A Captured Market: Option Arms

February 6, 2009

It was bizarre enough to reinforce my already fierce misgivings about Option ARMs, but at the time I didn’t have a clear picture as to the purpose of the pre-payment penalties tied to those loans. Let’s clarify something about prepayment penalties before moving on.

Prepayment penalties emerged as a common feature of subprime loans, necessary to impose a certain degree of predictability for the lender or investor, to ensure the loan would remain on the books long enough to compensate the originating lender for the risk and expense associated with making the loan at all. Without prepayment penalties, there would have been no subprime industry. And without the subprime industry, a very large segment of the market has no lending options.

But prime borrowers are reliable, predictable, and at the time it was said that they do not represent an extraordinary risk. So it was extraordinary to see an entire specie of loans being pushed—hard—into the prime marketplace that was dominantly sold with prepayment penalties as a term of the loan. The benefits to originating loan officers and the account executives were clear—three to four times the compensation for an Option ARM as they’d receive for a traditional loan. I received no less than a dozen different varieties of excel based forms from various AE’s to demonstrate how the Option ARM was going to work miracles for potential clients.

These forms were necessary because most loan officers not bright. The demand for people able to take an application was so great for a while there, that anybody who walked in off the street was hired. There were more than a handful of idiots who found a comfortable home in the ranks of the loan origination community. And those idiot loan officers were the primary source of information for their borrowers. So it is safe to assume that a huge quantity of these poor people were victims of both their own stupidity and of significant omissions on the part of their loan officer; sometimes intentional, sometimes because the details simply exceeded the capacity of the LO to understand or explain.

The forms these AE’s provided showed how the borrower’s home price would continue to increase, how the minimum payment would slowly increase, allowing the borrower to buy a Hummer, a giant TV, take vacations all over the globe, and generally live the life of the rich and famous without having to go through the hassle and struggle of earning it. Homeowners were overjoyed and signed up for these loans as quick as they could. But their joy at having found a free-lunch would quickly turn to anger/fear/despair once they realized they’d made a deal with the devil. Apparently most people don’t like seeing the principal balance of a loan increase with each payment made. So, Option ARMs were particularly vulnerable to what was called “churn,” or a quick payoff via refinance into a more traditional loan. And all those refinances would kill the profit of the originating “Lender,” often being the now defunct Lehman Brothers or Bear Stearns. This is when the borrower would suddenly learn the meaning and power of a prepayment penalty.

Unfortunately for most, they were trapped by the terms. A 100% loan leaves no equity in the home. And without equity, few homeowners are in a position to refinance. A refinance transaction costs somewhere around 2.5% for all the associated fees, and normally that fee is paid by part of the remaining equity (the loan amount is increased by the amount of the fees). But few borrowers who extracted 100% of their equity on an Option ARM could afford or stomach the 5.5% fee it would cost to refinance back out into a traditional fixed rate product. They were captured. This was great news for the investment banks who were concerned primarily about the short term—keep runoff low in the portfolio until it can be sold off! Don’t worry about what happens when those loans re-cast, and the borrowers can no longer afford to make the payments . . . Housing always goes up, right?!

We all know how that turned out.


Missed Fortune Pt 2

February 6, 2009

At this point, I can only wonder how many people who had been diligently paying down their trusty 30 year fixed rate for a decade, had the misfortune to encounter somebody promoting the Missed Fortune plan (or something like it—Ric Edelman/Steven Marshall/Bellevue Mutual Mortgage anybody?), and now live with the financial wreckage of an over-leveraged home and an investment that was tied to the success of the stock market.  How many insurance policies have been destroyed or remain at risk due to the problems at AIG?  Maybe quite a few.  Maybe none.  Insurance isn’t my thing.

For Douglas Andrew’s part, he used existing training groups to tap into a willing and eager group of brokers, bank managers, VP of sales, loan officers who wanted a way to capture as much of the booming mortgage business as possible. He quickly set up a training program run out of Salt Lake City (if memory serves) where he charged loan officers, brokers and insurance agents tens of thousands of dollars for a brief training program he coined as TEAM. I’ll try to find out what that acronym stood for. It seems as though the program quickly evolved to acquire all the trappings of legitimacy without necessarily acquiring any of the substance. I never attended, but did inquire with their sales rep regarding what exactly would be covered. He never did tell me.

From outside appearances, the course provided attendees with a superficial introduction to the products they were going to be pitching to their customers; then extensive training on how to use the provided sales collateral, and slicker-than-greased-goose-poop power-point presentation, and a lapel pin of an impressive looking “certification.” All of this marketing and sales training was designed to overcome the natural and well-founded fear and suspicion they were bound to encounter by clients who were being told to abandon a familiar approach to home ownership in favor of an unfamiliar, complicated investment strategy.

Resistance would be high at first. But Americans are pliable, and incredibly stupid. And they’ll do almost anything to avoid that fact being revealed publicly. Hit them with a bunch of terms that they don’t understand, concepts that don’t make sense, and super polished slides that show just how dumb they’d be to *not* do this, and they’ll agree just to avoid being discovered.  The more complex and unrealistic, the better–less chance the customer will know its all a bunch of bs.

This fact was leveraged by the tens of thousands of loan officers who profited like crazy during the boom. Most loan officers had never mastered the basic concepts of finance. They were generally not college educated, and from the hundreds that I knew, it was common for their financial life to be in shambles immediately prior to discovering the easy money mortgage-goldmine.

These people were selling financial tools, and offering advice they’d memorized from a script.


The Misfortune of “Missed Fortune”

February 6, 2009

Douglas Andrew was among the first “gurus” from outside the mortgage industry to see opportunity in the origination community, and tap that opportunity to his own benefit.  He appeared out of nowhere around late 2005, and had a strategy that was going to make everybody rich–loan officers, insurance agents, investment banks selling Option ARMS, and the customers who took part.  Everybody would get the big pay that came with big risk, but only the home owners got the risk.

This was the general breakdown. Home prices were cooking by 2005, and everybody knew it. This map from Feb ’05 lays out difference in prices from sales in ’03 to sale prices by the end of ’04 for the general LA area, just to jog your memory. Homes that had previously been worth $400k as recently as 2003 were suddenly deep in the $600k territory, meaning many home owners potentially had hundreds of thousands of dollars locked up in equity.  As a whole, California alone represented hundreds of billions in notional equity gains-exactly the sort of juice that attracts near-con-artists like Mr. Andrews (as well as Wall Street’s finest).

Up until this point, all the ma and pa’s who’d bought their last home back in the late eighties or nineties were staying on the sidelines. Many had refinanced from a conservative 30 year fixed to one with better rates. Some chose a 15 year with much lower rates, simply because they could. But there were still quite a few who were basically on the sidelines. How do you get these folks onto the field, doing transactions?!

How do you *always* get the working class to do really dumb, massively dumb things with their money? You sell the magic pill.

In this case, the magic pill was simple. Extract the home equity using a 100% cash out mortgage. Interest only loans were great, but option-arms were ideal. The equity that was extracted would then be used to buy one of a variety of insurance policies, or an annuity. The annuity income would be tax free, while the interest on the mortgage would be tax-deductable—and this technical spread was the arbitrage opportunity. It was supposed to make the homeowner rich. It certainly would go a long way towards making the loan officer, lender, insurance broker rich.

Loan officers at the time were typically charging a 1% origination fee, while being compensated 3-4% by the lender. The incentive was significant. I don’t know what the average transaction was for the entire country, but can comfortably say that in the Seattle area, $300k would be conservative, and for the favor that loan officer got paid somewhere between $12k and $15 for that transaction alone. (Call center or other “captured” loan officers that had leads fed to them typically earned about 35% of that fee, others who generated their own leads would more often earn 70-90% of it). Oh, that sort of compensation was very unusual, and was only attached to that single product type. “Lenders” paid those hefty bonuses to loan officers for getting the borrower to agree to onerous and unnecessary terms—high margins and in *every* case possible—a prepayment penalty*.  (More on the scandalous relationship between Option ARMs, prepayment penalties, MBS, Investment Banks, Lehman Bros, and Bear Stearns in another post).

I am not an insurance agent, and do not know how they are compensated for the insurance policies or annuities, but at the time that Mr. Andrews was making his thrust into the consciousness of the origination community I was told it was very handsome. Comments posted on the Amazon page of Mr. Douglas’ book echo that sentiment. More than a handful of the critical reviews suggest that the “investment strategies” promoted in the book are a thinly veiled sales pitch, and are likely to introduce an extraordinary degree of risk to anybody who should actually implement the plan as explained.

At this point, I can only wonder how many people who had been diligently paying down their trusty 30 year fixed rate for a decade, had the misfortune to encounter somebody promoting this plan, and now live with the financial wreckage of an over-leveraged home and a decimated investment.

For Douglas Andrew’s part, he set up a training program run out of Salt Lake City (if memory serves) where he charged loan officers, brokers and insurance agents tens of thousands of dollars for a brief training program he coined as TEAM. I’ll try to find out what that acronym stood for. From outside appearances, the course provided attendees with a superficial introduction to the products they were going to be telling their customers to use, and then extensive training on how to use the provided sales collateral, power-point presentation, impressive looking “certification” to overcome the natural and well-founded fear and suspicion they were bound to encounter.

UPDATE:  My first encounter with this particular scam was via Loantoolbox.com sometime in 2005.  A year or so after having discarded the entire thing as a giant load of Bull, my parents called to say they wanted me to come over and talk.  They’d just had a meeting with a really nice, really bright loan officer who had an idea, and they wanted to hear my thoughts.  The guy they’d visited was a recent graduate of Douglas Andrews’ “TEAM” school of snake oil sales.


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September 11, 2007

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The email Bag!

November 1, 2005

Wholesale Account Executive emails; subject lines from October ’05:

“Round 2 of the 475 FICO Special. . . ”
“100% One-Loan Non-Owner Occupied!!!”
“Condos, SFRs, Duplexes, 95% NO-DOC w/660″
“MILLENIUM’s OPTION ARM – 1.5%”
“Countrywide Introduces the 40 Year Pay Option ARM”

and on November 1,

“November is National No-Doc Month at PDFC!”


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