This is a continuation of my thoughts around the article Tracing The Collapse of WaMu published in the Spokesman-Review.

In the mid 1990’s American Savings Bank and Great Western were niche lenders known for two products – the negative amortization loan (Option Arm is the “common” name for this product) AND the no income verification loan. I worked at a competing S&L in California at that time and am very familiar with those products.   My bank did not offer the products but my loan clients would frequently ask me about these competing products.

Until the mid-1990’s both loan programs were utilized in an ethical and common sense manner for the most part, and to this point these products had been in existence at least a decade without trouble.

Then banks and other large investors jumped into this niche and started peddling these products to the masses – most of whom had no reason to obtain one of these loans.

Here's an insider's look at the no income verification loan

Towards the end of  its life, the no income verification loan had gained almost all the attributes of a full  documentation loan (fixed rates, 30 year terms, etc.) with the sole exception that the rates were higher and the borrower only had to "state" their income on the loan application.

Why would someone, who could verify their income, pay a higher interest rate just for the convenience of not having to provide 1 W2 statement and 2 pay check stubs to document their income?

I think you know the answer to that - because that borrower did NOT make enough income to qualify so they lied on the loan application, or were encouraged to lie on their application by their lender.

I even spoke to one borrower in 2004 that came to me after refusing to sign loan documents presented to him at the closing table by his current lender. Turns out the other lender had increased this borrower’s income on the loan application without even telling him – the borrower only found out when he was sitting at the closing table and was asked to review and certify the loan application as “true and correct.” I guess the tiny print at the bottom of the loan application that says the FBI will  lock you up for committing loan fraud got his attention!

No Income Verification Loans – Then and Now

Here’s the main distinction between then and now – and I think the problem will be pretty obvious.

1995:

· These borrowers paid a premium to obtain the loan to reward the bank for the additional risk.

· Good credit was required.

· The borrower had to demonstrate they had substantial liquid reserves, sometimes as much as 6 times the amount of the monthly income they stated on the loan application – hence a verification that the borrower did in fact make a decent living.

· Typically only made to self-employed borrowers.

· Required a down payment of 10% to 20%.

· The banks held these loans in their own portfolios and posted adequate loan loss reserves against these portfolios.

· Commissions to the loan officers were generally 1-2% of the loan amount – thus making them not overly attractive to “sell.”

· These loans were not sold to Wall Street, thus limiting the risk of default to only the bank that made the loan.

2004:

· Interest rates were artificially similar to a 30 year fixed rate by offering a low 2, 3, or 5 year fixed term.

· No income verification loans were being made to people with 620 FICO scores, or lower.

· Cash reserves severely limited to 2 times the new house payment, if any required at all.

· No longer limited to self-employed people only.  Now these loans were being made to borrowers who had easily verifiable income because they were regular employees. There were even lenders who would allow a retired person collecting Social Security to “state” their income.

· 0% down payment was available.

· Commissions to the loan officers were easily collected up to 3-4% of the loan amount.

· Wall Street started buying these loans in huge pools, now spreading the risk of default world wide.

Was Washington Mutual the only lender who had employees abusing this loan product?  Nope!  They are being picked on because they are the object of the article that raised the issue.

My point is that negative amortization loans and no income verification loans are now treated universally as "bad" loan products.  As with any potentially dangerous product, it is the human that causes the problem not the product itself.

Part 3 - The Option Arm will be done and posted in a day or two.  Stay tuned!