Thursday, June 11, 2009

Option ARM Accounting

Option ARM:

There are 2 key features to this loan, those being the rate component and the option component. ARM refers to the loan being an adjustable rate mortgage. The interest that the borrower pays fluctuates over time (it is usually fixed for an initial period of time) and is linked to a benchmark rate. For example, a loan may be indexed to the 1 year Treasury Bill rate. Each year, the mortgage payment is recalculated using the new rate observation.

This feature has been more common in Europe, but volume picked up in the USA when the overall interest rate level was quite low. In theory, there is nothing wrong or sneaky about these loans. They offer a degree of stability to banks because they can avoid the danger of a flattening yield curve. For the consumer, rising rates usually (I repeat, usually) coincide with higher home values. So their payments may be higher, but their homes are worth more.

The danger, as with most things, is in the disclosure. A consumer must have knowledge of the reset schedule, benchmark rate, initial fixed rate period, teaser features and future personal earnings expectations when making a decision.

The option component refers to the flexibility the homeowner has in making a mortgage payment. Typically, the mortgagee can make a fully amortizing payment (standard principal & interest payment), an interest only payment (only the standard interest due for that month) and a specified minimum payment (less than the interest only payment).

If a borrower does not make the full payment, the residual is tacked on to the balance of the loan. This is referred to as negative amortization. The principal balance actually increases over time.

Rising home prices mitigate the issue of negative amortization because it keeps the loan to value ratio in check. However, when prices fall, the ratio moves markedly higher. In addition, the choice of payments masks the intention of the borrower. A homeowner with every intention of defaulting can stay in the home longer by making very small payments.

A few years ago, I dove into a Washington Mutual annual report. What I found was absolutely horrific. On page 57 of the 2007 annual report is a table that spells out earnings from option ARMS.

December 31,




(dollars in millions)

Loan balance
$ 58,870
$ 63,557
$ 71,201
Capitalized interest recognized in earnings that resulted from negative amortization



Total amount by which the unpaid principal balance exceeded the original principal amount



Balance of loans that experienced a net increase in negative amortization during the year



Percentage of borrowers whose final loan payment of the year resulted in negative amortization:

By number of loans

50 %
51 %
42 %

By value of loans





Of course, the natural question is: How can the bank be sure that they will ever receive that money?

What happens when a loan of that type defaults? Do they restate the previous period's earnings lower?

This product is the single worst idea in financial history and ranks on the top 14 of all time worst human brain droppings.

JP Morgan is now the proud owner of these WaMu loans. Wells Fargo via Wachovia via Golden West also holds a large chunk of this stuff. Several estimates place the amount of these loans originated at $750 billion over the last few years. Not surprisingly, the bulk were backed by California real estate.

One more thing: these loans are subject to recast. Recasting occurs when the principal balance of the loan hits a specified level over a given time horizon. At that point, the mortgage payments are recalculated based on the new unpaid balance. As this occurs, foreclosure will skyrocket.

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