Mortgages: September 2007 Archives

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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There are several possible options to deal with this issue, depending upon the exact situation.



For A paper, both spouses must qualify, credit score-wise. The way around this is a quitclaim to the spouse who has a good credit score as sole and seperate property. The catch is that then the good credit score spouse has to qualify for the loan on their own. If the other spouse is the one that makes all the money, if the good score spouse is in a profession where the needed income isn't believable for stated income, or a whole list of other possible reasons, you may have to go sub-prime.



For sub-prime, the spouse who makes more money is the one that will be used as the determination, so as long as the second spouse is in the same vague general ballpark, scorewise, you can still use both incomes to qualify. If one spouse makes slightly more money but the other spouse has a much higher credit score, it can be to your advantage to do it stated income with the spouse who has the better score primary. You can't do this if one spouse is a doctor and the other works fast food, but you can if they're both in the same industry, or in industries where the incomes are roughly comparable, so long as the job titles and employment history don't render the claim unbelievable. The classic example of this working is both spouses in sales, paid on commission. In some instances, a quitclaim can still be the way to go.



Now if you do a quitclaim, the property doesn't have to stay quitclaimed. As soon as the loan funds, you can quitclaim it back to husband and wife as joint tenants with rights of survivorship, or whatever you want. Quite a few spouses are understandably reluctant to give up all ownership interest, but it's a temporary measure; it doesn't have to stay that way. As soon as the loan funds, you get the spouse who qualified for the loan to quitclaim it back to husband and wife, or the trust, or however they want the vesting to be. The better escrow officers I work with will usually have the quitclaim back made up and sent out for signatures without even being asked (I found this out one time when my clients didn't want it quitclaimed back, and called me when they got the form in the mail. I just told them to shred it, and called the escrow office to tell them not to bother).



Caveat Emptor

Article UPDATED here

One of the casualties of the current lending meltdown is the high loan to value second mortgage. With many properties locally having lost twenty percent or more of their value, a second mortgage on a property that ends up in default may well lose every single dollar the lender put into the loan. It shouldn't surprise anyone that lenders don't want to get into that kind of situation. Even though I (and most other credible analysts) are convinced that the values are stabilizing locally, the money markets are still in fear mode over the money they have lost or are on track to lose.

The result is that lenders of junior financing aren't nearly so willing to go to 100% financing any longer. Even when the same lender is lending the money for both loans, the people who underwrite the second mortgages are (usually) a different division. So when the property goes to foreclosure, the division who underwrote the first mortgage may end up with every dollar or nearly every dollar of their invested money, and they come up smelling like a rose. The division that underwrote the second mortgage that got wiped out and came out with 10 cents on the dollar loses their shirts, and everybody gets fired. The lender I've probably done the most business with just did away with all programs offering over 90% financing - doesn't matter the credit score or how much we can prove they make (UPDATE: My mistake - it was only subordinate financing over 90%, which further emphasizes my point). This is going to impact how much business I do with them, of course, but they've decided they're not willing to accept the risk in order to get the business - which is their prerogative.

They're hardly alone. It has been increasingly difficult to get second loans over the last couple of months. With the situation as I've have discussed, and second mortgage lenders in the process of losing every penny they put into loans, they understandably don't want to do it.

There is an alternative. There are still any number of lenders who will accept 100% financing on one loan with Private Mortgage Insurance (aka PMI).

Private Mortgage Insurance is an insurance policy that the borrower pays for but which insures the lender against loss. It does get the borrower the loan, but that is the only good the borrower can expect to get out of PMI. It does not prevent your credit rating from being ruined, it does not prevent any deficiency judgments that you may be liable for, and it definitely won't prevent the 1099 love note that tells the IRS you owe taxes on debt forgiveness. All it does is shift the entity that loses the money from the lender to their insurer, so that if you default, you'll be dealing with the insurer instead of the lender via subrogation.

What is going on here is that lenders are shifting the risks to insurers, who are in the business of taking risks via the Law of Large Numbers. Yes, the insurers know they will lose a certain number of these bets, but they are comfortable that overall they will make money at it. It is to be noted that lenders can improve their profit margins by self insuring, but they're not in the business of insurance. I'm certain some of them insure themselves in one way or another, but they isolate the risks away from their lending divisions, which are in the business of making money by loaning it out and having those loans repaid in full. When a lender loses a dollar because the loan wasn't repaid in full, that hits them where it really counts - bond rating, stock price, value of their mortgage bundles on the secondary market. When an insurer loses a dollar due to paying a claim, that's part of their daily business. They're in the business of paying claims, fully expecting premiums to more than pay for those claims.

As I said in One Loan Versus Two Loans, PMI is more expensive than splitting your mortgage into two loans, but when nobody wants to do second mortgages with less than ten percent down payment, the choices may narrow down to accepting PMI or not buying the property. The only other alternative that comes to mind is a private party loan, either in the form of a Seller Carryback (which comparatively few people are willing and able to offer) or the "good in-law" loans that were popular before lenders started liberalizing their standards in the 1970s.

(I haven't been in the business that long. I've never heard the phrase actually used by another professional, although I actually did a transaction that involved one earlier this year. I learned it from textbooks, as even in the early nineties when I both bought my first property and went back for my accounting degree they were a fading memory)

Paying PMI does have the net effect of decreasing the loan that potential buyers will qualify for, so this development should cause some small amount of additional downwards pressure in prices. For those interested in irony, the lenders are contributing to their own immediate losses by bailing out of the low equity financing market. People who have to pay a higher effective rate for the money can't afford to spend as much for a property, which means that current owners, whether they're borrowers or lenders, won't be able to get as much money for them.

One last thing before I finish. Don't get too hung up on the fact that you may end up paying PMI when experts (myself included) advise you not to. It's one of those voodoo words and concepts like "points", that people freak out about because they've been warned about them but they don't really understand. Just like points, many experts, myself included, often advise you not to pay PMI. But if you have one loan that is over 80% loan to value ratio, you are going to be paying PMI in one form or another. As I said in How Do I Get Rid of Private Mortgage Insurance (PMI)?, it can be a separate charge or camouflaged by being built into the rate, but you're still paying it. There are advantages and disadvantages to each choice, as I explained in that article. Choose your alternative with your eyes wide open and an understanding of the consequences, not because someone scares with with the voodoo phrase, "PMI."

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HI, My name is DELETED and my husband and I are searching for a way to get out of our Negative ARM loan before we get upside down.

Our problem right now is our loan to value. Our loan right now is at $547,367.80 and is only getting higher. Our house just appraised at $620,000.00. We have a prepayment penalty of $20,000.00 and would just like to get that covered. We feel we need a Jumbo loan if possible.

Our wish is to get into a 40 or 50 year fixed. My husband makes good money and I will be working in a couple of months making a decent income. Right now I am doing temp work. We can afford payments for our mortgage if we were to refinance but we are having a hard time finding someone who will take the risk with us. If there is a risk. We are just trying to get out of this loan that is going to end up taking our house from underneath us. Our credit is good and I feel there is a way something can be worked out

Can you help us?

I will try, if you're in California. First, let's stop and think a minute about your situation and what will benefit your pocketbook, rather than mine.

If you pay the penalty, your new loan is going to be approximately $570,000, even without points, something I truthfully don't think is going to happen the way jumbo rates are. Neither I nor any other loan provider can get you a loan that isn't available. $580,000 is more likely, considering prepaid interest, etcetera, unless you have some cash to pay it down. $570k and $580k are both within the band of 90 to 95%, so I have to price it as a 95% loan to value ratio.

But what if you don't have to pay the penalty? Now staying at or below 90% loan to value is a real possibility, and the loan can be priced as a 90% loan, giving better trade-offs. The way we might be able to do this is to check if we can get your current lender to refinance you. It'll likely mean renewing your prepayment penalty, but better that than paying $20,000 in penalty. Even if you end up with a higher rate than you might otherwise get because your lender doesn't have the lowest rates, $20,000 is almost four percent of your loan amount. Over the course of the 3 years of the new prepayment penalty (since that's standard for negative amortization loans), you'd have to save over a percent per year to break even with another lender. As I said in "Getting Out of Paying Pre-Payment Penalties", sometimes lenders will not require you to pay a penalty if you refinance with them and accept a new penalty.

In short, if we check with your current lender first, we might save you $20,000 cash plus the interest on it. So let's figure out who your lender is and ask.

The second alternative is to find out how long until the penalty expires. Make at least the interest only payments every month until your payment expires. How long do you have left on the penalty? If you've only got six months or a year left, rates just aren't low enough to make it worth your while refinancing right now, especially Jumbo loans, which even if your loan to value ratio was below 80% would still cost you nearly two points for a 7% loan. If you pay at least the interest only payment, you're not getting in any deeper. When the penalty expires, maybe rates and the market will be in better shape and you'll get a better loan. Matter of fact, with the current mostly psychological meltdown in the loan market, it's a moderately good bet, especially as opposed to just flushing $20,000 paying that penalty. If you have less than a year left on the penalty, I strongly urge you to make the interest only payments (or more), and come back to me about three weeks before it expires. From that point, by the time I can get your new loan funded, the penalty will have expired.

Even if you're only six months into your loan, we'd have to save you about about 1.5% on the rate for you to come out ahead by paying that penalty. $20,000 times 12/6 divided by $547,000 gives a current rate of 7.3%. As you'll see, a blended rate of 6.67 is about as low as I can get for this situation. Your rate would have to be at least 8.2% now for paying that penalty to be in your best interest.

The loan market today is a very different creature than it was a few months ago. Let's look at the alternatives, assuming your lender will waive prepayment with a new loan. Even so, let's look at a loan amount of $558,000, which is about where you're going to be with closing costs and one point.

At 90% CLTV, I currently have a 30 year fixed rate loan at 7.375%, with PMI of about 0.7% on top of that. At $558,000. Payment would be about $4180, of which roughly $325 is PMI, $425 is principal, and $3430 is straight interest. Real cost of the loan would be roughly $3755 per month. Even if I could get you a 40 year amortization at the same rate, the payment would be $3945, and at 50, the payment would be $3843.

Or we could split the loan into a 80% 30 year fixed rate first at 7.375 without PMI and a 10% second at 8.55%. Payment on the first, about $3426, of which $3048 is interest and $377 is principal (numbers don't add due to rounding to the nearest dollar). On that 30/15 second of roughly $62,000, the payment would be $479 and the interest $442 while the principal is $37. Real cost of the loan, roughly $3490 per month, $265 less, and more of it is likely to be tax deductible. Plus, in terms of payment, I've saved you more than the difference between the thirty and forty year amortization, and almost the difference between the thirty and fifty year amortization.

Or, we could split the loan into a conforming first at $417,000 with a $141,000 second, again on a 30/15. Now that first mortgage is at 6.125%, for a payment of $2534, of which $2128 is interest and $405 is principal. The rate on the second drops also, to 8.3%. Payment, $1064, of which $975 is interest and $89 is principal. Real cost of this loan, $3103 per month, and the total payment is only $3598, another $307 per month less than the second alternative and $582 less than the first alternative.

Before I close, it occurs to me to ask if you are actually able to make those payments. Because the fact is that you owe $547,000 right now, and that's a cold hard fact that nobody is going to change. Quite often, people get put into negative amortization loans because that's the only way they're going to make the payment on that much debt. If you cannot realistically make these payments, delaying the inevitable will only cost you more. As things sit, you might come away with a few thousand dollars if you sold now, and then you can buy something you can really afford. If you wait, things are going to get worse, and you're going to end up with a short payoff and a 1099 love note that says you owe taxes, plus maybe a deficiency judgment, having your credit ruined, and still not having the home of your dreams. This doesn't make me popular right now, but what people like you are going through now is the result of people in my professions who wanted to be rich and popular, rather than actually doing what was best for the clients. Were I in your shoes, I'd likely be asking a lawyer if there's some liability on the part of your lender and real estate agent.

Caveat Emptor

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