End of Option ARMs?

Last week I found an ally. John C. Dugan is head of the Office of the Comptroller of the Currency, a government body that regulates much of the banking industry. His office has the ability to make a rule and make it stick. Hooray!

In a speech to the Consumer Federation of America, he said that the Option ARMs, those with the potential for negative amortization, raised issue both about protection of consumer who borrowed under these terms and the soundness of the lenders who made the loans. I think he is correct, as you have also heard from me during the past year.

One problem the housing and finance industry faces is that we are running out of customers. In the past few years, my industry has refinanced almost every credit-worthy borrower in the country. As the pool of available borrowers diminished, our industry came up with new ways to attract more people. The first move was to loosen the underwriting criteria. That made it possible to approve loans for borrowers who would have been denied in previous years.

The other move was to re-market the old negative amortization ARM that had been around since the late 1970s. It was given a new name, the Option ARM. With this loan the borrower is obligated to make a minimum payment at an artificially low teaser rate. Many of these loans start out at a payment rate of only 1 percent, not enough to even pay the interest that accrued during the month!

The borrower also has the "option" of making a larger payment, the full interest that is due, or an amount that would amortize the loan over 30 years or even 15 years. That's how it gets this name.

Now, you could ask, "If this loan has been around for so long, why is it so dangerous now?" The answer is that in the old days, lenders would not do these loans unless the borrowers were making a large down payment, 20 percent, or, in later years, 10 percent. Today lenders are routinely offering 100 percent financing using these loans alone or in conjunction with a piggyback second loan.

In the old days, borrowers had a cushion of equity that they had created with their down payment, and lenders felt secure because the equity in the property protected them in the event of foreclosure. Today, such protections rely solely on whatever increase in value results from improvement in market value. That has been good for the last few years, but we can't count on this happening every year.

What happens with this type of loan is that when the borrower makes a payment that is less than the interest due, the unpaid amount is added to the principal balance. At the end of 5 years, the loan terms provide that the loan become fully amortizing with payment at the current interest rate calculated by adding the margin to the index.

I did a spreadsheet showing what might happen with such a loan over 5 years. I took a $400,000 loan, typical for California these days. In your area you can adjust the loan size but the relative numbers are accurate. At the current interest rate of 6 percent, the interest due is $2,000 per month. However, the obligatory payment is only $1,286.56, and it would increase by 7.5 percent each year. In this example, the $713.44 unpaid interest would be added to the principal. I assumed that rates would rise modestly from 6 percent today to 7 percent.

At the end of 5 years, the principal owed had risen from $400,000 to $447,000. Worse, the new obligatory payment rose to $3,160.50, almost two and one-half times the original payment of $1,286.56. Frankly, some of the people with these loans simply will not be able to make that payment and will have to sell or face foreclosure.

If the market values increase by 20 percent in that same period, from $400,000 to $480,000, they    can sell, pay the real estate broker a 6 percent commission, netting $451,000. They still have to pay off the $447,000 which gets them only $4,000 which almost certainly will be eaten up by other selling costs. Net return? Zero!

I saw a report that said the over 30 percent of the loans being done today are these types of loans. So multiply this situation by 2 or 3 million and you can see why Mr. Dugan and I are concerned about the future. No one in power listens to me, but, thankfully, he can have a significant effect on the future by putting severe restrictions on the industry. I hope he does.

If you know someone who has this type of loan, I hope you will encourage them to refinance now into a loan product that better fits their needs and goals.

Be careful out there.