Pick-A-Pay Goes Away...

Posted by: Dean Foust on June 30, 2008

pick-a-pay.gifWhen 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.

armreset.jpgYou 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.

wachoviastockchart.pngI 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.

Reader Comments

FrequentTraveler

June 30, 2008 08:42 PM

I frequently travel through Charlotte and the area likes to promote its housing market as having escaped much of the pain in other locations. But if BoA and Wachovia stumble (and looking at the coming wave of ARM resets that is fairly certain) then the effects on Charlotte could be very painful. Similar events took place when BoA left Wilmington, DE.

Leo

July 1, 2008 01:33 AM

Businesses in many industries have gotten themselves in this same dilemma. The balance of power within corporations is the most lopsided it has ever been - years of experience and wisdom have been thrown out for youth and number crunching skills. Leadership ability no longer has anything to do with positively motivating people toward a common goal, it's now finding a bully who's closest to being a sociopath to "motivate" the troops. When workers question the direction of the company they are relegated to the back of the train where that coach will be left behind at the next station. In a pack of wolves the Alpha male is the strongest, smartest and likely most experienced of the pack. He protects, leads and nurtures the pack to achieve its goal of survival or they simply perish. In corporate America the true Alpha males have been killed off as they slept by rogues hiding behind spreadsheets and mountains of data.

eru

July 1, 2008 11:52 AM

nobody interestedin discussing about Wachovia?

Enma melendez

July 1, 2008 12:17 PM

is this bank helping custumers or going to be out of buisness.after this comment:
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.

Tom T

July 1, 2008 07:48 PM

Wachovia aka World Savings has made some bad loans in the past. However they have recently tightened up guidelines so much that they have rejected some very high quality loans unfortunately. It would be nice if the core World Savings people spun off from Wachovia's big corporate umbrella and operated like they use to. Loans that make sense. High credit score borrowers with significant equity postions of 30% down payments or more. It is not worth it to a borrower with 30% invested in a home with a high credit score to walk away from a home and damage their credit.

scambuster

July 2, 2008 05:06 AM

CEO of banks and mortgage companies now means Criminal Executive Officers. Wearing fancy monkey suits and chomping cigars, these CEO thought they could spin bogus mortgage IOUs into gold. Talking out of the side of their mouths, they even got the insurance companies holding the bag. Look happened to Ambac and MBI. The massive liquidity meltdown resisted even Fed Reserve intervention to the tune of $500billions. This means the liquidity crisis caused by the massive fraud in toxic mortgage papers is a blackhole. Remember that Bearn Stearn, Countrywide, Wachovia, Citibank, Caryle Group, UBS, WM, Merril Lynch, LehmanBros, CreditSuisse, BoA, and etc, etc have suffered huge losses that even UncleSam can't help. Preliminary estimates is 2 trillion dollars of taxpayer money will be required to stem the hemmorrhage. (CEO gets the golden parachutes and the taxpayer foots the bills, so what else is new?) What happen at Wachovia happened similiarly at other banks: Greed and more greed lead to repackaging mortgage IOUs that had questionable value. These are the bogus IOU papers still held and insured by business corporations that are waiting for the other shoe to drop. The day of final ARM reckoning is still one to two years away. Stay tune for massive foreclosures and more collapse of this giant pyramid hoax formulated by real estate dealers, agents, mortgage brokers, and property appraisers. Brace yourself for the repeat of the '29 Depression.

Theo E.

July 2, 2008 06:25 PM

This was a good product for many; however, the ARM scare in the industry has pegged these as bad loans. It's unfortunate, but when this does turn around the media will be writing articles about how difficult it is for home owners to obtain financing and banks are not being fair. The majority of loans in default were made with 0 down and had rates fixed for only two years. They had huge adjustable margins, which made for a perfect storm for default.
As far as Golden West, I am sure their default rates have increased, but no where near as many as the banks that did 100% financing and shorter term fixed rate options.
Golden West margins were always well priced. In addition, clients needed 30%+ down to even qualify. Here again, the banks are digging their own grave. They want to make their investors happy and no one in the lending industry is stepping up to the plate. It’s a sad sight because home owners are the ones suffering not too mention home values.

Citizen Zeus

July 3, 2008 02:50 AM

Oh, boo hoo it was the poor unrecognized alpha males with all their rationality-quickening testosterone that got screwed. If we'd only listened to them and not those weenie, nerdy number crunchers. What a joke. It is precisely the so-called (brain-dead, steroid-driven) alpha males that caused this mess. Yes I believe in old school, but that'd be our grandparents generation, the one's who grew up in the Depression and knew about maintaining the public good, working hard and playing by the rules. This baby-boomer "alpha" crap is the self-absorbed pseudo-vanguard that created this mess and the number crunchers just provided the justification. The only consistent quality in the so-called alpha male is his ability to take the credit and the profit and stick the blame and liability on someone else (see both Bush and Clinton for the classic symptoms). Take responsibility for once in your life!

Paul E. Math

July 3, 2008 07:00 AM

Theo E., I beg to differ.

You say 'when this turns around the media will be writing articles about how difficult it is for home owners to obtain financing'. Do you mean 'home buyers' rather than 'home owners'? Home owners should not need additional financing. Extracting the equity in your home is like voluntarily paying more for your home - you have to pay this money back! And anyway, being denied a heloc or home equity loan is hardly a tragedy worthy of media attention.

If you meant that home buyers won't be able to get financing when the market turns around, I think you mistake cause and effect. The housing market will not 'turn around' until buyers are able to get financing they can afford. So the situation you describe is a physical and logical impossibility.

Also, any notion of a 'turn around' is a mischaracterization. Home prices will continue to fall until they stop falling and then they will appreciate slowly, at the same rate as inflation. That's it. No 'turn around'. Yearly double-digit home price appreciation will always be a short-lived fantasy.

Golden West is a turd and Wachovia shot themselves in the foot by making this acquisition. I doubt many of their clients really had 30%+ down payments, as you claim. Otherwise they would not be defaulting at such dramatic rates. What is more likely is that they had 0-5% down and the seller gave them 25-30% cash-back to be used as 'down payment'. This shady practice was commonplace, particularly among homebuilders selling new homes.

Good luck everyone. Don't bite off more than you can chew.

ross klein

July 3, 2008 08:19 AM

Wachovia had over 120 billion of these loans,half of which were in Cal.If the housing market continues to head South ,then a loss of over 30 billion is certaintly within the range of possibility.Add that number to the 24 billion of construction loans, then total losses could easily add up to 45 billion.The only way for Wachovia to avoid chapter 11 is for another institution to take them over.The 45 billion could be used as a tax write off so the real losses would probably be in 35 billion range.If the takeover price is 10 then the total cost to the acquirer would be 55 billion or 27.5 per share.

Jesse C

July 3, 2008 10:50 AM

The pick a pay mortgage allows people with fluctuating income manage their monthly cash flow and tax exposure. Shutting down the product is not the answer but rather only approving the loan for clients who have been succesful building a substantial net worth. This product is your safest mortgage vehicle for the consumer since it has a lower monthly payment than say an interest only loan or fixed rate. The banks are once again being myopic and with elimination of quality products and tougher underwriting will continue to fuel the fire of defaults.

Annie

July 3, 2008 09:59 PM

Although Wachovia would like to do nothing better than to turn their pick a pay nightmare into a fixed payment dream..it isnt going to happen..how can you make a affordable payment when a high percentage of these loan customers choose to pay the lowest tier payment that adds to their mortgage balance? That means they CANNOT AFFORD the mortgage..trying to make something like that affordable is well...unrealistic..

David, former World Savings Account Executive

July 8, 2008 02:05 PM

I left Wachovia back in December because of the slow down in the market. For a while after Wachovia bought world savings it was advertising to us sales reps that the pick a pay loan was the 2nd biggest money maker for the company and helping to keep the bank strong as the housing market continued to close. In an attempt to compete with all the other banks selling "option ARMS" wachovia lowered the start rate to as low as 1% while the fully indexed rate increasd to mid to upper 7%, thus excellerating the negative amortization. This was the fatal error that Herb Sandler wouldn't have made. Before Wachovia bought World Savings the CEO, Herb Sandler increased the minimum payment for fear of a market turn around. Wachovia lower the rate and was over aggressive.

Morf Zoonberry

December 3, 2008 05:17 PM

Wells Fargo will buy Wachovia.

Thank you for your interest. This blog is no longer active.

 

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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