Believe it or not, the 'optimal' mortgage is an option ARM

Posted by: Peter Coy on September 21, 2007

If you had to name the most toxic, dangerous, foolhardy kind of mortgage loan that exists, you’d very likely pick a pay-option ARM, which lets borrowers get deeper into debt by paying less than the minimum interest they owe each month and adding the unpaid interest to the loan principal. Worse yet, you might say, would be a pay-option ARM with a very high penalty for prepayment so borrowers can’t get out of it easily once they’re in it. There’s a move afoot to ban these worst-of-the-worst loans.

Guess what? The worst is actually the best.

Yes, according to a new study by professors from Columbia and New York universities, the “optimal” mortgage in a perfect world is precisely that kind of loan—an adjustable-rate mortgage with an option for negative amortization and a ban (or at least severe restriction) on prepayment.

Crazy? Not as crazy as you might think. The key, according to professors Tomasz Piskorski of Columbia Business School and Alexei Tchistyi of New York University’s Stern School of Business, is that this kind of mortgage is optimal only in a perfect world—namely, one in which borrowers are fully rational and always do what’s in their own best interest.

In the real world that we are condemned to inhabit, many people who took out option ARMs foolishly believed that they would never have to pay more than the bare minimum monthly payment. They have stuck with that minimum payment month after month, causing their loan principal to go up and up. At some point they have hit (or soon will hit) a ceiling on total permissible mortgage debt, at which point the terms change and their monthly payments soar to unaffordable levels. Next step: default and foreclosure.

The immediate reaction of most non-academics is that these economists have their heads in the clouds, or somewhere else. Former Federal Reserve Chairman Alan Greenspan has come in for the same kind of criticism for having said during the housing boom that millions of homeowners could save money by switching from fixed-rate to adjustable-rate loans.

But there’s a more positive way to look at the research. If the optimal loan really is better for homeowners who behave rationally, maybe it makes sense to get people to behave rationally through extensive, even expensive, consumer education. In an interview, Piskorski told me that by his rough calculation, the benefits of the optimal mortgage vs. a conventional mortgage amount to a least half a percentage point of interest—namely, $50 billion or more a year for the U.S. as a whole. In other words, you could devote many billions of dollars a year to consumer education about these misused-but-potentially-valuable loans and still come out ahead.

For those with patience for details and a head for numbers, I can refer you to the 65-page, equation-filled academic paper, downloadable here.

Alternatively, here's a quick, intuitive feel for the three parts of the concept:

*The option to pay less than the minimum monthly interest owed on the loan is valuable for people with good self-control whose income fluctuates a lot. They can pay just a little in lean months and catch up in fat months. It's good for lenders, too, because they don't have to foreclose on people who fall behind, which is an expensive process. People with steady incomes don't need this feature, but having it doesn't hurt them.

*The fact that the loan is an ARM--namely, its rate fluctuates with market interest rates--is especially valuable to lenders. This is a subtler notion, but the idea is that if there are going to be a certain number of defaults in a pool of mortgages because of random bits of bad luck like a job loss or a divorce, the lender would prefer that they be concentrated during periods of high interest rates. Why? Because when market interest rates are high, the lender that forecloses and gets back (most of) its money can redeploy the cash in high-yielding alternatives. The lender would prefer not to foreclose and get its money back when rates are low and other options are unattractive. An ARM loan achieves what the lender wants. Borrowers, meanwhile, are neutral about whether they default in periods of high or low market interest rates.

*Finally, the economists say the optimal loan contract would outright ban getting a new loan from a different lender. There are no such bans. But they say that the prepayment penalties that are common in subprime loans are a good second best. How could that be? Because lenders will offer more favorable terms if they know that they'll be able to hang onto the loan long enough for it to be profitable. If they fear that the borrower will refinance at the drop of a hat, they'll give less favorable terms.

One neat twist is that the paper demonstrates that an interest-only loan coupled with a home equity line of credit is also optimal because it's the functional equivalent of an option ARM. Think about why: Someone with an IO loan and a line of credit is equally able to tap into home equity (i.e., add to the principal owed) from month to month.

Piskorski says he and Tchistyi have received strong support from other professors and are seeking to publish their paper in a major journal.

Says Piskorski: "Obviously people are to some extent irrational. But if you want to ban this type of contract, you should really weigh the benefits and the costs. How much could you educate people? Make people understand them. Provide them with software. Make a federal law that requires the lender to reveal what this contract is about."

Reader Comments

ifyoudontunderstanditdontbuyit

September 21, 2007 5:25 PM

Both Warren Buffett and Chip Mason would not buy sthing they do not understand. But of course, we now have to rescue the dumbest of the dumb who believe in free money.

Mark Prosachik

September 21, 2007 6:11 PM

Didn't Nobel prize winning eggheads cause the LTMC collapse in the late 1990's? We don't need academic advisemnt based on theoretical assumptions like a rational borower, which we all know rarely exists in practice.

If the theory has any validity, let the professors take out an option ARM.

Michael Shorey

September 21, 2007 6:49 PM

The author of this article is an academic moron! Book smarts but no street smarts.
Any one who has been in the mortgage business for more then two years can tell you the "concept" is sound, but the reality is that people are sold this type of loan to buy a house that they can not afford with the idea that the neg am adding to the balance will be out weighed by the "equity you build in the property".....opps, I guess the market corrected this year and many people found themselves re casting into a loan payment they can't even come close to affording, not to mention that they are upside down on the LTV and can't refi their mortgage.
This product was made popular because the lenders who sold the product offered mortgage brokers huge rebates on the loan product! So the broker would turn around and tell the borrower that they would only charge them very little to do the loan.
This is truly predatory lending in the true sense of the definition and is one of the biggest reasons the foreclosure rate has ski rocketed.
This guy needs to get his head out the books and get into the real world....

Jim

September 22, 2007 11:37 AM

If you have brokers and wholesale account executives selling pay option arms with the highest margins and with 3 year prepays it is not to benefit the borrowers its to make the company the most amount of money with little regard for what will happen to the borrowers greed kills huge fines and jail time will teach the mortgage industry not screw the homeowners

Dan Green

September 23, 2007 7:10 PM

A little over a year ago, this same mortgage product was the Business Week cover story. Mara called them "Toxic Mortgages".

Wow. Thank goodness you have this blog, Peter, or else the information may never have seen publication.

Jim D

September 24, 2007 1:58 AM

So - is this the same "perfect world" where communism actually works? I bet it is.

Doug

September 24, 2007 10:35 AM

This is why economists are in colleges and not in the real world.

The real lenders over the last several years did not give both prepayment penalites and favorable terms to the borrower. The lenders gave both prepayments and bad loan terms.

This can be seen when the borrower can not refinance out of high interest while the rates skyrocket on them. This is because the prepayment penalty make it impossible to refinace the loan.

darren brown

September 24, 2007 12:11 PM

All my investment properties are in this type of loans - I dont understand you ! I love this loan - it gives me the freedom to make what ever payment I want. I guess I use more that 13% of my brain unlike others - Darren

Chuchundra

September 24, 2007 2:59 PM

The mistake here is that a borrower taking out an Option ARM with a serious prepayment penalty needs to be more than just rational about their borrowing, they need to be more than reasonably well-informed about the ins and outs of the mortgage business, YSP, margins, points, etc., to make an informed decision about which loan from which lender offers the best deal and how to spot fraudulent mortgage brokers looking to rook them.

An Option ARM is a very complex financial product and if you make a mistake with it is can mean the financial ruin of your family. Given the level of understanding that most people have of money and finance, experts shouldn't promoting this type of product for the general population, even just in theory.

finances

September 25, 2007 10:44 AM

For an example of savvy borrowers (complete with pic) go there http://www.nytimes.com/2007/09/25/business/25broker.html?hp . Maybe those borrowers were misled, but what went through their minds in the first place thinking that they could afford to buy a house with monthly loans payments HIGHER THAN THEIR MONTHLY INCOME ???? Also remember that any attempt to consider that some borrowers are dumber than other when it comes to additions and substractions is POLITICALLY INCORRECT FINANCIAL SKILLS PROFILING.

Matt Carter

September 25, 2007 7:32 PM

For another take on this study, check out Calculated Risk.

http://calculatedrisk.blogspot.com/2007/09/clockwork-mortgage.html

Steve C.

October 2, 2007 11:40 AM

An example where the academics are right, but wrong.

The option ARM is the perfect loan for anyone with financial discipline. Constantly adjusting interest rate, yet the ability to under-or-over-pay each month.

However, the hundreds of thousands of undisciplined, unsophisticated borrowers who were unlucky enough to meet an unscrupulous loan broker were not the ideal target customer for this type of loan. They got one anyway, lured by absurd teasers rates and qualifying the borrower at the teased rate.

Finally, witness World Savings, whose portfolio is 99% option ARMs with stellar results. If option ARMs are so toxic, why has their portfolio done well through all market cycles? Gee, could it be they only lent money to those who knew what they were getting?

Barry B

October 8, 2007 6:06 PM

Financial Planners tell us to always pay ourself first. What if the borrower pays the minimum payment and uses the difference of the full payment and minimum payment to contribute to their 401k. The 401k contribution will reduce their taxable income and will grow tax deferred with compound interest over the life of the loan. The future value of the money saved can be used to reduce the priciple balance later on down the road. Do the math. Cash flow, liquidity and preservation of capital are all good reasons to pay the minimum provided you can afford the full payment.

Brian Lawson

October 26, 2007 1:22 PM

Darren and Barry.....you can't be serious!!!! Taking a loan at ~3% IO min payment when the underlying rate is really 8.875% is the most moronic thing in the history of history. I am the license holder in AZ. Do you have any idea how many people were ripped off by brokwer (and the lender) with the BS minimum payment crap. With a 4.5% margin and a 5.4% LIBOR on a max cap of 115%....in a DECLINING market....do you know how many people are now "forced" to pay the fully indexed and outragious payment...with ZERO chance of refi or sale becasue they owe $50,000 more than the home is worth!!!! WHY NOT USE THE CofI as the Index??? I know....I know....becasue the rebate isn't as big becaus ethe CofI is a less volatile index. Jesus people are dense!!! People like Barry and Darren. I HATE Option ARMs and I am glad Countrywide is almost dead in the water for doing it to people left and right!

Michaela S.

October 30, 2007 3:23 PM

The MAIN problem and resulting negativity here is the fact that option arms are very sensitive and complex financial tools. They have been around since the 80's, but mostly available as a sophisticated instrument allowing more flexibility in managing finances, not simply as a way to own a home. Once they have been marketed as a commodity mortgage without the clear explanations required to clarify their purpose and intent - the outcome was, unfortunately, predictable. Being a financial professional it may be easy for me to say it - but I do believe that educating the public is a must. This is not a one-size-fits-all product. The professors studying this mortgage are not necessarily "with the head in the clouds", they just say it like it is: people need education and tools. It's like the old saying: go to the bank when you DON'T need the money. Above all, this mortgage is not about the rate itself, it's about the WAY it is structured for a period of time. This flexibility will call for a higher price, that is done by design. And, one more CONSISTENTLY forgotten detail: the deferred interest due to the lender it slowly corroded by inflation. This means the borrower has access to the money TODAY to do something with it, whereas the lender does not. The purchasing power and investment opportunity cost of the deferred interest is lost to the lender. This is not theory, it's reality, except it most likely was not properly explained to the borrower, hence the current situation. In the end it's all consumption vs. conservation, with the discipline to have and reach certain financial goals.

Eric Johansen

November 21, 2007 1:12 PM

Brian Lawson & Michaela S (above) are right-on; stole my thunder so I'll not reiterate their excellent comments. I'll add as a financial professional that when W-Fargo & Countrywide came out with their "125%" mortgages many years ago I discouraged clients from getting into such nonsense. This is more of the same! What good is ANY theory practiced by incompentents? Why hand a loaded and cocked firearm to someone untrained in its use? The SEC & NASD onerously regulate that industry. Similar scrutiny brought to bear on the mortgage industry is years overdue. By the way a much simplier, better idea to get rid of any mortgage faster is the Money Merge Account offered by United First Financial. It really works and Broker Banker Magazine even e

Michaela S.

December 5, 2007 11:23 AM

Eric, your comments were somehow cut off. Please continue so we can follow. Thanks for your comments so far. I also agree that regulation is way overdue, and education is of even greater importance. Specializing in option arms, I noticed that marketing materials were few and far between, with just a few serious players offering them. These players are still here, but they only deal with A paper loans, no subprime. As a practical matter, the way to avoid an option arm recasting earlier than its term due to excessive principal approaching 110% or 115% of the original loan balance is to just pay more into the principal so as to slow down this process. Of course, when panic strikes there are no solutions in sight, but that is why the public needs to be aware and educated about the practical aspects of this loan. It's almost too simplistic to say this, but when we are driving too fast and a pole is approaching - do we not hit the brakes? It's been a pleasure posting here, thank you Mr. Coy and Business Week.

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About

BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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