ARM Pains

ARM Pains

Washington Mutual is hobbled by increasing defaults

on the one-time popular payment option ARMs.

CREDIT MARKET By Bob Ivry and Linda Shen / Bloomberg News

Washington Mutual Inc., the thrift that lost 92% of market value in the past year, is being dragged down by a mortgage product once hailed by former Chief Executive Officer Kerry Killinger as a boost to profit.

As many as 45% of borrowers with payment-option adjustable-rate mortgages issued from 2004 to 2007 and bundled into securities may default, according to Fitch Ratings analysts Roelof Slump and Stefan Hilts. Washington Mutual held $52.9 billion of the mortgages, also called option ARMs or negative amortization loans, on its books in the second quarter, with defaults doubling to $3.2 billion from the end of 2007, according to a filing with the U.S. Securities and Exchange Commission.

"You look at all the major players in the option ARM market and they're all on their knees," says Andrew Laperriere, Washington-based managing director at the International Strategy & Investment Group research firm. "These companies have changed their stance on these loans dramatically. They were defending them as late as a year ago. They said these loans would be fine."

Two of the top five option ARM lenders, according to a ranking by industry newsletter Inside Mortgage Finance, are no longer in business and the other three have ousted their CEOs and seen their market value erode in the worst housing recession since the 1930s. Seattle-based Washington Mutual, the largest U.S. savings and loan, fired Killinger on Sept. 8 after 18 years as CEO, citing his failure to stem losses from home mortgages.

Payment spikes

Option ARMs allow borrowers to skip part of their payment and add that sum to their principal. Monthly payments increase after five years or once the loan balance reaches a predetermined limit, usually 110% to 125%. Introductory interest rates can be as low as 1%.

For the average option ARM borrower, payments will rise 63%, or an additional $1,053 a month, when their rates reset, according to a Sept. 2 report by New York-based Fitch.

Because typical option ARM borrowers make less than the full payment each month, according to Fitch, they don't build equity in their homes. When house prices fall, they owe more than their home is worth. That leaves lenders facing losses if the loan defaults and they foreclose.

About 83% of the option ARMs issued from 2004 to 2007 were underwritten without full documentation of borrowers' incomes, Fitch says.

"For most borrowers, once their loan resets, there's no place for them to go," says Hilts of Fitch. "A high percentage of them don't have equity, so they can't refinance, and they don't have the income to withstand the payment shock."

Four percent of Washington Mutual's option ARM portfolio probably will reset in the second half of this year and 13%, or $7.1 billion, will reset in 2009, according to the SEC filing.

Home price declines

With home prices falling 18.8% nationally from their peak in 2006, according to the S&P/Case-Shiller Home Price Index, almost one-third of borrowers who bought their homes in the past five years now owe more on their mortgages than their properties are worth, real estate valuation Web site Zillow.com says.

Washington Mutual issued half its option ARMs in California, according to the thrift's second-quarter regulatory filing. One in 130 households there were in some stage of foreclosure in August, making it the state with the second-highest rate, data compiled by Irvine, California-based RealtyTrac Inc. show. Nevada is No. 1.

The thrift made 13% of its option ARMs in Florida, the state with the fourth-highest foreclosure rate, according to RealtyTrac.

"It's not the product, ultimately, it was how it was administered," says Gary Townsend, chief executive officer of Hill-Townsend Capital LLC in Chevy Chase, Md., referring to Washington Mutual.

Killinger said in a July 22, 2004, conference call with analysts that option ARMs were a product that would boost Washington Mutual's profit margin.

"We will emphasize origination of higher margin product such as option ARMs and we will emphasize originations through our retail and wholesale channels," Killinger said.

Six months later, Chief Financial Officer Thomas Casey told analysts that the lender would "push that option ARM as hard as we can."

"We believe that the option ARM is a differentiating product for us, and we're continuing to see nice gains on that compared to some of the other products that are out on the market right now so that will be a continued focus for us," Casey said Jan. 20, 2005.

Killinger's departure from Washington Mutual came as the thrift signed a memorandum of understanding with its regulator requiring the bank to improve its risk management.

An e-mail to Washington Mutual spokesman Brad Russell was not returned.

Wachovia

Washington Mutual was the second-biggest provider of option ARMs in the second quarter, behind Charlotte, N.C.-based Wachovia Corp., which held $122 billion of the loans, according to a company filing.

Countrywide Financial Corp., formerly the biggest U.S. mortgage lender, had $25.4 billion of the loans on its books in the second quarter. Bank of America Corp. bought the company on July 1. The Calabasas, Calif.-based lender had the third- highest amount of option ARMs.

Downey Financial Corp., a savings and loan based in Newport Beach, California, held $6.9 billion at the end of the second quarter, according to a filing, making it the fourth-largest U.S. option ARM lender, according to Bethesda, Maryland-based Inside Mortgage Finance.

Downey, with second-quarter assets of $12.6 billion, has lost 95% of its market value since the beginning of the year. It replaced its CEO, Daniel Rosenthal, on July 24.

Seized by regulator

In July, IndyMac Bancorp Inc., the Pasadena, California-based lender that began as a spinoff from Countrywide, became the third- largest bank in U.S. history to be seized by its regulator, the Federal Deposit Insurance Corp., after depositors withdrew more than $1.3 billion in 11 business days. IndyMac held $3.5 billion of option ARMs, the fifth-largest amount.

Wachovia, the fourth-largest U.S. bank, lost 71% of market value in the past year. In July, the bank ousted CEO Kennedy Thompson, whose $24 billion purchase of Golden West Financial Corp. in 2006 came with a portfolio of option ARMS.

Robert Steel, the former Treasury official who replaced Thompson as Wachovia's CEO, said at a Sept. 9 investors conference in New York that he approached the option ARMs "as if we were a distressed investment manager."

Brock Davis, a broker with U.S. Express Mortgage Corp. in Las Vegas, calls option ARMs "neutron loans" because "three years later the house is still there and the people are gone."