all through this, the press band played on. So sad -they could have played the role of consumer advocate instead of industry bullhorn, but now it's too late. Thank God the blogs were able to get to at least some people before they made the biggest financial mistake of their lives.
sorry bout the typos-but you get the nuanced drift...
classic bubble...
we're entering the last phase of it now, this is when people start blaming previously loved professionals and businesses.
Herb Sandler never disappoints me. Never. Just when you think youve heard the most ridiculous comment ever, Herb steps up to the plate and gives a mighty swing:
It's not the loan that's the problem, says Herbert M. Sandler, CEO of World Savings Bank, parent of Golden West. The problem is with the quality of the underwriting.
Uh, Herb, the Option ARM in its current incarnation was designed to get around the little problem of "quality of underwriting."
Yesterday I spent some time rooting around in WAMU's latest financial statements in response to an issue raised in another post, and I found this gem in the footnotes to the latest 10K (italics are mine):
Certain external factors have, over the last five years, contributed to a reduction in the credit risk inherent in the Option ARM portfolio. The two most significant economic factors affecting the Option ARM portfolio are prepayment rates, which operate to reduce the risk of payment shock in the portfolio caused by the 60-month recasting event, and changes in housing prices, which affect current loan-to-value ratios. The risk of payment shock is reduced because many Option ARM borrowers will prepay their loans prior to the occurrence of the first 60-month recasting event. Furthermore, credit risk usually diminishes when housing prices appreciate. Option ARM loans originated prior to 2005 have benefited from a longer period of housing price appreciation than loans originated in 2005; with such earlier originations accounting for 62% by balance and 71% by number of Option ARM loans held in portfolio at December 31, 2005, current loan-to-value ratios have generally improved in many cases offsetting the credit risk associated with negative amortization that may have resulted from the borrowers use of the minimum payment option.
Translation: "Forget all that crap we said about responsible underwriting. Cheap refis and bubbly house prices have been keeping these dogs afloat. Unfortunately, the 2005-2006 vintage appears to be screwed."
Or as someone said recently on another subject (I find news items to be largely interchangeable these days):
In retrospect, said Michael A. Sheehan, the former deputy commissioner of counterterrorism in the New York Police Department, there may have been too much hyperventilating going on.
cariboo hits the nail on the head, stating the problem as clearly as I have ever read. Well done.
And k harris, I agree that no one should use an ARM who is not financially sophisticated, but I don't buy your rationalization that Greenspan's advice was ONLY intended for those people.
I have never considered, and would never consider, using an ARM. There is simply too much risk involved for an ordinary Joe like me. Like many others how had fixed rate loans pre-2001, I instead refinanced my fixed into a lower rate.
There is a related article in the WSJ this AM: Housing Chill Begins to Pinch Nation's Banks Banks have ridden the real-estate boom over the past five years by pitching traditional loans, newfangled mortgages and home-equity loans that can be used to pay off credit-card bills or fund a new plasma-screen television.
While the banks reduce their exposure to these loans by selling some of them into secondary markets, real estate still amounts to a chunk of their assets.
As a result, real estate, including mortgages, home-equity loans and commercial loans, represented a record 33.5% of the U.S. banking industry's $9.298 trillion in assets in July, according to the Federal Reserve. The numbers represent the highest level in the Fed's database going back to 1973.
...
the mortgage market is filled with new types of loans that were far less prevalent -- or didn't exist at all -- in previous housing downturns. These products, such as interest-only loans or adjustable-rate mortgages in which the borrower can choose from multiple payment options, are viewed as more risky than traditional fixed-rate mortgages. The trade association says that fewer than 25% of all mortgages are adjustable-rate loans.
"The oldest saw in banking is that bad loans are made in good times," Keefe's Mr. Cannon says. "We have never really faced a weakening housing market with the structure of the mortgage market as it is today."
Best to all.
CR, HERE's a line from the Bus. Week story I wasn't aware of:
"banks don't have to report how many option ARMs they underwrite."
I don't recall seeing ANYTHING in the suggested policy changes rectifying this, do you? THIS WOULD BE ABSOLUTELY AMAZING!
Hey, Bailey. It seems like you and I are never awake at the same time lately.
Financial institutions have to report "nontraditional mortgage" information to their regulators, and the draft guidance makes the reporting requirements more detailed and stringent.
But the SEC doesn't require publicly-traded banks to report to the public everything they have to report to the regulators. And non-public banks don't have to report squat to the public.
The public institutions that have been providing optional details about their Option ARM portfolios lately--like WAMU--have been doing so because the stock analysts and rating agencies have been forcing them to answer some questions. I know I sleep better when I have to rely on stock analysts.
outsider: Timing an event that will (or just may) happen at an unknown point is always a crap shoot. That the event does not hit randomly, but the shakers and movers can bring it about at will or delay it by changing economic parameters mostly unpredictably doesn't help either.
Hey Tanta. Seems like old times, me thanking you for clearing up some of the "small" stuff very few seem to even question these days. I did read the OCC guidance (I even listened closely to a recent talk Dugan gave for hints), but I missed this. I know "the SEC doesn't require publicly-traded banks to report to the public everything they have to report to the regulators", but it's something I periodically forget. It's just too hard for me to reconcile, I guess.
I hope every day's better for you & this one's better than most.
What time period is represented in the "map of misery"? Is that through 2Q 2006?
As a former business reporter and current mortgage lender, this BW story is misleading. Or doesn't fully understand the Option ARM product. I'm not saying that there isn't a problem, but the problem is not described correctly by BW. (I've never originated an Option ARM because because I never had an appropriate borrower for this loan.)
Option ARM are no greater evil than traditional ARMs or interest only loans.
Option ARMs are complicated to explain but payments aren't about to skyrocket. The payments have been steadily going up because of rising interest rates.
Let me explain how it works. There are 2 rates in an Option ARM, a real underlying interest rate and an artificially low rate. The real rate adjusts monthly and immediately when the loan begins. The real rate is typically the moving average of the LIBOR (typically 6 month) or the MTA, the 12-month Treasury moving average. And index plus a fixed margin. The margin can be anywhere from 1.5 to 3.25%. Once chosen, the margin is fixed, and the margin is where the lender makes its profit.
The artificially low rate is offered at 1% to 3.9% depending on the lender. The fake low rate is fixed for year, then steadily adjusts.
For example, we have a home value at $375K, and a loan of $300k. (The loan is 80% of the appraised value. The same rules apply with the Option ARM as with any other loan. If you don't have 20% down, then you have PMI or a second mortgage to avoid PMI.)
Let's use 2% for the artificially low rate and the 6-month libor (today at 5.45%) and a fixed margin of 2. So today's real rate is 7.45%.
So in our example, the 4 options are:
1) a fully amortized payment with an artificial rate of 2%. The payment on a $300K loan at 2% is $1,108.85. (The payment doesn't not include taxes and insurance)
2) Interest Only payment of the real rate. Interest only is simple interest, and the payment at 7.45% is $1,862.50.
3) Fully amortized payment at the real interest rate on a 30-year term. At 7.45% fully am, the payment is $2087.38.
4) Fully am on a 15-year schedule. Payment is $2,772.52
I'm sure no one uses option 3 or 4.
If the borrower uses Option 1, then the loan will negatively amortized. Since the real interest rate is 7.45, paying $1,108.85, the loan balance will increase by $753.65 to $300,753.65. (300,000 + 1,862.5 - 1108.85). Over a year, your principal will grow by $9K at the fake rate and payment.
The fake low payment is set for a year, then increase by 7.5% each year.
1,108.85 X 1.075 = $1,192.01
If you choose to pay option 2, then your balance stays at $300K. At some point, generally after 10-years, the loan will be forced to amortized at the prevailing rate, otherwise the balance will never be paid off.
To qualify for the Option ARM, lenders use higher scores than FannieMae or FreddMac. High 600s, although the qualifying scores have dropped of late. Plus the borrower has to qualify at the real rate (7.45%) not 2%.
The benefit is if you are in a house for 2 to 5 years, then it's a great loan keeping your payment low until you move or trade up. And the LIBOR and MTA had been 2% lower two years ago.
Lenders don't do 100% with Options ARMs because they typically cap the negative amortization at 115%. The danger comes even at 80LTV (loan to value) the house drops from $375 to some lower value.
Why someone would get a Option ARM (or a traditional ARM) for their house which they expect to keep for a long term is a mystery.
Traditional ARMs have been better than Option ARMs because of low fixed rates. Why get an Option ARM where the underlying rate adjusts each month? A tradition ARM is fixed for 3, 5, 7, 10 years. And those rates have been below 6% until this year. 3-1ARM had rates in the 3s when the Fed Funds rate was at 1% at the bottom of the easing cycle.
BW says that brokers are paid more for the Option ARM. THAT IS NOT TRUE. Brokers are paid with origination or discount points like any other loan. And/or with the fixed margin. Our example used 2 as the fixed margin, the higher the margin, the more the broker is paid.
And the police officer example in the story about a prepayment penalty: that is no different than any mortgage. The prepayment penalty is spelled out and must be signed at closing. Even if you don't understand the amount of penalty, you understand that one exists and that you signed. You can't blame that on the lender.
The traditional ARMs are more the danger because they will be adjusting in the next couple of years. Even then, that's a slow growing problem. If you have a 4% 3-1 ARM, the rate typically only adjust by 1% or 2% (depends on what loan product) per year. It won't go from 4% to 8% in one adjustment.
whoops, my cap portion is incorrect.
ARMs are often describe by 3 numbers, 5/1/5 or 2/2/5.
The first number is the initial adjustment, the second is the subsequent annual adjustment, and the third is the lifetime adjustment.
So a 4% adjustment is possible, if rates have moved as much. Like the Option ARM, the traditional ARM is tied to an index and a fixed margin.
Hue: Why somebody would get an option ARM for a house where staying put is while perhaps not the primary but a possible scenario is no mystery to me at all.
I have met people who did this precisely because this was the only way they could afford "the payment" here & now. (Well, there & then as this was some time ago.)
Hue: thanks for the detailed post. I think we agree that these loans are generally a bad idea. I still don't think most borrowers understand all this, or that most mortgage brokers and loan officers explain it very clearly. There was some guy on a CR thread not long ago who was going on about how his mortgage payment with an Option ARM was actually "negative carry," because he's convinced that his accrued but unpaid interest is tax-deductible. Let's hope for his sake he gets disabused of that before he tries to claim it on his 1040, but the point is I bet he got that idea from his broker, who got it from some goofball website. And I think we can agree that I dont think Ill stay in the house that long is right up there with Im sure Ill continue to get bonuses and stock options every year and my income will keep going up. Maybe, maybe not, but you wouldnt be the first person who didnt get a pony. It used to be the role of the underwriter to break this sad news to people. Now were supposed to use the borrowers confidence that the future will go as planned to justify making the loan.
And even if you want to take the position that the borrowers are to blame for not reading or understanding their loan documents, you have to wonder at the enthusiasm with which lenders have been making loans to borrowers who dont seem to be reading the closing documents before signing them, or who seem to put as much weight on what they read on the internet as they do on the actual covenants in their promissory note. Theres paternalism and then theres plain old watching out for your counterparty risk, and the apparent alertness and attention span of the counterparty is a relevant fact. I have no time for anyone who uses informed rational agent assumptions in their risk models and then refis someone out of a 5.25% fixed rate into an Option ARM. Either you change your risk model or you refuse to touch that sucker-born-yesterday loan, and it has nothing to do with paternalism. I didnt realize that the borrower was an idiot is no more respectable an excuse than I didnt realize my payment could go up.
I do take issue with this part of your post:
To qualify for the Option ARM, lenders use higher scores than FannieMae or FreddieMac. High 600s, although the qualifying scores have dropped of late. Plus the borrower has to qualify at the real rate (7.45%) not 2%
Higher scores than Fannie and Freddie for the same product? I don't think so. Fannie and Freddie dont buy Option ARMs. Comment continues below:
Furthermore, as you know, the credit score FN/FH will accept depends on what their automated underwriting systems think of the entire picture of the loan, including down payment, documentation, LTV, etc. Both agencies generally state 620 as the minimum FICO they accept for A quality loans in general, but its misleading to compare that to a 660 minimum on an Option ARM and say were stricter than the agencies.
What you dont mention is debt-to-income ratios. It doesnt matter if you use the fully-indexed rate to qualify a borrower if you at the same time raise your maximum DTI from 38% to 45%. Here are the guidelines from the first broker hit I got on Google for Option ARM maximum DTI:
\t95% Purchase 650 score, 40% DTI, full documentation (80/15)
\t90% 640 score, 45% DTI, full documentation (80/10)
\t90% 695 score, 45% DTI, Stated No Income Verification (75/15)
\t80% No min. score, 45% DTI, full documentation (20% down can be gift)
\t80% No min. score, Stated No Income Verification, 45% DTI (no 4506 or 8821)
\t75% No min. score, Stated No Income No Assets, 45% DTI , up to $1 Million
Pick-A-Payment Option Arms
If my gross monthly income is $5,000 and I have no other debt, my DTI under your example is 22% on the minimum payment and 42% on the fully-indexed fully-amortized payment. And if my car and credit card payments push the DTI over 45%, I can just state a little more income, cant I?
Lenders don't do 100% with Options ARMs because they typically cap the negative amortization at 115%.
Certainly nobody Ive heard of does a 100% LTV Option ARM. But look at the random example of guidelines I just found: a 95% CLTV (80% first, 15% second). Even the broker admits thats hard to get, so lets assume that 90% CLTV is probably the realistic maximum for these things at origination. The three big problems here, which can work in combination, are: a) the value is only as good as the appraisal, and even the best appraisal has a standard acceptable tolerance of 5%; b) almost all of these programs allow the second to be a HELOC, and so even if the line is limited to the amount of the down payment, the borrower can keep it there by interest only payments or subsequent draws; and c) as you note, the negative amortization on the first mortgage pushes the original CLTV upin your example, by 2% in the first year. My point is that there are built-in reasons to think that apparent 10% equity isnt much protection even before we thrown in a softening real estate market.
Option ARM are no greater evil than traditional ARMs
Yes, they are.
I have met people who did this precisely because this was the only way they could afford "the payment" here & now. (Well, there & then as this was some time ago.)
cm, this is the part that is hard for me to understand because this person must have qualified for the loan with the real rate, higher payment. So to the underwriter, this borrower could afford the higher payment. Unless it was in one of those state income situations. But even at that, you can't state the income that is far above your salary in a particular field in a particular geographic area.
Underwriters are careful not because they care about the borrower, the company doesn't want to own the loan, it has to be legit to sell to the investor.
If that person could only afford the house with Option ARM then that is no reason to buy. But plenty of lenders are willing to originate that loan and plenty of investors are willing to buy that loan. That is the same as buying a house at 100% (with traditional ARMs and seconds)wiht interest only products. Renting a house with a mortgage!
Is it the chicken or the egg? Marketing makes people do this or people come with an idea they have to buy a house, and the lender is just willing to supply a product even if it's a short term fix that will lead to financial disaster?
In my experience, it's hard to talk borrowers out of bad loans, they come with an idea with what they want. And there is another lender whispering sweet nothings to them while you are telling them the truth. But generally I don't win those borrowers. I don't tell them what they want to hear.
And even if you want to take the position that the borrowers are to blame for not reading or understanding their loan documents, you have to wonder at the enthusiasm with which lenders have been making loans to borrowers who dont seem to be reading the closing documents before signing them.
Tanta, you won't find many lenders talking people out of loans or bad loans. And there are plenty of loan officers who intentionally deceive people and hoping they sign anyway.
It's a 100% commission business. Loan officers just originate the loan, sometimes knowing it's a bad loan and looking the other way. A lot of car salesmen went into the biz during the boom. And a lot of people from technology or investments who were forced to follow one bubble to another because of where the economic growth was, even if it's a fleeting bubble. It's a mean of survival or old-fashion greed for the lender or loan officer. They're just sales people who often don't even understand the loan product, and it's not necessary either, to successfully close loans. And thinking about the financial consequences of the borrower or economy down the road? Nah ... If a loan officer could find a comparable paying job, they wouldn't be in 100% commission mortgage sales.
My company is a LendingTree lender, meaning we get leads though LT and that means intense
My company is a LendingTree lender, meaning we get leads though LT and that means intense competition. A lot of time, borrowers go with loan officers telling them what they want to hear. If someone tells you you can get a 30-year fixed at 5.5% (which doesn't exist right now), these borrowers go for that even if the loan is different at closing. They don't back out or not signed. It has been a couple weeks in the loan process, rates may have moved, or they needed the cash, or the sales contract deadline etc. and they end up with the loan that an honest loan office pitched at the beginning.
Often times, borrowers who accept these bad loan are strapped financially at the time, like the couple in the 60s in the BW story. They needed $50,000 in cash, a low payment. Well, that loan doesn't exist, or only exists as an Option ARM. Basically, they can't afford their financial situation. Is it crazy to refinance for any kind of loan when you are in your 60s on a fixed income?
It's easier to blame the loan officer when it blows up down the road. Not to say the LO is without blame. The borrowers are like spouses of cheaters pretending they never saw the signs or saw it coming.
Faced with a situation where either it's a paycheck or telling people they should not do a loan, many loan officer will take a paycheck.
Higher scores than Fannie and Freddie for the same product?
No, I just mean it's generally harder to qualify for an Option ARM versus a vanilla Fannie or Freddy ARM or fixed product.
And that is what I meant by Option ARMs are no more evil because they are harder to qualify for. The entire system is bad, and Option ARMs are not worse. I admit I don't know the accounting issue at the investor level, when to book the payment etc. that BW described.
Higher scores than Fannie and Freddie for the same product?
No, I just mean it's generally harder to qualify for an Option ARM versus a vanilla Fannie or Freddy ARM or fixed product. It's hard to generalize on scores alone, until you run the loan through the automated engines.
Lenders use Fannie and Freddy guidelines and software even though they don't sell certain products to Fannie or Freddy.
And that is what I meant by Option ARMs are no more evil because they are harder generally to qualify for. The entire system is bad, but Option ARMs are not worse. I admit I don't know the accounting issue at the investor level, when to book the payment etc. that BW described.
To coin a phrase, theres going to be hell to pay.
Let's keep things simple. My thinking before was that I will get a house only when I have at least 50% money down. Now I think I raised my bar to 75%.
In other countries of this world you either pay money down or you don't get the so much desired product.
I'm as apocalyptic as the next guy about housing due to the debt bubble but is anyone else concerned about the sentiment aspect of a major weekly magazine with a bearish front cover on housing? Could be a contrarian signal despite the obvious fundamental problems in the housing market.
Samuel, this is not the end, it's not even the beginning of the end, but I think it might be the end of the beginning.
When the cover story on BW is "The Death of Real Estate", it will be time to buy.
Hue said:
"cm, this is the part that is hard for me to understand because this person must have qualified for the loan with the real rate, higher payment. So to the underwriter, this borrower could afford the higher payment."
What? In MD's new "Lifeline" program designed to bail out those who used exotic loans, the site specifically states the interest-only payment is used to qualify the borrower. There is no way that lenders used the borrowers ability to repay the whole loan when qualfiying them, or else these loans wouldn't be a problem, correct?
"cm, this is the part that is hard for me to understand."
I was talking about the original Option ARM that I'm familiar with. The investors my company used for those products required people to qualify with the real rate, fully amortized (option 3 in my earlier example). I'm not familiar with the Lifeline program, or the Option ARM where the borrower qualified with the lowest payment.
Option ARMs are different than traditional ARMs, where some programs allowed people to qualified with the interest only payment.
Because people needed to qualify with the real interest rate, it never made sense for me to originate an Option ARM since a traditional ARM was better with a fixed rate during the fixed period.
A lot of news stories that say the Option ARM payment making sudden jumps don't explain why the payment rocketed. In my experience the minimal payment only goes up 7.5% year over year. The sudden jump to a real payment must have been triggered because of the Neg Am reaching some LTV level.
The other mystery to me about Option ARM is that if people got into those in 2004, the traditional ARM rates were really really low, in the 5s or high 4s at the time. Option ARMs made no sense then either.
Looking at that site, the Lifeline program is for people who are caught in the jam with exotic mortgages. It doesn't talk about how people qualified for exotic mortgages in the first place.
There is no way that lenders used the borrowers ability to repay the whole loan.
No, not the whole loan. It's the payment and rate that is used in qualifying.
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