An interesting article in the Wall Street Journal today about Wells Fargo & Co. modifying some of its worst loans into interest-only loansgot me thinking about the housing recovery in a new light.
The article is about pay option ARM's or Wells' particular version called "Pick-a-Pay."
Whatever you call them, these are the loans where you decide what you want to pay each month, and whatever is left over is tacked on to your principal.
Pay option ARMs are the new subprime, defaulting at high rates now thanks to adjustments as well as good ol' unemployment. According to its Q3 earnings report, Wells Fargo, the fourth largest U.S. bank by assets, has $79.2 billion in debt on these loans alone, down from $101 billion a year ago, in addition to other ARMs and fixed-rate loans and full-term loan modifications. Wells didn't make the Pick-a-Pay loans, they just inherited them when they bought Wachovia at the beginning of this year. Wachovia relished in selling these risky products in the most overheated housing markets. Suffice it to say, many many many of these borrowers are way way way underwater on their loans.
Enter the interest-only product, which will allow borrowers to defer their balances from 6 to 10 years. This keeps the borrowers in their homes, paying a little every month. I called over to Wells Home Mortgage and spoke with CFO Franklin Codel. He told me that Wells has written down principal on the "vast majority of these loans." Yep, just given that debt away, written down so far the tune of $2 billion, or about $46,000 per modified loan. So far Wells has turned about 43,500 Pick-A-Pays into interest-only ARMs.
The article in the Journal suggests that this is a great way for Wells to avoid more writedowns, but Codel says, "that's totally false."
"On the Pick-a-Pay portfolio, we took the portfolio and impaired it when we bought Wachovia," he adds. So they've already written these loans off. If the modified loans perform, then I guess that's gravy. But why not put these folks right into a 30-year fixed?
Spokesperson Teri Schrettenbrunner explains, "The interest only-option is important because if you fully amortize the loan over thirty years, it kicks up the cost for the consumer. The way to make the loan sustainable and affordable was to put them into an interest only." In other words, borrowers couldn't afford the 30-year fixed.
So why is this a bet? Because it still keeps Wells tied to billions of dollars worth of underwater debt. Many of these borrowers are so far in the hole that some will eventually walk away. Schrettenbrunner argues, "The statistics that we have suggest that people do not look at their houses as simply a house; They look at it as a home." Codel put that into a number. "Our redefault rate is less than half the industry average, which is around 40 percent, so we are in the 15 to 20 percent range."
Of course, much like the Administration's Making Home Affordable program, after a certain amount of time the interest payments will move higher and add principal. We don't talk enough about where those interest rates might be in 1 or even 10 years. I'm wondering just how much borrowers will want to pay for a home in which they may never see real substantial equity. Codel argues that most borrowers are not as far underwater as we always say, that they're maybe 5 or 10 percent now, but I beg to differ.
I get an awful lot of emails from borrowers in the big bad states of California, Florida, Arizona and Nevada who are 20-50 percent underwater on their loans. These states are where the pay option ARMs were most prevalent and where home price appreciation will be molasses-like in coming. Even with principal forgiveness, normal price appreciation just isn't going to make that up.
In the Q3 report, Wells states, "Based on recent data and our current view of the mortgage market, life-of-loan loss estimates for both impaired and non-impaired Pick-a-Pay portfolios have improved from our acquisition models." How?? Three factors: Loan modifications, "some stabilization in the current outlook for home prices", and "observed improvements in delinquency roll rates."
Two out of three of those, in my view at least, are bets.
Questions? Comments? RealtyCheck@cnbc.com