Exotic Loan Problems 'Inevitable': WSJ

The Wall Street Journal reports on the 'exotic' loan business. "Oil prices are rising, economic growth slowing, housing sales faltering, consumers weakening and earnings outlooks dimming. So stock investors have, naturally, become more optimistic. Faith burns strongly that the Federal Reserve will manage the economy perfectly. Investors seem to believe that the power of the Fed resides in the title of 'chairman,' and that infallibility is passed to the holder, papal-like." "It's possible to see this whole phenomenon in the sunny climes of southern California, home to a modest bank called FirstFed Financial Corp., a Santa Monica bank with a $1 billion stock-market value. Its main business is option adjustable-rate mortgages. Option ARMs let customers choose how much to pay each month, including a small minimum. It's just like a credit card, with the same catch: The unpaid interest is tacked onto the mortgage and the balance grows larger." "The earnings that result from such loans are squishy. Even when a customer makes only the minimum payment, a bank books the full monthly payment into earnings. But these are noncash earnings. At FirstFed, such earnings are surging. Last week, it reported that the amount of interest that customers are rolling into their mortgage balances, known as 'negative amortization', rose $25 million in the fourth quarter to $63 million for the year, up from $6 million a year earlier." "Fully 51% of FirstFed's pretax income and 41% of its net interest income was from negative amortization in the fourth quarter. Investors are blithely ignoring the inevitable problems these banks will endure with their option-ARM customers. Just yesterday, mortgage giant Countrywide Financial Corp., another seller of option ARMs, reported rising delinquencies." "The banks all say that their losses on option-ARM mortgages long have been minimal. That's true. But the California housing market hasn't gone through a boom like it just went through." "Unlike Golden West, which is famously disciplined about its lending, FirstFed doesn't use its own housing appraisers. That should be a red flag to investors. Over 80% of FirstFed's recent loans have been 'low documentation' loans, meaning they required less confirmation about whether the customer was a good risk. Through the first nine months of last year, over 13% of its mortgages were NINAs, 'no income, no assets.'" "Analyst Fred Cannon notes that the number of customers who are prepaying their loans is rising. That is good for earnings in the short-term because the penalty fees from prepayments are high. But he figures that means savvy customers who are good credit risks are prepaying now rather than face higher rates in the future. He worries those who remain are doing so because they can't afford to do otherwise, making only the low-minimum payments." "That means that, just as earnings are starting to rise, these banks are likely to need to set aside more and more for mortgages that go bad."