A Prime Example

MORE BAD NEWS KEEPS ROLLING IN from the mortgage industry. If you simply can’t read another word about subprime mortgages, you’re in luck. Prime mortgages have now joined their younger brothers and, in some respects, are now in on the fiasco.

Option adjustable-rate mortgages (ARMs) have bled into the once profitable prime mortgage industry. Once reserved for only trustworthy borrowers with good lines of credit, the lending standards became relaxed and option ARMs began to grow in popularity. It isn’t difficult to see why this would happen.

An option ARM is similar to the standard ARM that we’re familiar with. Borrowers become attracted to an extremely low introductory, or teaser, interest rate that lasts for the first few months. These teaser rates can sometimes be as low as 2%. Of course, nothing good lasts forever, and very quickly the rates shoot up.

The difference is that with option ARMs, borrowers have the choice to pay as much or as little as they want per month. The first option they can choose is the traditional way to pay on a mortgage. With this option, the borrower pays the principal and the interest every month for either a 15- or 30-year term. The principal amount of the mortgage decreases with every payment.

The second option is an interest-only payment, in which the interest is paid every month, but the principal amount remains unchanged.

The third, and most attractive, option is the minimum monthly payment. This option does not pay on the principal, nor does it fully cover the interest due. This kind of payment comes in very handy when a borrower is strapped for cash or is expecting to have an increase in income in the near future.

The problem, of course, is that it isn’t as simple as just delaying your payments. The amount of interest not paid is just added to the principal amount owed. This comes back to hurt borrowers in two ways. First, the rates adjust after the introductory period and then reset at a certain point, usually the five-year mark. What happens then is that the amount of money that you owe has increased, rather than decreased, over time. Essentially, this is just adding to the price of your house.

Once the rates reset, the new interest rate is calculated on the new amount owed, which is the original principal plus any unpaid interest. Borrowers find themselves in the unenviable position of having to pay more money in less time. The amount of interest owed has also risen exponentially, and many homeowners will find themselves simply unable to pay.

Countrywide Financial Corp. began to offer these kinds of loans in 2003 and is currently one of the largest lenders of option ARMs. The amount of option ARMs that Countrywide sold began to grow and grow as the loan officers realized how simple they were to sell. Commissions began to rise and Countrywide itself noticed how profitable these mortgages were.

Now, just like we’ve seen in the subprime sector, loose lending practices and overall foolish planning by top mortgage companies like Countrywide have led to many late payments and defaulted loans. Not quite at the level of subprime, but certainly rising, option ARMs, according to The Wall Street Journal, currently account for 41% of Countrywide’s loans. Of those option ARMs held by Countrywide, 5.7% were at least 30 days late.

Although many issues have arisen along with the popularity of option ARMs, this does not mean that they are fundamentally flawed. For many borrowers who have an unfixed income, these types of mortgages can sometimes be the smartest option. For example, real estate agents whose income can swing severely from month to month would be wise to finance their homes with an option ARM. That way, they can pay more during good months and less during less successful months.

That being said, many of the borrowers who got themselves into this mess were not set up that way. Many were simply trying to purchase a loan that they really couldn’t afford. If blame is going to be passed around, it must then be given on both sides of the spectrum. Borrowers should certainly be much more realistic when it comes to the type of home they can afford. Lenders should also carry a moral and financial obligation to make sure that they do not push a loan on someone who will later be crushed by its growing weight.

This does not mean that the “big bad” mortgage companies should shoulder the responsibility for making sure that every lender makes a wise decision. But with stricter lending practices, and an eye to making sure that the customer is actually capable of keeping up their end of the bargain, many companies would not find themselves in this predicament.

Countrywide, which previously was one of the biggest offenders with these lax lending practices, is now leading the charge in tightening up its standards. Of the option ARMs that Countrywide lent last year, 89% of them would now not meet its new standards. The mortgage giant is expecting a housing market fallout soon and is bracing itself with new standards and better philosophies.

Better late than never, Congress has introduced a bill that would put strict regulations on these lending practices. Democratic Representative Barney Frank (Mass.) introduced a bill that would go after mortgage brokers who engage in “predatory lending practices.” Frank has long pushed for federal regulations on mortgage lending in which lenders would not be able to make any loans that a borrower would be unable to pay back.

While the public may see this as a step in the right direction with the government swooping in to help the little guy, critics of the bill believe that it would simply be too little, too late. Federal regulations would merely set a regulatory floor while many state laws that currently exist are already far stricter. Many critics claim that this would only add confusion to an already muddled situation.

Under that thinking, it appears that Congress is trying to fight a fire with a squirt gun. Damage has already been done, and without the mortgage companies policing themselves, more deterioration could occur. Mortgage companies need to look out, not only for their borrowers, but for themselves in the long run by making wise and responsible decisions, instead of going after a quick buck.

Until next time,
Jamie Ellis

November 1, 2007