negative amortization of mortgages = bank profits!!?!

[jk]

[i originally posted this in housing but it had very few views, so i moved it here]

from barrons 8-21-06

The following figures are from Washington Mutual's annual report: At the end of 2003, 1% of WaMu's option ARMS were in negative amortization (payments were not covering interest charges, so the shortfall was added to principal). At the end of 2004, the percentage jumped to 21%. At the end of 2005, the percentage jumped again to 47%. By value of the loans, the percentage was 55%.


Every month, these borrowers' debt increases; most of them probably don't know it. There is no strict disclosure requirement for negative amortization.


This financial system cannot work; houses are not credit cards. But WaMu's situation is the norm, not the exception. The financial rules encourage lenders to play this aggressive game by allowing them to book negative amortization as earnings. In January-March 2005, WaMu booked $25 million of negative amortization as earnings; in the same period for 2006 the number was $203 million.

i hadn't realized that banks carrying loans that were non-performing would increase their reported profits. the bank has little [immediate] incentive to put non-paying or under-paying mortgages into work-out. if they do that, they report a loss. if, on the other hand, they are "understanding" and allow the mortgage holder to miss payments or underpay in the hope of better times to come, they immediately report the shortfall as profit! i'm not sure what might bring this game to an end. it appears that banks could continue doing this for quite a long time. [SeanO have any input?]

[blazespinnaker]

Re: negative amortization of mortgages = bank profits!!?!

That's pretty incredible

I wonder how much of that increase is due to old loans negatively amortizating and how much is just increasing popularity of the program.

[blazespinnaker]

Re: negative amortization of mortgages = bank profits!!?!

ahh, misread that. I thought it as 55% of their mortages Just of their option arms. I wonder what percentage of their mortages are option arms..

[jk]

Re: negative amortization of mortgages = bank profits!!?!

it's even better...

Typically, these so-called option adjustable-rate mortgages, or option ARMs, let customers choose how much to pay each month. They can make the standard principal-and-interest payment or pay just the interest. And then there's the even dicier option to make just a low minimum payment, as with a credit-card bill.


Hey, when there are Escalades to buy and home prices are always rising, you really have to learn to stop worrying and love that minimum payment. The catch is that the unpaid portion of the interest gets tacked onto the principal -- a "negative amortization" that increases the size of the mortgage. Left with more debt, the customer is more vulnerable to rising rates.


These products are advertised in misleading ways. Banks pitch that customers can pay back the loan at a rate of, say, 1%. But that's just the rate used to calculate the minimum payment in the first year, not the actual underlying rate. The rising popularity of option ARMs concerns some prudent banking executives, including Golden West Financial's Herb Sandler, who runs the midsize bank with his wife and sells plenty of the mortgages. Some lenders "are clearly faking their borrowers out," he says.


Along with Golden West, publicly traded lenders with big exposure to these products include Countrywide and Washington Mutual and smaller California banks such as Downey, First Fed and Indymac. Golden West has been selling them for 25 years and has a solid track record with them, even in recessions and rising-rate environments. When fully explained to the right customers, such as a Porsche salesman who makes plenty each year but doesn't know how much he'll score from month to month, "it's a terrific borrower loan," says Mr. Sandler. "We have never had a delinquency, much less a foreclosure, due to the structure of the loan."


But some banks are lowering their credit standards, sometimes qualifying borrowers based on their ability to make the minimum nut, not whether they can afford the whole deal. "That is an outrage," Mr. Sandler says.
Option ARMs are wonderful not just for borrowers who can't afford their houses, but also for investors who look only superficially at a bank's earnings report. A bank books the entire amount that a customer owes as income each month, not the minimum payment that's actually paid. Voilà, noncash earnings.

It gets better: The unpaid interest gets tacked on to the bank's outstanding loan total, allowing the bank to display loan growth, which investors love. "You get earnings and growth. What more can you ask for?" says Keefe, Bruyette & Woods analyst Fred Cannon.

[jk]

Re: wamu's exposure to option arms

from wamu's recent 10-q- i have not figured out how to get the right formatting in the summary chart. i went through and re-inserted all the spacing, and then the bulletin board eliminated it all again.

With the current flat yield curve environment, the interest rates offered on the Company's short-term adjustable rate loans, such as the Option ARM, are higher than rates offered on medium-term adjustable-rate mortgages and fixed-rate products. Accordingly, short-term adjustable rate loans, as a percentage of total home loan volume, declined from 37% in the second quarter of 2005 to 31% for the same quarter in 2006


Summary Financial Data (Continued)

Three Months Ended Six Months Ended
June 30, June 30,
2006 2005 2006 2005
(in millions)
Supplemental Data
Average balance sheet:
Total loans held for sale $ 24,536 $ 44,884 $ 27,164 $ 41,613
Total loans held in portfolio 242,334 213,638 237,446 210,496
Total interest-earning assets(1) 313,239 290,841 310,523 283,971
Total assets 349,300 320,508 346,812 314,207
Total interest-bearing deposits 165,239 149,144 161,855 145,910
Total noninterest-bearing deposits 35,013 34,377 33,813 33,466
Total stockholders' equity 26,594 21,676 27,025 21,510
Period-end balance sheet:
Total loans held for sale 23,342 51,122 23,342 51,122
Total loans held in portfolio, net of
allowance for loan and lease losses 241,840 211,494 241,840 211,494
Total assets 350,884 323,196 350,884 323,196
Total deposits 204,558 184,317 204,558 184,317
Total stockholders' equity 26,131 22,013 26,131 22,013
Loan volume:
Home loans:
Short-term adjustable-rate loans(2):
Option ARMs 11,256 19,564 20,033 35,208
Other ARMs 1,859 367 4,802 1,341

looking at the option arms issued for the 2 6month periods jan-jun 05 and jan-jun 06 and guestimating july-dec 05, you've got about 80 billion in option arms written over the 18month period. total assets are 350 billion, so at least 25%, and likely more, of the assets are option arms. makes me want to short the stock or buy some puts tomorrow morning.

[blazespinnaker]

Re: wamu's exposure to option arms

from wamu's recent 10-q- i have not figured out how to get the right formatting in the summary chart. i went through and re-inserted all the spacing, and then the bulletin board eliminated it all again.


looking at the option arms issued for the 2 6month periods jan-jun 05 and jan-jun 06 and guestimating july-dec 05, you've got about 80 billion in option arms written over the 18month period. total assets are 350 billion, so at least 25%, and likely more, of the assets are option arms. makes me want to short the stock or buy some puts tomorrow morning.

Not a bad idea, JK. But, maybe the ticket is to find the *worst* offender (relative to their earnings) and short them.

Is WAMU the worst offender?

[blazespinnaker]

Re: negative amortization of mortgages = bank profits!!?!

Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $239 million and $50 million for the three months ended June 30, 2006 and 2005.

on page 40 of WM's 10-q..

So, of the 1358B in interest income, that would be 17% or so. And growing!

7% of net income. Maybe when it goes to 20% of net income I'll look into buying some puts. Assuming it's not already priced in ..

Definitely going on my watch list, though.

[EJ]

Re: negative amortization of mortgages = bank profits!!?!

The challenge with shorting banks that hold these loans is that the price peaks in bank stocks are harder to pick out of the real estate cycle than they are for, say, home builders. The RE bubble peaked in the US in mid-2005 and that shows up clearly and without any lag in Toll Bros' stock price. The rise in WM's stock price, though, does not show the same kind of extreme correlation.

As the chart above shows, Toll Bros. is looking like a tasty short with a steep rise and peak in mid 2005, but WM has done nothing dramatic over the course of the housing bubble, and has been hanging in around 40 to 45 since 2003.

The last dramatic decline in WM stock occured between 1998 to 2000 when the stock fell into the high teens from about 30. We'd need to dig around to see why, but we can rule out macro factors as that was the most frothy phase of the stock market bubble; anyone holding WM stock at the time must have been bumming out.

WM competes with Bank of America, Golden West and Wells Fargo. Comparing each to WM, BAC is clearly not the "growth stock" in the sector and looks like the worst short candidate.

BAC vs WM




Golden West vs WM

Golden West has seen an even more dramatic rise off year 2000 lows than WM and, depending on the degree to which option ARMS and other dubious products are driving their profits, may represent a better short opportunity than WM.

Wells Fargo vs WM

From a distance, Wells Fargo appears comparable to WM as a short candidate, but zoom in to a one year chart and we see that both are off their peaks.

Can't rank the short opportunities among them without digging deeper into the composition of their loan portfolios, but as far as timing goes, it's reasonable to guess we'll see a decline in WM, for example, from its current trading range back into the teens or even lower over the next 12 to 18 months, and now is probably a better time to place a bet, rather than waiting until the the news is out that a significant and growing portion of their income is generated by unsustainable sources, such as option ARMs. You'd think that this would already be priced in but then that was not the story with Toll Bros. either; the stock dropped with the market, not ahead of it.

Suspension of disbelief seems to be the order of the day for RE related stocks.

[blazespinnaker]

Re: negative amortization of mortgages = bank profits!!?!

well, these silly banks also have derivatives which complicate matters, and would perhaps explain the smoothness of their stock price. I could imagine a scenario is that any offset in loss on the option arms will be equalled by a profit in their deritivate portfolio.

which is actually the way to go, assuming they're booking any losses on those derivatives now..

[jk]

Re: negative amortization of mortgages = bank profits!!?!

well, these silly banks also have derivatives which complicate matters, and would perhaps explain the smoothness of their stock price. I could imagine a scenario is that any offset in loss on the option arms will be equalled by a profit in their deritivate portfolio.

which is actually the way to go, assuming they're booking any losses on those derivatives now..

as i understand it, the real problem in bank accounting is their ability to alter assumptions about risk, and thus put money in a cookie jar of "reserves" and then pull it out again at will.

[blazespinnaker]

Re: negative amortization of mortgages = bank profits!!?!

In theory it is a reason why the banks can be so aggressive about sub prime lending practices, because if things do go south, they'll still do OK because they have hedged their risks.

We only have to ask ourselves about the hedge funds or whoever that are underwriting these derivatives.

Are they backed up? What happens if things go south and they can't pay the banks back like they've promised? What happens to the banks?

[jk]

Re: negative amortization of mortgages = bank profits!!?!

In theory it is a reason why the banks can be so aggressive about sub prime lending practices, because if things do go south, they'll still do OK because they have hedged their risks.

We only have to ask ourselves about the hedge funds or whoever that are underwriting these derivatives.

Are they backed up? What happens if things go south and they can't pay the banks back like they've promised? What happens to the banks?

i am not sanguine about the banks' ability to hedge themselves properly, even if there were no counter-party risk, which there is in spades. i think there is a sig probability of some financial institution[s] going belly up during the next sig downleg.