Payment-Options ARMs - Friend or Foe?
Payment-option ARMs have garnered a ton of negative publicity in the consumer press because of the risk these instruments allegedly pose to consumers. Some firms, such as Chase Home Finance, refuse to originate POAs, citing not only the moral hazard but the fear that these instruments could be ticking time bombs.
So, is the POA loan the "Great Satan" of mortgage finance or just misunderstood? It depends on who you ask. Many lenders like the loan and some, including mega-thrift Golden West Financial, have been funding POAs for years without any adverse effects.
To better understand the POA issue let's first review the product. A payment-option loan is called exactly that because it offers the homeowner four different payment choices each month. The "option" that seems to worry consumer advocates the most is the "negative amortization" choice which allows the mortgagor to make the lowest monthly payment possible by creating an "accrued interest" debt that must be settled at some point in the future.
Certain lenders making POAs have told us (not for attribution) that a large majority of the their borrowers are choosing the neg-am option which means instead of building up equity in their new abodes, they're piling up debt. There may be nothing wrong (or bad) about taking on added debt as long as the mortgagor's job prospects are good or the value of the home keeps rising.
Then again, as we all know, eventually the piper must be paid, the chief question being will the piper be paid when the home is sold or refinanced or will the piper be paid when the house sells at a bankruptcy auction.
Mortgage lenders and servicers should indeed worry about POAs and take a prudent approach to underwriting the product. In the end, these fears about neg-am could prove to be overblown. But there is another issue at stake here, having to do with the lender and income recognition.
When a borrower with a POA chooses the neg-am option, the lender who made the loan gets to book the interest payment as "accrued" even though the institution has not actually received the money from Joe and Mary Six-Pack.
The more negative-am POAs a lender has on its books, the greater that receivable. Follow me so far? From what I understand, the accrued interest can be booked as income. In other words, the lender gets to count something as income even though it actually hasn't received the cash yet. (I love GAAP accounting.)
Now, maybe there's nothing wrong with that but it sounds very close to the "gain-on-sale" debacle that cratered the nonprime industry back in 1998/99. One analyst suggested to me that accrued (but uncollected) interest isn't so bad as long as the loans are properly underwritten.
He also suggested that accrued interest results in a receivable being created that costs next to nothing. (Creating new receivables without paying for additional overhead can prove quite attractive to funders.)
But here's one other issue to consider - if the firm with POAs on their books is a real estate investment trust (public or otherwise) and it's hooked on paying dividends, what happens when volumes and profit margins hit the skids?
It takes a ton of cash to run a mortgage operation. (Anyone reading Mortgage Servicing News knows that.) In this scenario, depository hungry POA holders might be fine, but REITs might turn cash flow negative in the event of a volume decline. If many REITs face this problem, will it turn into an industrywide train wreck? We should have our answer by year-end.
Paul Muolo is executive editor of both MSN and National Mortgage News. He can be e-mailed at Paul.Muolo
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