Investors Fret Mortgage Balloons Will Burst

By JESSE EISINGER
July 27, 2005; Page C1

There has been plenty of talk about a housing bubble, but very little about a mortgage bubble.

Now investors are starting to see worrisome signs in some banks' latest quarterly earnings reports. In others, such signs are absent. Good news? Nope, because disclosure is so poor at so many banks.

As home prices have soared, banks have been enticing customers with sweet-sounding mortgages that lower monthly payments, including interest-only loans. The most dangerous development is mortgages that offer payment options.

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.

But there could be credit problems down the road. And at some point, it's plausible regulators might fret about the bank's capital.

Last week, Golden West's stock took a hit after it disclosed how much its exposure to option ARMs has increased. The company reported that $160.2 million of its loans was actually unpaid interest tacked on to borrowers' principal -- that negative amortization I mentioned. That's a huge leap from last quarter's $90.2 million and $27 million in last year's second quarter.

The company reassures investors that the total is a mere 0.14% of its loans. But as a percentage of net interest income, the $70 million change in the negative amortization figure was 10% in the second quarter, compared with 5% in the first quarter and practically nothing a year ago, says Mr. Cannon.

Mr. Sandler says Golden West's lending practices are disciplined, so it won't get into trouble. The only risk, he concedes, is that home prices decline broadly, in which case all mortgages suffer, regardless of structure.

But good companies are often undermined by the irrational practices of competitors. It's not quite fair of me to pick on Golden West. I do so only because it fully discloses its exposure.

Other major banks are more reticent. Washington Mutual disclosed some aspects of its exposure for the first time this quarter, but left questions unanswered, says Mark Agah, analyst for independent research firm Portales Partners. It originated $19.6 billion of option ARMs in the second quarter, or 37% of its home-loan volume. WaMu didn't report the total amount of deferred interest beefing up its loan totals. Instead, it said option ARM borrowers' principal had grown by $26 million, or 0.04% of outstanding balances. That doesn't count all the deferred interest from borrowers who paid down their principal for a time but then started making minimum payments. Washington Mutual actively sells most of its option ARMs into the secondary market, but that market might not always be available on attractive terms.

A WaMu spokeswoman says in an email that the company is considering how best to disclose option ARM data.

Countrywide discloses even less. It says its second-quarter ARM volume was $67 billion, or 56% of its home-loan volume. But the company didn't disclose the percentage of option ARMs in its financial statements and doesn't disclose the amount of negative amortization. In response to questions from investors during its earning conference call yesterday, the bank said that 20% of its loan production this year has been option ARMs, at least 50% from California. Countrywide said on the call that it, too, planned to increase disclosure.

What should investors do? Problems won't come today or tomorrow, but don't look now: Rates, they are arisin', and that's when some borrowers will run out of options. At least investors still have some options left. Like reducing their exposure to mortgage banks.