A Farewell to ARMs: One Less Option

by Brian Brady

Commercial Real Estate Finance Expert
Structured Debt and Equity
Licensed Real Estate Broker in AL, CA, and FL

Author website

Are Option ARMs the next casualty in the non prime mortgage meltdown war? Wall Street fired the shot heard ’round the world in the mortgage default war by demanding repurchases from subprime lenders. Lenders either closed their doors or waved the white flag and allowed the conquering army to annex them.

The next battle in the mortgage default war may have already been fought and decided long before the soldiers have time to lace up their boots. That battle is the “dirty bomb” that we call the Option ARM. I think Friday afternoon was the equivalent of Paul Revere’s midnight ride.

I received an e-mail from IndyMac Bank, a respectable non-prime and prime lender and leader in the negative amortization loan products, that said:

1- IndyMac Bank is retiring all 12 MAT products over the next few weeks. This is the traditional low start rate, negative amortization loan.

2- They are increasing the minimum payments and reducing the max price. No more four point rebates for mortgage brokers on an intentionally vague product.

3- They cite the popularity of the FlexPay 5/1 ARM for the 12 MAT demise. The Flex Pay 5/1 ARM has a fixed rate for five years with an option to pay less than the interest due which does defer interest. The advantage to the Flex Pay 5/1 ARM is that the potential negative amortization is completely predictable and not subject to the whims of interest rate fluctuations.

Now, three initial thoughts cross my mind:

1- Option ARMs are dead. That’s hard to believe. Jeff Brown states a great case for alternative loan products last week when he says that builders build and lenders lend. He’s been around long enough to know that opportunists capitalize amid fear and vacuums. Lenders with high exposure and nebulous underwriting guidelines will be decimated when the piper comes calling in the form of higher defaults. Lenders with cogent underwriters will survive and cherry pick the good borrowers with this useful loan product.

2- Wall Street is not at war with lenders but is betting on lower interest rates. If the Wall Street securitization departments believe that rates will be materially lower in five years, they would encourage borrowers to lock into a fixed period rather than ‘float” with a monthly ARM product. The fixed period rate loans will fetch a higher value in the secondary mortgage markets. A bit of a conspiracy theory but plausible.

3- IndyMac Bank is one of the more conservative lenders out there and is taking proactive actions to shore up their servicing portfolio because of defaults. Could this be the initial draft of water before the tsunami hits? I fear that this may be the more likely theory.

I have long watched Countrywide Financial because of their sheer size in mortgage origination. They’ve been quite successful in their efforts through three distinct marketing channels: retail, wholesale, and correspondent. They are innovators in product development and have vertically integrated by setting up their own securities brokerage firm. They didn’t wait for the mountain to come to Mohammed. They brought Mohammed to the mountain.

Countrywide was the largest originator of what they call “Pay Option ARMs” in 2004 and 2005. They were successful by offering large yield spread premiums to the mortgage brokerage community for these products. They knew that unscrupulous brokers and originators would “sell” the low 1% start rate while ignoring the fully-indexed rate charged to a customer. World Savings, the long-time leader in this product offered a 2% rebate to originators, Countrywide offered up to 4.5% rebate (with inflated rates to compensate). Basically, it was prestidigitation.

Let me explain my paranoia. My good friend and colleague, Sean Purcell, has long been a doubting Thomas of the modern negative amortization loan product. He summed it up best when he asked me, “Don’t you think there will be a problem when a lender pays a 4% commission while other lenders usually pay 1.5-2%?“. That, folks, is the ticking time bomb.

Here are some warning signs the painfullly paranoid (like me) might feed upon:

1- Countrywide Announces Change in Board Of Directors

2- Fitch Ratings Agency Downgrades 33% of Countrywide Loan Pools; particularly their “expanded criteria” guidelines which include Pay Option ARMs

3- Methinks he doth protesteth too much; Chairman and Founder Angelo Mozilo sold $140 million worth of stock last year while literally screaming that Countrywide should not be penalized by stock traders because of the subprime meltdown.

Negative amortization loans are an excellent financial planning tool. Countrywide has long been a favorite of originators because of their adaptability and innovative lending products. This time, I think they may have overreached. I’m raising our readiness condition to DefCon-4.