Pay Option ARM and Hammered

Karen DeCoster recently noted the same Business Week article I did titled “Nightmare Mortgages."

The article notes a possible looming problem for individuals who opted for what are called pay option ARMs (adjustable rate mortgages) as the financial vehicle for their home purchase or refinance.  Some of those who did utilize this financial vehicle are going to get hammered.

In a nutshell, what a pay option ARM offers to individuals is the ability to choose to make either a fully amortizing mortgage payment (a monthly payment which covers all interest currently owed, plus a portion of the principal), an interest only payment (no payment to principal), or a minimum payment which does not cover all the interest currently owed and the remaining interest currently owed is then added to the existing principal balance, which is termed negative amortization.

Karen, somewhat erroneously, begins her comments on the article with this comment,

A superb Business Week article on all things evil as regards ARMs (Adjustable Rate Mortgages).

The Business Week article is well written, and Karen’s comments are worth reading also, but ARMs are not in anyway evil.  ARMs are simply riskier financial vehicles than your standard vanilla ice cream fixed rate mortgage.  Especially the pay option ARM.

I’ll not comment any further on Karen’s post, or the Business Week article, but I will offer some insights on what I think is the actual issue with the sale of this loan product to individuals.  A lack of ethics within the mortgage industry, more specifically the subprime/non-conforming loan industry, an issue which is touched on in the Buisness Week article.

Having recently been deep in the trenches of the subprime/non-conforming mortgage industry, I was privy to the large push which was instituted to sell the pay option ARM to the masses as if it was the best thing since sliced bread.

The hook for this loan product is its initial low monthly payment.  We all know how low monthly payments are sold.  They’re hollered at us from teevee, radio, and print ads, repeatedly, as if it is the one and only reason to buy the product being pitched.  The subprime/non-conforming mortgage industry pitched the pay option ARM the same way.

The risks associated with the pay option ARM, in most cases, were pooh-poohed by the sales staffs of lenders who were selling the product to individuals.  A fact which may be attributable to both the ignorance of the individuals working for the lender (up to 60% of many lenders sales staffs have been in the mortgage industry for less than one (1) year and quite possibly do not know the difference between the mortgagor and the mortgagee let alone what negative amortization is), and the willingness of the masses to gobble up the low monthly payment hook with no further due diligence.

Granted, there are loan disclosure documents which must be signed and dated by prospective borrowers, which fully disclose the mechanics and risks of pay option ARMs, but they are rarely read by prospective borrowers.  This in and of itself is not the lender’s fault.  But it is interesting to note that today some mortgage lenders are consolidating all of the disclosures which must be signed and dated by borrowers into a paperback book format.  Thus, only one (1) document requires the borrower’s signature, which is the acknowledgement page of said disclosure book, which states that the borrower acknowledges receipt of all required loan disclosures, and that the borrower understands the disclosures contained within the book.  Of course, the majority of borrowers are only looking to confirm the low initial monthly payment quoted to them over the telephone, rather than having to actually read and understand something, so the disclosure book becomes a drink coaster, or is tossed aside and then read after the deal has been consummated, which, of course, is too late.

What I found most disturbing, ethically, about the sale of this loan product, was the fact that it was being sold to individuals who it had no business being sold to simply so the lender could put another loan on the books.  The loan was being sold to individuals on fixed incomes, to individuals in real estate markets known to be stagnant or depreciating, and to individuals who could barely qualify for the minimum monthly payment due at the inception of the mortgage.  Individuals at the most risk for payment default were (are) being sold the riskiest home loan product on the market.

ARMs are not evil, they are simply financial tools.  The issue is the ethics of those pushing the this loan product to those individuals who are least capable of operating the tool.

Posted by on 09/06 at 06:08 AM

  1. Good to see you back, John.

    Though I check Karen’s blog from time-to-time, I find her to be utterly and completely clueless when it comes to practical financial, banking, investment, trade, real-estate, etc.

    She’s an academic when it comes to this stuff. Uh, a _poor_ academic, which explains a lot.

    My biggest laugh? There was a post some time ago when she criticised Warren Buffet (_WARREN_BUFFET_!!!) for using some credit-spread or naked-option selling techniques on certain derivative instruments in order to raise cash.

    Huge laugh. She hasn’t a clue what she’s talking about. Most of my income now comes from derivative trading. I wring my hands in worry all the way to the bank.

    Posted by Richard Nikoley  on  09/13  at  11:34 AM

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