More Mortgage Carnage Still to Come

Forget subprime, the new problem child of the mortgage industry is payment option ARMs (Adjustable-rate mortgages). A payment option ARM (POA) is a type of mortgage that was especially popular from 2004 to 2007. POAs give borrowers options for each monthly payment: they can either pay the interest plus amortized equity, only the interest, or less than the interest. If a borrower chooses to pay less than the interest the amount of interest not paid is added to the total debt. This is called “negative amortization” because it keeps current mortgage payments artificially low by increasing future payments (mortgage lenders called it the “I’ll worry about it tomorrow option”).

There were $500bn POAs originated in 2006 and 2007 (a strong upward pressure on housing prices). These mortgages are a looming disaster because after a few years of negative amortization these mortgages are reset so homeowners have to pay a rate that amortizes the loan over the rest of the 30-year period. For many homeowners this means their monthly payments will double after their reset date.

Also, the borrowers of these loans were qualified at the starting low rates of 1-3%. Mortgage lenders weren’t worried about their qualifications because as long as housing prices kept increasing they had little risk of loss. Not surprisingly, mortgage research found that roughly 75% of these borrowers chose the negative amortization option. The real breaking point for these borrowers is going to be when their mortgages are reset and they have to pay enormous monthly fees. Considering these borrowers were never qualified to begin with and unemployment is increasing, it is not hard to imagine how it will affect defaults. The following chart from the IMF (via Credit Suisse) indicates the carnage ahead:



All financial institutions will be affected by this, but mostly Bank of America. Countrywide (which Bank of America acquired in January 2008) was the largest POA originator. Angelo Mozilo, Countrywide’s CEO, wanted these loans so badly he paid a 3% premium for them from brokers, further encouraging quantity over quality. When Countrwide was acquired, it held $98 bn of these mortgages on its balance sheet under the asset class “held for investment” so they wouldn’t have to write them down. From Chain of Blame, a detailed account of mortgage lending, “for $4 billion Bank of America was buying a potential black hole.” That is, of course, assuming Bank of America can’t get rid of its bad assets to the PPIP.

It was very depressing seeing the chart above for the first time today. It’s more evidence that the current optimism about the financials is overdone.