Trying to Rehabilitate the Negative Amortization Loan - NOT!

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The negative amortization loan is a very popular loan with certain kinds of real estate agents and loan officers. It has two great virtues as far as they are concerned. First, it has a low payment, and despite the fact that people should never choose a loan - or a house - based upon payment, the fact is that most people do both, and the negative amortization loan enables both sorts to quote a very low payment considering how much money their client is borrowing. Furthermore, because it has this very low minimum payment, it enables these agents and loan officers to persuade people to buy properties that they cannot really afford. When someone says, "I'll buy it if the payment is less that $3000 per month," this brand of agent goes to a loan officer that they know will reach for a negative amortization loan, without explaining this loan's horrific gotcha, or actually, gotcha!s. Instead of someone ethical explaining that the real rate and the real payment are way above $3000, and this is only a temporary thing, they keep their mouth shut and pocket the commission.

This commission is, incidentally, far larger than they would otherwise make, and that's the second advantage to these loans from their point of view. When the pay for doing such a loan is between three and four percent of the loan amount, with most of them clustering around 3.75%, and they can make it appear like someone can afford a much larger loan, that commission check blows the one for the loan and the property that this customer can really afford out of the water. When they can make it appear like someone who really barely qualifies for a $400,000 loan can afford a $775,000 loan, and the commission on the $400,000 loan is at most two percent of the loan amount, that loan officer is making over twenty-nine thousand dollars, as opposed to between four and eight thousand for the sustainable loan, and that real estate agent (assuming a 3% commission per side) is making over twenty-three thousand dollars as a buyer's agent for hosing their client, as opposed to $12,000 for the property the client can really afford. Not to mention that if they were the listing agent as well, not only have they made $46,000 for both sides of the real estate transaction, but they have found a sucker that can be made to look as if they qualify for that property, making their listing client extremely happy - the more so because one of listing agents standard tricks is talking people into upping their offers based upon how little difference it makes on the payment. Ladies and gentlemen, if the property is only worth $X, it's only worth $X, and it doesn't matter a hill of beans that an extra $20,000 only makes a difference of $50 on the minimum payment for an Option ARM, as these loans are also called. Indeed, Option ARM (aka negative amortization) loan sales were behind a lot of the general run-up in prices of the last few years. By making it appear as if someone could afford a loan amount larger than they really can, this sort of real estate agent and loan officer sowed at least part of the seeds by making people apparently able, and therefore willing, to pay the higher prices because the minimum payment they were quoted fit within their budget. When someone ethical is showing you the two bedroom condo you can really afford, fifteen years old with formica counters and linoleum tile floors, these clowns were showing the same people brand new 2800 square foot detached houses with five bedrooms, granite counters, and travertine or Italian marble floors. Talk about the easy sale! Someone who's not happy about what they can really afford now finds out there's a way they can apparently afford the house of their dreams!

So now that the Option ARM has finally been generally discredited by all the damage it has been doing to people these past three to four years, and has become well known, and deservedly so, by the moniker "Nightmare Mortgage," among others, this type of agent and loan officer are jumping for joy and shouting from the rooftops that a couple of professors have done apparently some work showing that "the Option ARM is the optimal mortgage." It was reported in BusinessWeek, which would have reason to celebrate if this defused the mortgage crisis, and therefore the credit and spending crunch that comes with it.

The problem is that the "Option ARM" these professors are talking about has very little in common with the Option ARMs, or more properly, negative amortization loans that are actually sold for residential mortgages. If you read their research, the loans they describe actually look a lot more like commercial lines of credit secured by real property. There really isn't much more in common between the two than the name.

The characteristics the professors describe in their ideal loan include first, it being the lowest actual rate available. This is not currently the case. In fact, since I've been in the business, it has NEVER been the case - or even close to being the case. The nominal rate can't be beat, but the nominal rate is not the actual interest rate you are being charged. Ever since the first time I was approached about one of these by a lender's representative, I have always had loans at lower rates of interest, with that rate fixed for a minimum of five years. For the last year and a half or so, I've had thirty year fixed rate loans - the paranoid consumer's dream loan, which usually carries a higher interest rate than anything else - at lower real rates of interest than Option ARM. When you're considering the real cost of the loan, it's the interest you're paying that's important. The lender, or the investor behind them, isn't reporting the payment amount as income. They're reporting the cost of interest to the buyer as income, and that's what they're paying taxes on as well. But because people don't know any better than to select loans on the basis of payment, lenders can and do get away with charging higher rates of interest on these. The suckers pay a higher rate of interest than they could otherwise have gotten, and their balances are going up, which means they're effectively borrowing more money all the time, on which they then pay the inflated interest rate that is the real cost of this money. What more could you ask for, from the lenders and investors point of view?

Now there is a real actuarial risk associated with these loans, as well, which does increase the interest rate that the lenders need to charge. This is that because there is an increased risk that the borrower's balance will eventually reach beyond their ability to pay, a risk which is exacerbated by how these loans are generally marketed and sold, a larger number of borrowers will default than would be the case with other kinds of loans. So these loans aren't all fun and games from the lenders point of view, either - as said lenders have been finding out firsthand for the last several months as the loans go into default. This leads us to the second dissimilarity between these loans as they exist, and the loans said to be optimum by the professors research, and this one is a real problem from the lender's point of view.

You see, the professors' study assumes that the lender can simply foreclose as easily and as quickly as sending out an email. That's not the way it works. First of all, foreclosure takes time, and it costs serious money. The law is set up that way. To quote something I wrote on August 23rd, 2007:

It takes a minimum of just under 200 days for a foreclosure to happen in California, and we're one of the shorter period states. Notice of Default can't happen until the mortgage is a minimum of 120 days late. Once that happens, it cannot be followed by a Notice of Trustee's Sale in fewer than sixty days, and there must be a minimum of 17 days between Notice of Trustee's Sale and Trustee's Sale. Absolute minimum, 197 days, and it's usually more like 240 to 300, and it is very subject to delaying tactics. There are lawyers out there who will tell you if you're going to lose your home anyway, they can keep you in it for a year and a half to two years without you writing a check for a single dollar to the mortgage company. It's stupid and hurts most of their clients worse in the long run, but it also happens. Pay a lawyer $500, and not pay your $4000 per month mortgage. Some people see only the immediate cash consequences, and think it's a good deal.

So that loan is non-performing for a time that starts at just under nine months, and goes up from there. This costs the lenders some serious money - money which they expect to be actuarially compensated for, which is to say, everybody pays a higher rate so that the lender doesn't lose more money on defaults than they make on the higher rate. I checked available rates on loans this afternoon, and for average credit scores on reasonable assumptions, the closest the Option ARM came to matching the equivalent thirty year fixed rate loan was 80 basis points (8/10ths of a percent), and that wasn't an apples to apples comparison, as the Option ARM had a three year "hard" prepayment penalty, while that thirty year fixed rate loan had none, as well as the Option ARM had the real rate bought down by a full percent by a lender forfeiting sixty percent of the usual commission for the loan to buy the real rate down. How often do you think that's going to happen? Sure, the *bleeping* Option ARM had a minimum payment of about $1011 on a $400,000 loan, as opposed to $2463 for the thirty year fixed rate loan fully amortized, but the real cost of money was $2350 per month, as opposed to $2083 for that thirty year fixed rate loan, and the equivalent payment for the Option ARM was, that accomplishes the same thing $2463 does for the thirty year fixed (theoretically paying the loan off in thirty years, providing the underlying rate remains the same), was $2675. Not to mention that the thirty year fixed rate loan has the cost of money locked in for the life of the loan, where that *bleeping* Option ARM can go as high as 9.95%, and the prepayment penalty for that *bleeping* Option ARM starts out at $14,100, and is more likely to go higher than lower for the three years it's in effect. You can't just handwave $14,100 that the majority of people who accept a prepayment penalty are going to end up paying, for one reason or another.

Another characteristic of the Option ARM envisioned by the professors is a so-called "soft" prepayment penalty, where no penalty is due if the property is actually sold, rather than refinanced. That's not the case with the vast majority of real-world Option ARMs. With only one exception I'm aware of, they're all "hard" pre-payment penalties, and the one lender who offered the "soft" penalty has discovered it's not a popular alternative, because they had to charge a higher nominal rate in order to make it work. Since the minimum payment was higher, and it wasn't quite so easy to qualify people quite so far beyond their means, that particular lender had been contracting operations, even while the rest of the Option ARM world was going gangbusters. Indeed, their parent company sold that lender earlier this year, because they just weren't getting any profit out of them, and at one point, they had been a very major subprime lender (They were extremely competitive on 2/28s and 3/27s and their forty year variants, as well as versus other subprime lenders on thirty year fixed rate loans). Until I checked their website just now, I was not certain whether they're even still in business. I haven't heard from my old wholesaler in eighteen months now.

The Option ARM envisioned by the professors lacks the "payment recast" bug present in all current Option ARMs. Indeed, under all currently available Option ARMs, it is difficult to avoid this issue, because they recast in five years no matter what. Furthermore, they professors' assumptions as to the longevity of the loan were open ended - essentially infinite in theory, although no loan given to individuals can be open ended in fact because we're all going to die someday, and most of us are going to want to retire before that, at which point these loans would definitely not be paid down to a point where they're affordable on retirement income under anything like our current system.

One final crock to the whole Option ARM concept as envisioned by the professors seems to be that the borrower gets a reserve amount if ever they default. The obvious retort is "Not in the real world." That is contrary to every practice of lending as it currently exists. That is the very basis of the real estate financing contract - the lender gets every penny they are due, first, and the borrower/purchaser/owner gets everything that's left over. As the authors themselves note, this does create a moral hazard for the lenders. Furthermore, and I must admit I'm not certain I'm reading the relevant passage correctly, another characteristic of the "Option ARM" they propose is that the lender gets primary benefit of any gain in value, and at least under certain circumstances, takes primary risk for any loss. In case you were unaware, this would completely sabotage the benefits of leverage that are the main reason why real estate is a worthwhile investment. This would certainly make the communities that make their living off selling other sorts of investment happy. Lenders, and especially current owners, not so much. Furthermore, I'm pretty certain that if they think about the economic consequences of this, real estate agents and loan officers don't want this to happen, either.

Those aren't all of the differences or relevant caveats, by any means. I took quite a few notes that I haven't yet covered, but it's bedtime, and by this point it should be obvious to anyone who took the trouble to read through the above that there really isn't a whole lot in common between the Option ARM as the contracts are currently written, and it is currently marketed and sold, and the loan of the same name as envisioned by the professor's research, except that name. Any claim that said research rehabilitates the Option ARM aka Negative Amortization Loan aka Pick a Pay aka "1% loan" aka (several dozen words of profanity), is based upon nothing more than the similarity in labeling, as if claiming a Chevette was the same thing as a Corvette, because they're both Chevrolets. Someone reading the professors' research would not recognize anything like the loan they are promulgating in any Option ARM currently on the market, because those currently offered are not based upon any of the same principles.

Caveat Emptor

Postscript: Lest I be misunderstood, I had previously come to a lot of the same conclusions that the professors had, although I had never integrated it into a single article, here or anywhere else. A lot of what they conclude, while pretty much theoretical, has some significant real world applications. Indeed, I have said several times in the past that leverage works best when it's maximized, and when you pay as little as possible towards paying off the loan, although that one result has to be modified for real world considerations like mortality, morbidity, and various psychological factors, which the professors mention in passing but do not really address or answer. I think I have some real academic appreciation for the value of Professors Piskorski and Tchistyi's work, and what went into it, and the results they have achieved. I had to dust off some portions of my brain (and mathematical textbooks!) that I haven't used in almost twenty five years, which was a treat of a certain kind once I got into it. Nonetheless, the products that go by the same name in the current world of loans have nothing to do with what these two distinguished gentlemen are talking about. The loan product I'm aware of that comes the closest is, as I said, a line of credit on commercial real estate.

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This page contains a single entry by Dan Melson published on September 26, 2007 7:00 AM.

Real Loans for Real People September 25, 2007 was the previous entry in this blog.

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