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by Aaron Krowne
Most readers are no doubt familiar by this time with the "subprime lending implosion" shaking out in the mortgage lending sector. This event resulted in a large number of major companies focused on this activity going defunct (i.e. bankrupt or preemptively shut down, such as Ownit and MLN) or otherwise disappearing (e.g., being acquired by larger financial entities in "fire sales," such as the sale of Option One to Cerberus a few days ago for less than half of the approximately $2 billion it was rumored they were seeking last year). I've been tracking this breakdown over at the Mortgage Lender Implode-O-Meter—at least, as meticulously as possible given the chaos reigning.
What is slightly less well-known is that the breakdown has already spread from subprime to other sorts of marginal lending, and mortgage lending in general, including 'Alt-A', prime second liens–which back home equity extractions–and any sort of high-LTV loan (loan amounts in excess of 90-95% of the property's appraised value, which itself is often inflated.
The latest batch of "imploded" companies on the Implode-O-Meter is heavy in Alt-A specialists, with a smattering subprime and even prime represented:
- MILA - mixed; loan mix unknown
- Home equity of America - Prime second liens
- Opteum (Wholesale) - Alt-A
- Innovative Mortgage Capital - Subprime
- Home Capital, Inc. - Likely concentrated in subprime and Alt-A
- Homefield Financial (Wholesale) - Alt-A
- First Horizon (Wholesale) - Non-prime
- First Source Funding Group - loan mix unknown
- Alterna Mortgage - Alt-A
- Solutions Funding - Subprime
And this really shouldn't be surprising. Driving the breakdown of all areas of mortgage finance is a rise in delinquencies across the board, including foreclosures and other nastiness. Readers of iTulip know that this is in turn caused by deteriorating real incomes for most Americans, especially when one makes an honest accounting of inflation, debt burden, and the rising cost but declining value of benefits like health care.
Even less known than all of the above is that there exists an area of mortgage finance that is even more "nuclear" than subprime and Alt-A per se, and involves what is certainly an even higher level of complicity. For all of the aforementioned areas of breakdown, one can make a reasonable case that this outcome was unanticipated, at least by the very shortsighted or unrealistically sanguine. The fraud and failed guidance were perhaps so omnipresent that these became so much a part of the fabric of lending such that people simply lost site of it. But not for Pay Option ARM lending, and more specifically, the accounting treatment of this sort of lending.
Pay Option ARMs are adjustable-rate mortgages what give the borrower the option of paying less than the normal monthly payment. With certain restrictions, of course. If the borrower chooses to do so, the difference between the "minimum"–the "fully-amortizing" amount–and the actual payment is simply added on to the principal of the mortgage. At a higher interest rate, or course. This is like making a credit card payment using the cash advance on a second credit card that charges a higher interest rate. This results in dramatically more debt overall, and a higher interest burden for the borrower overall.
The added interest is called "negative amortization," and typically there is a limit to how much of this can be added on to a loan–usually, 110% to 125% of the principal.
Now, on the face of it, this may seem like a ridiculous product. Who'd want it? And it is, for the vast majority of borrowers. As is typical in these situations, it can be argued that the savvy and well-capitalized can make legitimate use of such a product. But to generalize based on this wish is worse than wishful thinking. Instead, the moderate outcome up until now can be explained by the fact that house values kept rising, so refinancing was available to save the hides of many who relied on Pay Option ARMs and other exotic products, such as interest-only and balloon mortgages.
The way lenders or portfolio-holders of pay option mortgages account for negative amortization is surprising to the lay person: they simply take the negative amortization amount–that is, money not received–and add it to their earnings. This is called "capitalization of income from negative amortization" or "CINA."
Where this starts to become a potentially significant accounting issue is in how a number of mortgage lenders and bankers who have done extensive dealings in pay option products have begun to show a significant and increasing portion of their net income is now provided by this capitalized negative amortization:
Table 1: Negative-Amortization Exposure of Select Companies
| $ neg-am | %net int. income | %EBT | $net | %neg-am of net | period | |
| Downey S&L (DSL) | $ 85 | 68% | 111% | $ 43 | 258% | (Q1 '07) |
| FirstFed Cal.(FED) | 215 | 72% | 96% | 129 | 166% | (Y 2006) |
| BankUnited (BKUNA) | 41 | 52% | 114% | 27 | 152% | (Q1 '07) |
| WaMu (WM) | 360 | 17% | 29% | 784 | 46% | (Q1 '07) |
| Countrywide (CFC) | 654 | 24% | 15% | 2675 | 24% | (Y 2006) |
Without exception, the increase in the importance of negative amortization income to the bottom lines of these companies is a dramatic change from the situation a year or two ago—or even a few quarters ago. To get a taste for this effect, witness the following excerpt from FirstFed's 2006 annual report:
At December 31, 2006, 2005, and 2004, negative amortization, included in the balance of loans receivable, totaled $215.8 million, $62.6 million, and $5.5 million, respectively. Negative amortization as a percentage of all single family loans with fixed payment periods in the Bank's portfolio totaled 3.44% at December 31, 2006, 0.86% at December 31, 2005 and 0.12% at December 31, 2004. Negative amortization has increased over the last two years primarily due to increases in short-term interest rates."
Similarly, Countrywide's negative amortization income jumped from $74.7 mm at 12/31/05 to $654.0 mm at 12/31/06—a whopping increase in excess of 8 times.WaMu helpfully provided a graphical depiction of what is going on with negative amortization for them in their recent Q1 '07 8-K :
Note that negative amortization income has risen sharply, though it is still only about 2% of the total pay option portfolio. It will be interesting to see how this situation plays out. Also, note that even though this amount is a "small" proportion of the pay option ARM portfolio, it has a huge impact on net income, making up 46% of it as of the last figures released.
The point of this exercise is to get a feel for what the earnings of these companies might be without the negative amortization income—or rather, what they would be like if a significant amount of this income turned out to be illusory.
This practice of immediately marking-to-market negative amortization is actually considered valid under Generally Accepted Accounting Principles (GAAP). Of course, so were most of the tricks utilized by Enron. In fact, I would argue the neg-am situation is potentially even worse: in Enron's case, a lack of any earnings was typically marked to market as immediate profits at some questionable valuation. In the case of neg-am in mortgages, what is likely to actually be a loss is marked to book as a gain. I consider this essentially a "loophole" in GAAP, which has been found by these mortgage purveyors and, in my opinion, massively abused.
These companies will doubtless respond that they have confidence their borrowers will ultimately pay off the full amount of their debt, including the negatively-amortized portion. This is a valid assumption only when neg-ams are forming a roughly constant "background level" of income, relative to the total portfolio's size–though probably only some percentage of the neg-am earnings less than the full amount should be marked to market, given that certainly some percentage will still default.
But when the neg-am earnings are rapidly growing relative to portfolio size, it is hard to see how this is a benign event. If pay options are invoked occasionally and "randomly," as the above companies are sure to claim (see Fueling the FIRE Economy), the total amount should be low, and they should not make up a rising amount of a portfolio. Instead, it appears that significant numbers of borrowers in these pools are electing to invoke their pay options at the same time. Why might this be? And why would they be willing to do so at higher interest rates than their base mortgage?
I think the answer is simple: it is because they have to—they are too squeezed in terms of their income and expenses to pay their mortgages at the fully-amortizing rate.
This brings us to another important aspect of Pay Option Loans: aside from allowing creditors to chalk up high levels of dubious income, Pay Option doubles as an intrinsic "delay mechanism" that acts to keep delinquencies relatively low (e.g., WaMu's delinquencies on pay option loans were .63% in 2006, while negative amortization was nearly 2%, as shown earlier). Instead of failing to make your mortgage payment and becoming delinquent, you can simply pay whatever you can handle! At least, for a time. Thus, one should not take seriously the claims of these companies that all is well because their delinquencies are still relatively low (e.g. compared to subprime)—the usual warning signals have simply been diverted.
This game can continue only until maximum amortization levels are reached, or borrowers become in many cases completely unable to pay (for instance if they are mortgage lending professionals who have lost their jobs!). To make matters worse, when the negative amortization limit is reached, the rate of the loan resets (higher) and both interest and principal must be fully paid down. At this point, a late wave of defaults would hit, and the resulting write-downs of such an event would be even bigger for all that negative amortization. For example, a mortgage negatively amortized to 120% of its initial value which has to be sold at foreclosure auction entails an automatic 20% write-down of the negative amortization "income", plus a fire-sale price mark-down of 20%, for a total adjustment of 40% of the original principal (20% illusory gain and 20% actual loss). Of course, we are already seeing 15% discounts at new homes auctions, so I wonder if that 20% foreclosure auction discount isn't a bit generous.
Do not be fooled by another canard of pay option dealers: that the FICO scores of their borrowers are high, so the loans are sound. Indeed, these loans are typically classified as "prime," with average FICOs over 700. But that defense has now been soundly debunked by Fitch: the long-term performance of a mortgage loan depends more on the loan's intrinsict characteristics (CLTV/down payment size, ARM vs. fixed status, stated income status, etc.) than the borrower's a priori credit score, which is much less forward-looking.
Food for thought: many of these pay option ARMS are no-documentation ("liar's loans"), for example, 80% in FirstFed's case. When you add to this a recent survey by the Mortgage Broker's Association for Responsible Lending which found that 90% of no-doc cases actually did involve lying about one's income—by 50% or more in 60% of the cases—it certainly makes one go "hmmm".
I am not the first one to write an article on the pay option negative amortization scam. Pretty much every one of the above-mentioned companies has received its own exposé (e.g., FirstFed, Washington Mutual, Downey, et al.), but apparently analysts and the market in general have still not connected the dots. The dubious treament of negative amortization, assented to at the highest levels, is grossly misleading at best and, in my opinion, fradulent in effect.
If you aren't yet convinced there might be a problem with some of the companies mentioned above and their treatment of negative amortization, you might note that Countrywide CEO Mozilo has sold well over $66 million of shares in the last year–and buying essentially none), as have nearly all other insiders, and has seen two board members jump ship in the last few weeks. James Furash, the head of Countrywide Bank, also left abruptly a few weeks ago. BankUnited has had their Chief Accounting Officer abruptly leave and go to a much smaller bank, with no reason given.
Nothing to see here, folks. Move right along.
Note: At the time of writing, the author was short shares of some of the companies discussed above. He thinks you'd be crazy not to be.
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