Option Arms: "Iceberg Dead Ahead"

Mortgage and Lending with CQ Financial Group

There has been a lot of discussion in the press regarding the mortgage industry and foreclosures.  But in all of those discussions I have yet to see an accurate representation of what has happened (which is not much) and what is coming (which is another story entirely).  Our own local paper, The San Diego Union Tribune, has had a ball with the foreclosure mess.  Their headlines and articles have contibuted greatly to the problem in my opinion.  Lately, however, the have begun to (inadvertently) help us and I discuss that here.  Still, they continue to miss the boat... or more accurately: the iceberg.  The sub-prime issue is only what we currently see; the real problem, Option Arms, lurks just below the surface - and it is the size of Countrywide and Washington Mutual plus many more.  The US Mortgage ship Titanic be warned: "Iceberg dead ahead!"

Here is the concept in a nutshell: Virtually all lenders use accrual based accounting (as do virtually all corporations of any business type).  Standard practice in this type of accounting is to book accounts receivable even though you have not actually received the cash.  This is, as I said, standard practice.  But what do you think might happen when this accounting standard is practiced by a lender such as Countrywide or Washington Mutual; lenders with a tremendous amount of option arms on their books?  These lenders are booking the expected income (which is to say the interest income) from all of their loans.  Yet with option arms there is a percentage of customers (in some cases I suspect a very large percentage) that are paying only the minimum payment.  "OK", says the lender, "we are not receiving the income right now, but we will eventually".  Which is fine until you look at the mortgage reset tables and recognize the vast number of loans that will be going into foreclosure in the near future.  February and March of 2008 will see more loans (in dollar amount) reset than in the first NINE months of 2007.  These will not be sub-prime, high risk loans either but rather good, strong alt-A and A-paper loans.  To the degree that these loans are option arms the lenders will have to go back and remove that part of the interest income they booked but did not receive and will now never receive.  This often results in a process on Wall Street called "restating your earnings".  If you are curious how Wall Street views companies that restate their earnings, ask the people over at New Century Mortgage... oh, that's right; you can't.  They had to declare bankruptcy about 48 hours after they restated theirs.

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