By Moe Bedard

Let’s get something straight. Subprime loans are not the only thing that we need to worry about in this housing and mortgage crisis. It’s the hidden mortgage creatures in the “adjustable rate forest of the unknown” that are watching and waiting as they mature into full grown animals that we need to be concerned about.

Subprime’s red-headed cousin, the Alt-A mortgage product known as the “Pay Option ARM” (adjustable rate mortgage), hasn’t yet fully reared it’s ugly head. But let me tell you all something ladies and gentlemen, that head is mighty ugly and it might very well cause California to fall in to the Pacific Ocean and turn our Governor back into the Terminator to fight these evil mortgage animals that will wreak havoc on the Golden State in the coming years.

Pay Option ARMs common euphemistic names and AKAs;

  • WAMU – Option ARM
  • World Savings/Wachovia – “Pick-a-Payment”
  • Indymac – “Flex Pay”
  • “Cash Flow ARM”

What fun, creative names to describe such an ugly and toxic mortgage product.

For those that have been duped by the cutesy names (mainstream media, we’re looking at you), we have a simple but effective explanation of Pay Option ARMs:  A pay option ARM is a mortgage that comes with a “virtual” credit card, such that you can pay down the mortgage with the credit card when you need to (or when you please).  Sounds great, until you realize that:

  1. the interest rate on the credit card is higher than the mortgage, and
  2. the same person who sold you the mortgage sold you the credit card, and
  3. that person profited handsomely off both (PLUS a premium for selling you on the combination), and
  4. just like a regular credit card,  this loan has a limit, and when you hit it, you had better start paying everything back! (yes that means the payments are higher than the monthlies for the “regular” mortgage, so much for “affordability”!!)

Hmm.. seems pretty obviously toxic when put in clear terms, huh?

From Wachovia’s website;

At Wachovia, we understand the importance of flexibility and choice when it comes to choosing a mortgage. That’s why we’ve teamed up with our affiliate, World Savings Bank, to provide you with a mortgage solution that lets you choose the monthly payment you’re most comfortable with.

The Pick-a-PaymentSM Adjustable Rate Mortgage (ARM) offers you payment choices that allow you to take control of your finances. You have up to four different payment options each month1—Minimum Payment, Interest Only, Full Principal and Interest, or 15-Year Payment Option.2With the Adjustable Rate Pick-a-Payment, you could:

  • Make a lower monthly payment and temporarily increase your cash flow so you can free up cash for:
    • Retirement savings
    • Paying down high-interest debt
    • Funding college tuition
  • Make higher payments and pay off your home loan sooner
  • Keep mortgage payments low during the initial years of your loan
  • Control your budget based on your individual financial needs

Heck, they even trademarked the damn name as they continue to sell this loan like it’s a potty trained puppy to consumers and give borrowers all kinds of creative ways to only make their “minimum payment”. They say, “make smaller payments so you can retire or fund your children’s college tuition.”

And that’s just what borrowers are doing, but the excess money sure isn’t being used to fund Johnny’s USC tuition…

It seems as if the California consumer sure is making that minimum payment as they drive their Chevy Tahoe and fill up for $150 at the gas pump and pick up a double latte at Starbucks before driving to Macy’s to purchase the latest Gucci hand bag…

All the while, their middle finger is in the air directed at lenders like Countrywide and CEO’s like Mozilo. “Take your fully amortized payment and stick it where the sun don’t shine” they say.

Hell, why pay the fully amortized payment at $5,500 on a million dollar home that is worth $200,000 less then when they bought it just a year or 2 ago, when they can pay $2,800 and eat well and live well. Slowly buying time as they plan their exit strategy out of a depreciating asset that they have already emotionally cut themselves from and have become a mortgage renter, so to speak.

What about foreclosure?

“Big deal” the homeowner says as the thoughts of foreclosure do not scare them one bit, because they feel that they are actually doing the smart thing and not paying the man for something they don’t really own anyway. Plus, it’s already $200,000 underwater and losing equity by the second.

I guess only a fool would pay their fully amortized payment, right?

I know I am going to get the mortgage professional that says, “These are actually good loans when used properly for borrowers that are savvy and understand what they are getting into.”

Well, yes I agree, but that facts are that these mortgages have never been sold and are not being used for the purpose of what they really were intended for. These loans should only be offered to self- employed borrowers and independent contractors who need a flexible loan so they can keep paying their mortgages on time when their business is down. That’s when a borrower can pay the infamous “minimum payment”.


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.

There is a minimum payment crisis folks and it may dwarf the subprime foreclosure implosion of 2007!

Charts like these back up that point:


Those look alarming to us, to say the least.  These Pay Option loans are going to create some serious problems for the State of California (and to some extent Florida and other bubble areas) for years to come, as these mortgages mutate into massive creatures that will gobble up home values and send armies of homeowners into foreclosure death.

Instead of foreclosures wreaking havoc on the typical lower-class or middle-class neighborhoods, we will see upper-class and affluent areas that will experience huge increases in foreclosures because of these pay option ARM’. Wiping out massive areas of wealth in the state, one million dollar foreclosure at a time.

The California Association of Realtors (CAR) recently reported in November 2007 that counties such as Riverside, San Bernardino, and Sacremento have seen approximately a 15% decrease in values from November 2006 and counties like Orange County, have only seen a 1.1% drop in real estate values.

Are these numbers deceiving to the naked eye? Is this some freak occurrence that a neighboring county of Riverside, Orange County, could have seen only a 1% change in values while Riverside saw a 15% hit?

Or does it come down to common-sense analysis?

I think this is about the nature of the loans that were sold in these different counties.

Riverside was mainly a subprime, stated, 2/28, 600 FICO, 100% borrower with a $36,000 a year salary and Orange County is more of a Alt-A/Prime area, with 680 FICO borrowers, 90-95% loan to values, $75,000 a salaries and the land of the Pay Option ARM’s.

A county where the middle class can live like millionaires on credit and in million dollar homes is where they dwell. Well, at least for now.

Apparently HUD is pretty worried about the states foreclosure crisis, as they recently released this report titled, “California’s Deepening Housing Crisis”.

HUD identifies such factors as supply and demand, increasing housing costs/decreasing homeownership and other various issues that have contributed to the state’s housing crisis.

I think HUD forgot to factor in that lenders targeted borrowers in this state because they made a tremendous amount of mortgages to way too may people that could not afford these loans or the homes. They can sugar-coat it all they want. But it was these easy loans that lenders and brokers targeted borrowers with, so they could make more money per loan/unit then anywhere else in the country, that have caused the State of California to lead the nation in various foreclosure statistics.

This is what single-handedly and artificially drove up values in California. We wouldn’t be leading the nation in metropolitan areas with the highest foreclosure rates if these loans were not made in mass quantities to borrowers who could not afford them to begin with.

And we haven’t even begun to feel the brunt of the Pay Option ARM crash.

It is literally a ticking time bomb for the more affluent areas in Southern California such as Orange County, and in Northern California, such as the Bay Area. These areas have not been hit hard by foreclosures or declining values. But one thing is for sure, they will, BIG TIME!

A recent map called the “Map of Misery” by Businessweek shows that 25-30% of all pay option ARMs were made in California. The most of any state.

Map of Misery

Come out west if you want to live like a rock star and peddle pay options all day as you make 3-4 points a pop. California was the land of big, fat commission checks, 745 beamers and great looking lender account executives with silicon breasts, free lunches at Sharky’s and trips to Vegas… all were common in the life of a California loan officer.

McBrokers– Some broker chop shops churned out these loans en mass, like McDonald’s sells double cheese burgers. Running massive telemarketing operations and auto dialer’s that sent out thousands of calls a day, “If you would like a $1200 payment on a $400,000 mortgage please press 1”.

Their Wednesday morning sales meetings were geared on how to tack on 3 year hard prepays and defend YSP objections at doc signings. They certainly were not centered around ethics and prudent underwriting for qualifying borrowers, full doc on a 30 year fixed.

Broker chop shop, pay option training 101– Borrower says to loan officer, “What’s this YSP of $30,000?”, loan officer says, “Oh that’s a fee paid by the lender to our firm over the spread of the loan that’s yielded at closing. That’s why they call it YSP, which stands for yield spread percentage. “Oh, OK.” The borrower says as the notary turns it to the next page in unison with the hand signal from the loan officer.

Mercury News;

As the housing market boomed, borrowers figured they could always sell the home at a higher price if they got in trouble – and brokers pocketed big rebates for selling option ARMs, said John Diamond, a Chino broker with 39 years in the business.

Although a broker might earn $4,500 for selling a $300,000 fixed-rate loan, Diamond said, the commission could total $12,000 on an option ARM of the same size.

“These loans drove the whole industry from late 1999 through late 2006,” Diamond said. “It was just about the only thing any broker wanted to sell.”

Now the party is over.

And that was just the broker shops. Now, let’s talk about the big boys. You know, the lenders that pushed these loans in massive quantities via their retail units as they made big money on fees and 3 year prepays (huge prepayment penalties if a borrower wanted out of their mortgages).

Countrywide, Washington Mutual, World Savings, Downey Savings, Indymac and Bear Stearns were the biggest players in originating the Pay Option ARM’s and they sure did sell a significant amount of these loans in high cost states like California. Why? The main reasons are what I would like to call a “greedy two fold sinister plan”.

  1. More money per unit in California (business 101)
  2. According to General Accepted Accounting Roles (GAAP), lenders can claim deferred interest (negative amortization) as income and the lender can count as revenue, the highest amount of an Pay Option ARM payment (fully amortized payment), even when the borrower is making the bare minimum payment as their mortgage balance goes up. This means that lenders can claim this bogus future revenue as income now, even though they know full well that this loan will most likely default. The typical difference between the actual note and the 110% or 125% reset is allowed to be placed on the books of the lender as an asset. This is huge in a state like California. Thus, the lender can off set massive losses with these sneaky and creative accounting practices (sneaky mortgage business 2.0)

Did anyone see the interview with Angelo Mozilo, Countrywide Financial chairman/CEO and CNBC’s Maria Bartiromo at the National Housing Forum? Mozilo clearly stated that he is not going to offer loan modifications on these loans because they are what he called, “below market rates”.

Is the real reason Countrywide is not modifying these loans because they know they are up a toxic creek with out a Pay Option paddle? So, they can use those sneaky accounting practices and defer interest, claim the fully amortized payments as income and come out with one bogus quarterly earning report after another.

Buying time, so they can fool their investors and float in the bloody mortgage waters for just one or two quarters longer. Hoping all the while that Secretary Paulson and Bush bail them out from a certain drowning with a government life raft.

The recast loan to value for these Pay Options is typically at 115% and 110%. However, throughout 2006, these loans were being offered at 100% financing and in California, borrowers were eating this poison candy like a fat 9 year old kid and lenders and loan officers were living like Willy Wonka in chocolate-covered pay option ARM palaces.

What does all this spell for Californians? “California’s Billion Pound Gorilla”.


Up to 80% of all option ARM borrowers make only the minimum payment each month, according to Fitch Ratings. The rest of the money gets added to the balance of the mortgage, a situation known as negative amortization.

The Wall Street Journal;

About three-quarters of the $79.5 billion of loans held as long-term investments by Countrywide Bank are either option adjustable-rate mortgages, known as option ARMs, or home-equity loans.

Mercury News;

At Calabasas-based Countrywide Financial, which S&P said made about a quarter of all option ARMs last year, 3 percent of such loans held by the lender as investments were delinquent at least 90 days, up tenfold from 0.3 percent a year earlier.

Delinquency rates were even higher on option ARMs from other lenders, including Seattle-based Washington Mutual, S&P said.

Courtesy of Senator Schumer, we know that about  $27 billion of these holdings are Pay Option ARMs.  We have also seen data to the effect that Countrywide originated well over $100 billion of these loans into the secondary market—with unknown buyback exposure lingering.  Either way, someone will be hit by these hot potatoes, and the search to find out who promises to be every bit as dramatic as it was for subprime.

Quick fun fact – Countrywide has foreclosed on 3,768 homes in California year to date. More than double of it’s closest foreclosure cousin, Michigan.

The median home price in California as of November was $488,640. According to the California Association of Realtors (CAR).

If you do the quick math with the above Countrywide foreclosures in California at 3,768. Multiply that by the median sales price of a home in California of $488,640 and you will arrive at some pretty huge numbers to place a price on Countrywide’s REO inventory just in this state.

Countrywide has foreclosed on $1,841,215,520 worth of real estate in California, year to date. That is 1 billion, eight hundred-forty one million, two hundred-fifteen thousand and five hundred and twenty dollars.

Countrywide has almost a $2 billion dollar REO portfolio and that is just in California.

Just wait till those Pay Options hit the default lists in waves as homeowners walk from their million dollar homes in droves. I am sure many will walk at $300-$400,000 or more upside-down on their loans… by the time they are done milking lenders for one more day in their million dollar homes at rock bottom “mortgage rental” prices.

Washington Mutual Option ARM scary facts:

  • 24% their entire mortgage portfolio is Option-ARMs. It amounts to $58 BILLION
  • Washington Mutual’s loan-loss allowance rose 22 percent to $1.89 billion during the 12 months ended Sept. 30, nonperforming assets rose 128 percent to $5.45 billion
  • The industry norm for the ratio of loan-loss reserves to non-performing assets is around 150%.

I’d like to hear from the mortgage professionals out there that can shed some light on this dark secret that urgently needs a spotlight.

  • Will this be the second coming of defaults and explosions that will hit California?
  • Will especially the high cost areas take half a million dollar hits a pop on each foreclosure? (Meaning by the time the borrower walks from the loan, they will be upside down hundreds of thousands of dollars.)
  • Who the hell will ever buy these million-dollar homes ever again?

What a way to start off 2008: the year that the Pay Option ARM will wreak havoc on the State of California. We’re in for some very scary real estate times everyone and it looks like the foreclosure ride has just begun.