Wells Fargo's Mortgage Conversion Scheme: Delaying the Inevitable

If you are not familiar with what an option ARM mortgage is, read this piece [Aug 13, 2008: Option ARMs- Who Thought Up these Time Bombs?].

I too was unfamiliar with it, despite following markets closely, until I read a BusinessWeek article in October 2006. Interest only mortgages? Yep, I knew about those. Alt A mortgages? Yep. [March 19, 2008: Alt A Mortgages Beginning to Break Down] But option ARMs? Wow - eye opening.

In summary, these loans are the type where your mortgage payment not only does not cover the interest (as with an interest only mortgage) but does not even cover all of the principal. So each month your principal goes up. This is the best kind of loan for day trading homes (as was all the rage in 05-07). You put the least amount of money down, and hence your leverage is the highest. Once I read that article, it all began making sense to me; how people on $40K of income were buying $560K houses in California. And then I got very worried. But the bubble would not burst for 5-6 quarters after that reading.

As you should know by now, our financial oligarchs are doing everything in their power to deny what sits on their balance sheets; much like the bank zombies did for a decade-plus in Japan. Our government and central bank is complicit -- we have changed accounting rules, we've changed rules for marking losses on commercial loans, we've.... well, I won't rehash it. The reality is there is much bad out there that is swept under the rug in typical "kick the can" process. Out of sight, out of mind. If we just change the accounting, all our problems go away.

Another technique of "make believe" is not foreclosing on homes. I've read stories (many) where people have been sitting in homes well over a year without making a payment and not being foreclosed on, because the banks only want to admit to X many losses a quarter or else they might actually look weak. So we have this shadow inventory of defaulted homes that people are living in 'rent free' as banks look the other way, waiting for the miracle rebound, I suppose.

But, to come full circle to paragraph one, a very interesting tactic by Wells Fargo (WFC) in dealing with the most toxic of all mortgages (option ARMs) they are "transitioning" people into the second most toxic (interest only). That's Step 1. Step 2 is for Ben Bernanke to unleash enough paper dollars into the global economy, so as to inflate home prices back to where the home owner could actually sell the house in 5-10 years. Or, if that does not work, it will allow Wells to admit the loss in some far off year.

Obviously, either of these loans are of the worst variety as they allow people with no "skin in the game" to transform from renters to "owners," but only on paper. [Jul. 6 2009: WSJ - No Money Down or Negative Equity Top Source of Foreclosures] And people with no skin in the game are most apt to simply walk away. While this conversion might forestall the eventuality, I doubt it will change it for most. But, anything to keep the mirage going for now. [Dec 8, 2008: More than Half of Homeowners with Modified Loans are Back in Trouble] Heck, even the Wall Street Journal now uses "kick the can".

Via WSJ:

• Wells Fargo & Co.'s strategy for modifying troubled Pick-A-Pay mortgages looks like a game of kick-the-can-down-the-road.
• The fourth-largest U.S. bank by assets holds about $107 billion in debt tied to option adjustable-rate mortgages, a relic of the U.S. housing boom that allowed borrowers to make small monthly payments in return for increasing their mortgage balance. Many such borrowers now own homes worth far less than they owe in mortgage debt, and most can't afford a full monthly payment that pays down the loan's principal.
• To solve that conundrum, Wells Fargo is taking a gamble: The San Francisco company 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 worst-hit regions of the U.S. and a rise in consumer income, will eventually cover the bank's underwater Pick-A-Pay debt.

Considering many of these people are not 3, 5, 7% underwater, but 25-40%, that's quite a wager. Especially if we ever return to a normal market with mortgage rates around 6% and no free handouts for people to buy homes. That will drive prices down yet again. But again, it goes back to not admitting losses.

• The move to shift Pick-A-Pay borrowers into interest-only loans helps Wells Fargo avoid hefty write-downs on Pick-A-Pay mortgages that would likely result from foreclosures. But the strategy will leave Wells Fargo holding billions of dollars in mortgage debt tied to distressed properties in battered markets, especially California and Florida.
• Pick-A-Pay loans accounted for 10.8% of Wells Fargo's average total loans in the third quarter.
• Wells Fargo has written $2 billion off Pick-A-Pay balances for borrowers, or nearly $46,000 per modified loan.

Note: Wells Fargo did not actually do option ARM loans themselves, but inherited these when they got a sweetheart deal to take over the 4th largest bank, Wachovia, under duress in 2008. As part of the deal, Wells got handed a massive amount of tax breaks by Hank Paulson that was snuck into "TARP" at the last minute. Even the folks in Congress were outraged, once they bothered to read the bill a few weeks later. [Nov 13, 2008: Washington Post - A Quiet Windfall for US Banks]

Wachovia, on the other hand, was "Pick-A-Pay" central.

• Wells Fargo risks tethering itself to what former Wall Street executive David Shulman calls "wasting assets," since borrowers facing years of negative home equity likely have little incentive to maintain or improve their homes.

So, if Wells Fargo is being "good hearted," why not put these people in a fixed 30-year mortgage rather than interest only? Aha - devil in the details. Because these borrowers used option ARMs for a reason - they could not truly afford their home with a conventional mortgage. And they still cannot. Wells Fargo is writing down the principal by an amount that can get these borrowers qualified for "interest only" (i.e. the bare minimum), and we'll just kick the can for another half decade-plus.

Frankly, it's a disaster for the borrower to stay in these mortgages over the long run. They are just renting, as not one iota of principal is being paid.

Disclosure: No position

Comments

[igggy:]

And I thought no one could do what Countrywide could:
www.youtube.com/watch?...

Nov 06 03:25 PM

[Roger Knights:]

I guess WFC's losses will get put onto the gov't.'s balance sheet if/when a gov't. agency or the Fed buys these mortgages and the owners get converted to renters. Uncle Sham will backstop his fellow humbuggers. But then there'll be a "sudden stop," when foreigners stop backstopping US (buying Treasuries).

Nov 06 03:53 PM

[Mobywhite:]

I disagree with the idea that because they are underwater people will not take care of their homes and the value will drop.

California is an incredible place to live and because of this the demand on housing is usually very strong. My belief is that the homeowners will take care of their homes because they will get the benefit of the price appreciation down the road. And I, like most people in California, believe their homes will be worth a lot more five years down the road.

I think Wells Fargo should get credit for trying something that might work because all the other alternatives are lousy.

Nov 06 04:29 PM

[capital pains:]

WFC is not to be derided for providing a means for underwater homeowners to remain in their homes rather than be tossed out into the street to seek a rental unit While there may very well be an ulterior motive. Wells,and all banks needed to 'innovate' the interest only option as an alternative to foreclosures. While it is correct that the interest only mortgage holder is not gaining in equity, but merely renting. For millions of homeowners it ia an easy choice between remaining in their homes as renters' or incurring moving expensis, 3 months cash deposits to the landlord, new schools for the kids,etc.. All in all, not a pretty alternative to foreclosure.Factor in the huge fact that not having a foreclosed property on your block helps the other homeowners not continue to lose value in their neighborhoods. A big plus.
With our country facing a possible 10 million foreclosures, any sort of band aid is desperately needed. The banks making out as well in terms of 'shadow accounting' ..Well, if the banks weren't going to 'make out' do you think this alternatuve would exist !
Any stemming of the geometrically increasing number of foreclosures, is well worth the try.

Nov 06 08:37 PM

[fcharlie:]

WFC now has the ability to continue to generate cash rather than not, has the ability to maintain the balance sheet rather than write it down, the ability to to space out whatever remains of losses that would have all been taken today over a four year period, and take advantage of future appreciation in prices from this point on. Six years from now the original homeowner may still be underwater, but WFC, even if they "kick the can down the road" can perhaps receive tens of thousands more dollars from foreclosure in 2014 simply by waiting for some appreciation in prices. How is this a bad idea? What's the alternative? If someone owed me $1,000 and they told me they couldn't pay me $50 a month anymore, would I say oh well I just accept it as lost, or would I allow them to pay $10 a month and see what happens? It's not a hard decision to make.

Nov 06 09:05 PM

[Brian Chan:]

There're so many detractors for WFC. From traders like Tradermark to Dick Bove to Meredith Whitney. Many of them have all twisted and turned at some time, if not many, in their careers with their views. 50% of the time, they hit, the other 50 they missed. And when they miss, they change 360 degrees. Those actions are as described by Mr. Buffett as "throwing the dart and then drawing the bull eye around it." But one important guy whom has invested since 1991 till now is Berkshire Hathaway. Not only did they retain their stake, and trust in them, BRK seems to have increased their stake by a cost of $277 millions in the 3Q09 as can be seen from the latest 10Q report.

Nov 06 11:10 PM

[swissfrank:]

You're missing the point, surely. If someone owes me $1000 for an ASSET and fails to repay, then I'll take back the ASSET when the repayment stops. This would happen with a car loan. What we are talking about here is a loan secured on an asset, not an unsecured cash loan. With an unsecured cash loan, sure, $10 a month is better than write-off.

Imagine millions of newish cars being driven around by Americans who have largely stopped repaying their car loans while the finance companies offer cheap new payment options SO THAT THEY CAN KEEP THE CARS ON THEIR BOOKS AT ORIGINAL COST PRICE rather than have to account for the depreciated asset. That's where we are now.

On Nov 06 09:05 PM fcharlie wrote:

> WFC now has the ability to continue to generate cash rather than
> not, has the ability to maintain the balance sheet rather than write
> it down, the ability to to space out whatever remains of losses that
> would have all been taken today over a four year period, and take
> advantage of future appreciation in prices from this point on. Six
> years from now the original homeowner may still be underwater, but
> WFC, even if they "kick the can down the road" can perhaps receive
> tens of thousands more dollars from foreclosure in 2014 simply by
> waiting for some appreciation in prices. How is this a bad idea?
> What's the alternative? If someone owed me $1,000 and they told me
> they couldn't pay me $50 a month anymore, would I say oh well I just
> accept it as lost, or would I allow them to pay $10 a month and see
> what happens? It's not a hard decision to make.

Nov 07 02:05 AM

[Sterling Ha...:]

I guess "delay and pray" is WFC's best strategy to stay in business. They know the government will keep them on life support for the foreseeable future.

Nov 07 09:58 AM

[jcl9977879879:]

Wells claims to be one of the strongest banks out there... even if this is the only palatable approach, that's fine, you can support their decision making... they still have 1/10th of their total loans in an asset class that any sensible person would call a VERY TOXIC ASSET,,, WFC is NOT one of the strongest banks...

Nov 07 10:58 AM

[TraderMark:]

you do realize Wells Fargo would be in BK if not for the taxpayer?


On Nov 06 11:10 PM Brian Chan wrote:

> There're so many detractors for WFC. From traders like Tradermark
> to Dick Bove to Meredith Whitney. Many of them have all twisted and
> turned at some time, if not many, in their careers with their views.
> 50% of the time, they hit, the other 50 they missed. And when they
> miss, they change 360 degrees. Those actions are as described by
> Mr. Buffett as "throwing the dart and then drawing the bull eye around
> it." But one important guy whom has invested since 1991 till now
> is Berkshire Hathaway. Not only did they retain their stake, and
> trust in them, BRK seems to have increased their stake by a cost
> of $277 millions in the 3Q09 as can be seen from the latest 10Q report.

Nov 07 12:35 PM

[TraderMark:]

bingo swissfrank

last I checked the homes have actual value

admitting the "new value" is what wells and all the other banks want to avoid admitting


On Nov 07 02:05 AM swissfrank wrote:

> You're missing the point, surely. If someone owes me $1000 for an
> ASSET and fails to repay, then I'll take back the ASSET when the
> repayment stops. This would happen with a car loan. What we are talking
> about here is a loan secured on an asset, not an unsecured cash loan.
> With an unsecured cash loan, sure, $10 a month is better than write-off.
>
>
> Imagine millions of newish cars being driven around by Americans
> who have largely stopped repaying their car loans while the finance
> companies offer cheap new payment options SO THAT THEY CAN KEEP THE
> CARS ON THEIR BOOKS AT ORIGINAL COST PRICE rather than have to account
> for the depreciated asset. That's where we are now.
>
> On Nov 06 09:05 PM fcharlie wrote:

Nov 07 12:36 PM

[Steve J:]

Tradermark,
Here is a little additional color on the modification process:

WFC has taken steps to work with customers to refinance or restructure their PaP loans into "other loan products".
Tradermark, Why not mention the above?

For customers at risk WFC offers combinations of term extensions of up to 40 yrs, interest rate reductions, and in geographies with substantial property value declines gave permanent principal reductions.

Tradermark, when you state they are playing kick the can down the road by offering on a case by case basis interest only loans for 6 yr periods you neglected to inform people that WFC has also modified some loans to charge no interest on portions of their principle. Also, is it fair to eliminate the interest only option before the original recast period is up? WFC is seemingly being fair to the borrower.

WFC modifying loans by reducing principal and charging no interest on certain portions of principle seems to be pertinent to your thesis of delaying the inevitable, so how could this be left out of your article. In fact I find your article as slanted as the WSJ article if not more. The WSJ passed their article off as a half baked interview so therefore they don't present it as analysis, but the person being interviewed is somehow seen as at fault for his lack of presenting all the facts. Unfortunately people like you believed the article.

Per WFC: "As part of the modification process the loans are re-underwritten, income is documented and the negative amortization feature is eliminated. Most of the modifications result in material payment reduction to the customer. " Your characterization of this as being a scheme is a little over the top and is proven incorrect by the performance of WFC modified loans being significantly better than the industry average.

All of these modified loans show up on WFC balance sheet as NPA. Many of these loans were out of the group already written down by purchasing accounting, I'm not sure but it is my understanding they wouldn't have shown up in NPA's if left unmodified. If true this refutes the idea their balance sheet is better looking by modifying these loans. This is not a scheme but a win win win for WFC, PaP borrowers and anyone negatively impacted by the tsunami of foreclosures.

WFC has been modifying these loans for 9 months now, future articles will hopefully be able to include actual stats on the performance of WFC modified loans.

Nov 07 02:23 PM

[j-dub:]

What I simply can't figure out is how in the world ANYONE IN THEIR RIGHT MIND would ever do business with a bailed out bank again. They are a scourge on our economy and are recepients of funds that could be better funneled elsewhere.

I just don't understand it. Insolvent is insolvent and I am tired of all the accounting games.

Nov 07 02:38 PM

[j-dub:]

Odds are this post is from a bank employee or who has a spouse/child who works for WFC. Keep in mind, Mark that entities and its generally irresponsible employees would LOVE TO PRETEND THAT 2008 NEVER HAPPENED.

OH, THEY'RE NOT IRRESPONSIBLE?
I knew that valuing average homes here in Pinellas County, Florida at 7-8 times median houselhold income was insane.
And these BANKERS didn't?


On Nov 07 12:35 PM TraderMark wrote:

> you do realize Wells Fargo would be in BK if not for the taxpayer?
>

Nov 07 02:46 PM

[helplessobs...:]

For all you people who want to kick the people out of the homes take some time and go look at homes that have been taken over by the lender. Basements turned into cisterns, mold and peeling paint inside and outside, a target for vandals. An immediate lender outlay of $5 to $10k just for clean up is required. Since there is no market for the property it is best to keep someone in the house paying for electric power and cutting the grass. Call it "house sitting maintenance" which is designed to retain as much value as possible. An empty house is a truly wasting asset.

Nov 08 06:31 PM

[TraderMark:]

So perhaps everyone should abandon making their mortgage payments so we're all equal? I.e. we can all threaten that our homes will turn into vandalized lots and we all want a house sitting discount. Perhaps 40% off everyone's mortgage payment? That would seem more equitable to me.


On Nov 08 06:31 PM helplessobserver wrote:

> For all you people who want to kick the people out of the homes take
> some time and go look at homes that have been taken over by the lender.
> Basements turned into cisterns, mold and peeling paint inside and
> outside, a target for vandals. An immediate lender outlay of $5
> to $10k just for clean up is required. Since there is no market
> for the property it is best to keep someone in the house paying for
> electric power and cutting the grass. Call it "house sitting maintenance"
> which is designed to retain as much value as possible. An empty
> house is a truly wasting asset.

Nov 08 09:01 PM

[bigbear4511:]

ya but if you owe 1000 dollars and your interest is 6% and you only can pay two dollars a month, is the owner of the debt really getting anywhere.


On Nov 06 09:05 PM fcharlie wrote:

> WFC now has the ability to continue to generate cash rather than
> not, has the ability to maintain the balance sheet rather than write
> it down, the ability to to space out whatever remains of losses that
> would have all been taken today over a four year period, and take
> advantage of future appreciation in prices from this point on. Six
> years from now the original homeowner may still be underwater, but
> WFC, even if they "kick the can down the road" can perhaps receive
> tens of thousands more dollars from foreclosure in 2014 simply by
> waiting for some appreciation in prices. How is this a bad idea?
> What's the alternative? If someone owed me $1,000 and they told me
> they couldn't pay me $50 a month anymore, would I say oh well I just
> accept it as lost, or would I allow them to pay $10 a month and see
> what happens? It's not a hard decision to make.

Nov 09 02:37 AM