The Problem with Option ARMs

The NYT's Christmas Day installment of its big series on the financial crisis, The Reckoning, concentrates on Herbert and Marion Sandler, mortgage lenders in California who more or less invented the toxic option ARM.

The Sandlers come across as sympathetic victims of the bubble as much as perpetrators: They clearly cared more about underwriting than most mortgage lenders, and they didn't found the Center for Responsible Lending as some kind of PR stunt.

They also believed in extending mortgages to those who had been left out of the system in its more regulated days. In principle, option ARMs are a great product for people who might earn a lot of money but who do so irregularly. That's not just bankers with big end-of-year bonuses -- the example the article gives -- but also just about anybody who's self-employed or freelance, from actors or TV producers to carpenters and, yes, many journalists.

The fundamental problem with the option ARM, I think, was one based in behavioral economics. The idea behind it is that you can get away with making small payments in lean times, and then make up for them with big payments when the large paycheck arrives. But once the product started being sold to people without a lot of financial self-discipline, those people would just make the minimum payment every month, no matter what their income. And indeed, if they had credit-card bills or other high-interest-rate debt, that would have been the sensible decision to make.

But the result was principal balances which only ever went up rather than down, especially when option ARMs started being sold to subprime borrowers -- people for whom the product was not, initially, designed.

There's another important aspect of the psychology of option ARMs: They're really hard to understand, to the point at which Tanta once spent 3,700 words trying to explain how they work. As a result, it wasn't only the borrowers who didn't comprehend what they were getting into: It was also the brokers. Senior executives such as the Sandlers did understand the product, but in a weakness common to many smart people, they probably simply assumed that their staff understood it too, rather than actually checking on that. But many of their staff, like the borrowers, probably stopped at the point where the minimum payment was calculated, since not thinking about something like this is always easier than thinking about it.

It's possible that the Sandlers were evil and predatory lenders who deliberately abused the psychology of their borrowers -- but I don't think so, especially since they kept hold of their own loans, rather than securitizing them, and that strategy, had they not sold out at the top of the market to Wachovia, was bound to blow up sooner or later. Rather, I think that the Sandlers simply let themselves get sucked into a race-to-the-bottom marketplace, especially after Wachovia put its enormous balance sheet at their disposal, and that they reassured themselves with irrelevant historical performance figures from the 1990-1 recession.

I do wonder whether a "good" option ARM can ever be devised. Maybe the trick is to force net principal repayments every year, and just leave it up to the borrower when those payments come. But it's sad that so many option ARMs turned out so badly. Because the idea behind the product is not actually a bad one, if you ignore the psychology.

Comments

[1 of 4:]

An ARM without the negative amortisation minimum always made better sense. You still had the option to pay down when the big paycheck came, but there never was the deferral or negative amortisation option. That would make qualifying for the loan more strict.

2008 Dec 26 12:53 PM

[I should know:]

I competed with Herbert and Marion Sandler and their company, World Savings Bank, for years and years. Your statement that “They clearly cared more about underwriting than most mortgage lenders, and they didn't found the Center for Responsible Lending as some kind of PR stunt” is completely inaccurate. Their standards were almost nonexistent. They would approve nearly anyone and give them whatever program or product they wanted, but pushed the product that threw-off the most money to WSB, the option ARMS. Most of their loans were originated, not by WSB employed loan originators that may or may not have understood the pitfalls of this toxic loan, but by slimy mortgage brokers who only care about making the sale and making as much money as possible from the particular loan they were pushing; most often, the Option ARM. WSB paid the highest commission and SRP on Option ARMS, not standard ARMs or fixed rate products.

Here is a direct quote by Herb Sandler: “You have to understand how independent brokers work, they are the whores of the world.”

Despite that distaste, World Savings made extensive use of brokers. By 2006, they were generating some 60 percent of its loan business, he acknowledged. He said he was compelled to do so because of brokers were a dominant force in the mortgage industry. Money trumped ethics once again for the Sandlers.


I lost some business to these hucksters and snake-oil-salesman that were pushing this product, and at one-time the upper managers of our company went to the senior managers and requested that we be allowed to originate these loans, if even for the purpose of showing just how bad they were. When we were competing against this product and tried to tell buyers, Realtors, and builders how unethical the product was, they usually said we were just “bad mouthing” it because we couldn’t do them”. Our senior managers said NO, we would never do the Option ARM. The product was not good for our customers and was not good for our company and stakeholders. We didn’t like that answer, but it sure turned-out to be right. When the miscreant huckster team of Herbert and Marion Sandler sold out to Wachovia, one of their big selling points was the huge income they were making on these Option ARMS. When they became part of the Wachovia board of directors, they continued to press the origination of these loans and even convinced Wachovia to have it available to their bank branch originators. The bank branch originators hated the product and sold almost none of it.

Going back to your statement “They clearly cared more about underwriting than most mortgage lenders, and they didn't found the Center for Responsible Lending as some kind of PR stunt”; you are seriously mistaken, they could not have cared less about their slimy, pathetic underwriting standards and absolutely, positively attempted to shield themselves from criticism and cloak themselves in altruism by throwing a few milling over to the Center for Responsible Lending. It was very cleaver on their part, not unlike the support and financial contribution made by Bernard Madoff, the huckster extraordinaire, master of the Ponzi scheme, that were made to legitimate organizations. The Option ARM product was a giant Ponzi scheme dependant on a house going up in value to refinance and pay-off the unpaid negative amortization on the Option ARM.

Madoff and Herbert and Marion Sandler, three peas in a pod.

2008 Dec 27 10:01 AM

[I should know:]

CORRECTION:

- - attempted to shield themselves from criticism and cloak themselves in altruism by throwing a few - "million" - over to the Center for Responsible Lending.

2008 Dec 27 10:05 AM

[nym:]

It appears NYT has not done 'due dilligence.'

2008 Dec 27 11:40 AM