When Wachovia bought Golden West Financial two years ago, executives at the Charlotte-based bank gushed about how they could take the “Pick-A-Pay” mortgage that was Golden West’s signature product and expand it to the rest of its customer base nationwide. The product was a mortgage that gave borrowers several choices each month on how much to pay—a regular payment (the kind you’d make on a 30-year mortgage), a payment covering only interest, and a minimum payment that only covered a portion of the interest due and lumped the rest back on top of the principal amount. That created a situation called “negative amortization,” in which the loan balance could actually grow if borrowers only made the minimum payment.
The “Pick-A-Pay” mortgage – coupled with Golden West’s vaunted underwriting process – created an aura around Golden West that Wachovia couldn’t resist. The bank loved to crow about how during the 1990 recession, its losses from mortgages-gone-sour was less than 0.20% — a fraction of that traditionally suffered by mortgage lenders during a downturn. While much of Wall Street was in shock that Wachovia would acquire a big California mortgage lender at the top of the housing bubble, Wachovia execs acted as though they’d found the finance equivalent of Indiana Jones’ Crystal Skull. Buying Golden West not only gave CEO Ken Thompson the beachhead into California he’d long coveted, but also gave the bank a product and capability that would allow it to emerge from any housing correction unscathed. Or so they convinced themselves.
You know how this movie ends, right? The foreclosure rate at Golden West soared past the historical norms, the losses mounted, and last month Wachovia’s board forced Thompson to walk the plank—making him one of the highest-profile casualties of the housing bust. Wachovia recently told Wall Street that by the end of the housing bust, it could suffer losses on as much as 7% to 8% of the value of all Golden West mortgages. Just look at this chart from Credit Suisse showing the coming wave of option ARM mortgages that are scheduled to reset and you see the problems that are about to hit lenders like Wachovia.
And earlier today Wachovia announced it was suspending the prepayment penalties in Pick-A-Pay mortgages – and would strip out the “minimum” payment feature that resulted in negative amortization…
That’s an admission that a lot of borrowers were put into loans they either didn’t understand or couldn’t afford and that a further surge in defaults is inevitable. Wachovia clearly wants the ability to refinance these borrowers into loans they can remotely afford (of course, given that 60% of Golden West’s Pick-A-Pay mortgages are in California, where home prices are plummeting, many borrowers may simply choose to walk rather than keep paying on a mortgage that’s $150,000 more than the current value of their home).
How did Golden West – which crowed about its dearth of losses during the 1990 recession – blow it this time? I actually spent a day in San Antonio a little more than year ago meeting with the top executives from Golden West’s mortgage operations. The Golden West execs spent much of the day talking up their vaunted underwriting – while other lenders were engrossed in algorithms and computer modeling of loss rates, they employed a “common sense” approach to underwriting. That involved simple things like closely comparing an applicant’s income to their profession—which would raise red flags if a clerk at a video rental store claimed he was making $125,000.
But Golden West also talked up its exhaustive appraisal process. Golden West didn’t hire outside appraisers, as many lenders did this decade, but used a dedicated team of full-time appraisers. And these appraisers were not graded and incented by how many loans they signed off on, but by the accuracy of their appraisals over the ENTIRE LIFE of the mortgage – a scorecard that was, as they joked, a “forever file.” I even got to ride with a Golden West appraiser for 45 minutes and get a primer on all the tell-tale signs he looked at to accurately determine a home’s worth.
The idea was that by conducting such exhaustive scrutiny on the appraisal, Golden West ensured that IF the borrower went into default, the thrift could sell the house for as much – or even more – as it was on the hook for. That was an “asset”-based approach, rather than an “income”-based approach that put more weight on verifying a borrower’s pay and assets, and then analyzing how much mortgage they could afford. But this “asset”-based approach assumed that housing would never plunge in value—nor that borrowers would simply walk away from a house that plunged in value. And in recent weeks, the deficiencies in Golden West’s underwriting – for one, the thrift didn’t call employers to verify income – came to light.
I have to say that while I was somewhat impressed by what I saw that day in San Antonio, something didn’t completely smell right. The Golden West executives could show their PowerPoint slides about historic loss rates, and show photos of homes they’d loaned against when others wouldn’t, but I just kept thinking…yeah, but California housing is up a gazillion percent this decade, so much so that only a small fraction of Californians can even afford to buy at these levels. I’d watch all those “Flip This House”-type shows that my wife followed on HGTV and say, “$900,000 for that tool shed of a house? THIS is what Golden West is lending against???”
And as we now know, it’s going to cost Golden West and Wachovia a lot. Gary Townsend, a veteran bank analyst who is now a partner in Hill Townsend Capital, believe Wachovia could over time lose the equivalent of the entire $25 billion it paid for Golden West. I think it could cost even more. Wachovia had a near-death experience in the late 1990s, when its disastrous acquisitions of The Money Store and CoreStates Financial produced such huge losses that it was fortunate it wasn’t taken over by another bank.
I think there’s a real risk Wachovia gets taken out this time around by either J.P. Morgan Chase, Wells Fargo or…Goldman Sachs (yup, that’s the rumor floating around at the moment, which doesn’t completely make sense to me. Investment banks have historically been loath to get into commercial banking because of the lower returns). And with Wachovia’s stock now down 70% from its 52-week high, any acquirer may get to “Pick” what they “Pay.” And they might choose to pay--you guessed it--the minimum.
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.