Wells Fargo Solution to Option ARM Problem? Convert all Pick-A-Pay Mortgages to Interest Only Loans.

2010 will be a big year for four states because that is when the option ARMs are suppose to recast in droves.  State Attorney General Jerry Brown of California sent a letter to the top 10 option ARM servicers and banks late last week requesting information requiring firms to stipulate how much of these loans they have on their portfolio, recast dates, and what they are doing to remedy the problem.  Apparently Wells Fargo got the news and is deciding to convert its Pick-A-Pay option ARMs into interest only loans.

Let us dissect their press release since there is much to be gathered from what they are saying:

“NEW YORK (Dow Jones)–Wells Fargo & Co.’s (WFC) strategy for modifying its billions in troubled Pick-A-Pay mortgages looks a lot like a game of kick-the-can-down-the-road.

Wells Fargo, the fourth-largest U.S. bank by assets, holds more than $107 billion in debt tied to option-adjustable rate mortgages, a quintessential loan product from the housing boom that allowed borrowers to make small monthly payments in return for increasing their mortgage balance. Now, many Pick-A-Pay borrowers own homes worth far less than they owe in mortgage debt, even as many of them can afford a full monthly payment that pays down principal.”

Right off the bat Wells Fargo realizes that many of these borrowers will fall in that strategic defaulter category.  That is, many people will effectively walk away from their obligation because their home is so far underwater.  The notion that people will stay just because of an interest only loan is suspect at best:

“To solve that conundrum, Wells Fargo is taking a gamble: The bank is issuing thousands of interest-only loans that will defer borrowers’ balances for as long as six to 10 years. Wells Fargo is wagering that an eventual rise in housing prices in the country’s worst-hit regions, along with a rise in consumers’ income, will eventually combine to cover the bank’s billions in underwater Pick-A-Pay debt.

“We’re banking on the fact the economy will improve and recover over time,” Michael Heid, co-president of Wells Fargo Home Mortgage, said in an interview.”

This is an absolutely risky bet and one that isn’t even assured to pay off.  Wells Fargo is assuming that most of these people will remain simply because they are paying on an interest only loan.  In essence, they are going from being a neg-am home debtor to a home-renter.  Why would someone even do this?  Say you have a $400,000 mortgage on a home now valued at $200,000.  Just because you are paying interest would you stay?  Maybe if the interest amount is on par with rent.  But what Wells Fargo is forgetting is many of these buyers bought these homes as step up properties.  That is, their vision wasn’t to stay in the place for 5, 10, or 15 years.  The 5 year mark was essentially their moving on point:

“Wells Fargo’s decision to shoehorn thousands of Pick-A-Pay borrowers into long-term interest-only loans helps the bank avoid taking hefty writedowns on Pick-A-Pays that a wholesale push into foreclosures would likely produce. But the strategy will also leave Wells Fargo holding billions in mortgage debt tied to distressed properties in depressed housing markets, especially California and Florida, where the future for property values is hardly certain. Write-offs from Pick-A-Pays, therefore, could bring the bank years of burdensome costs.”

That is the key to the argument.  Their main goal is avoiding reality.  They want at any cost to avoid writing down the mortgage to actual market value.  Virtually 100 percent of these loans are based on inflated bubble housing values yet Wells Fargo wants to keep that pretense up.  Can they?  That is yet to be seen given 45 percent of option ARM borrowers are already 30 days late on their mortgages:

“Heid, who runs Wells Fargo’s mortgage-servicing unit, says most borrowers are motivated to pay their mortgages, even if they owe far more in mortgage debt than their houses are actually worth. One motivation driving borrowers is “kids and schools” having “a very strong play in why do people try and stay in their homes when they’re under water,” Heid said.

Teri Schrettenbrunner, a Wells Fargo Home Mortgage spokeswoman, said: “Not all people look at a house as just a house. They look at it as a home.”

Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) also purchased billions in Option-ARMs when they swallowed failing rivals – Countrywide Financial and Washington Mutual, respectively – although those two banks’ option-ARM book represent much smaller portions of their total loans.”

I hate to tell Heid, that may be true in other parts of the U.S., but many of these California option ARM borrowers did not look at the home as a home.  It was a speculative bet on housing prices continuing to go up.  And given that option ARMs are largely a California problem (58%) then we can’t use nationwide trends for a the most bubbly market in the country.  The play to emotions is suspect.  Is a 700 square foot shack just a home if it has a $500,000 option ARM mortgage?  You tell me.

“Wells Fargo says it has written $2 billion off Pick-A-Pay balances for borrowers, or nearly $46,000 per modified loan. The bank has modified 43,500 Pick-A-Pays so far this year through September, and said the program is highly effective at keeping borrowers in their homes. It said the program eliminates the nearer-term risk for borrowers of sharply ballooning payments.”

$2 billion down, $107 billion to go.  We’ll see how this plays out.  Going to interest only isn’t a panacea.  In fact, interest only mortgages are toxic mortgages as well.  Imagine the government color coded warning system and visualize option ARMs as the absolute worst, followed by subprime, then followed by adjustable rate interest only loans.  Let us look at one example:

“One borrower, Danny Annan, an Orange County, Calif., engineer, just finished weighing one of Wells Fargo’s loan modifications. The bank offered to reduce his loan balance by $100,000 and transfer the remaining balance to a six-year interest-only loan with an initial interest rate of about 4.9%, Annan said. The offer will still leave Annan more than $100,000 under water on his home.”

“It looks like a Band-aid,” Annan said. “It’s not like we’re not being appreciative,” added Annan, citing he’s left with little alternative but to sign the bank’s offer by the deadline. He said two homes on his block have been empty for more than a year after his neighbors turned in the keys and walked away.”

So the bank is still writing down the mortgage by $100,000 and the borrower is still underwater by $100,000.  It is ironic the tone that is being given.  This borrower wants the home to be modified to the current level of homes on the market!  I doubt Wells Fargo will be doing many mods like this.  What will probably occur is interest only mods and hoping that people still pay on the note.  That is simply another gamble from the banking industry.  But for the past decade, the banking industry has been resembling Las Vegas more than any traditional banking model.

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