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.