One of the ugliest consequences of the last housing boom has been the rise of risky loans known as option ARMs. The adjustable-rate mortgages let borrowers make smaller monthly payments than they actually owe, with the shortfall getting tacked onto the balance. In recent years that feature has allowed many people to buy more house than they could otherwise afford. Once the balance hits a certain level, the loan resets with higher payments--often, so high that borrowers end up in deep financial trouble.
Bank regulators have been paying close attention. In October, the Office of the Comptroller of the Currency issued new underwriting and disclosure rules designed to protect consumers from risky loans they don't understand. These new standards, along with the weakening housing market, have had a chilling effect on some big option ARM lenders: Washington Mutual Inc.'s (WM) volume fell 29% in the third quarter from a year earlier, to $11.6 billion, while Countrywide Financial Corp.'s (CFC) originations dropped 48%, to $14.9 billion.
But that doesn't mean option ARMs are going away. According to Desmond Macauley, a managing director of RBS Greenwich Capital, a brokerage and research shop, option ARMs made up 15% of mortgage originations in the first half of this year, up from 8% last year. And much to regulators' chagrin, most of that volume has come from new players that don't fall under the purview of the OCC: investment banks, real estate investment trusts (REITs), private equity players, and other mortgage outfits eager to make option ARM loans and then sell them off to professional investors.
Mortgage REITs have been feasting on exotic mortgages lately. American Home Mortgage Investment Corp. (AHM), for instance, originated about $5.4 billion of option ARMs in the third quarter of 2006, making it the No. 7 option ARM lender behind Countrywide, Golden West, and Washington Mutual. Analyst David C. Stumpf of A.G. Edwards Inc. in St. Louis notes that American Home's underwriting standards seem solid so far. But he worries that its independent sales force of brokers may not be explaining the risks well enough to their customers. "There is no question that the risk profile is elevated," he says. American Home Mortgage declined to comment.
ENTER WALL STREET
General Motors Corp.'s (GM) mortgage financing business has also been a huge player in option ARM lending lately. Its Homecomings Financial unit alone increased its volume to $1.6 billion in the third quarter, up from $769 million last year. GMAC is set to be sold to New York private equity firm Cerberus Capital Management and other investors, where it will stay outside the OCC's reach. GMAC says it makes sure consumers know the risks and that it lends only to strong borrowers.
Wall Street is getting into the game, too, by acquiring mortgage lenders. Merrill Lynch (MER) on Sept. 5 bought First Franklin Financial from Cleveland-based National City (NCC). Morgan Stanley (MS) on Aug. 9 agreed to buy subprime underwriter Saxon Capital Inc. (SAX). Others are on the block, including H&R Block's (HRB) Option One unit. The Street's goal: to obtain pipelines of mortgage loans they can sell directly to investors.
For now, it's working. "There's a tremendous amount of cash in the marketplace searching for return," says Jim S. Fowler, director of research at JMP Securities, a boutique investment bank in San Francisco. Adds Frederick Cannon, an equity analyst for New York-based Keefe, Bruyette & Woods: "From a pure profitability standpoint, these loans still look pretty good to these people." But, he says, "it's interesting that the people who know this product best are scaling back."
The biggest worry for consumer advocates is the market's shift from regulated to unregulated players. Now it's up to individual states to rein in option ARMs. Says OCC Chairman John C. Dugan: "The issue is whether states will adopt the nontraditional mortgage guidance in the same form as the federal agencies. If they do, will they implement it in the same way? There could well be a significant gap."
By Mara Der Hovanesian