BoA Cuts Off Countrywide ARMs to Save Body of Mortgages

The Wall Street Journal “Bank of America in Settlement Worth Over $8 Billion” (online) and “Bank of America Settles Countrywide Suit” (print) report that Bank of America (BAC) settled with the attorneys general in multiple states regarding risky loan practices. Up to 390,000 subprime mortgage borrowers could have their loans modified so that their payment won’t exceed 34% of their income. These modifications could “cost” more than $8.6B to Bank of America and investors who purchased securities composed of Countrywide mortgages. The reality is that the savings will probably be much greater than the cost.

The attorneys general called Countrywide’s practices predatory lending. The mandatory modifications include: principal reductions to facilitate refinancing to government backed loans and reducing interest rates to as low as 2.5%. The negative amortization in option ARMs will be removed and prepayment penalties eliminated. Investors might have to approve certain modifications to mortgages held in securitizations.

The settlement could actually be of great benefit to Bank of America and become a model for other banks. Both Washington Mutual (WM) and Wachovia (WB) claimed to be moving in this direction, but were so lethargic that they imploded before they could show any results. Merrill Lynch (MER) on the other hand simply dumped the bad stuff, leaving others to sort through the mess. I don’t know whether WaMu and Wachovia could have remained independent if they preemptively modified all of their option ARMs, but I think the chances would have been much better.

Bank of America is being forced to create value from junk. Loans which are current and accruing are far more valuable than loans in default or hopelessly loaded with negative amortization. The biggest impediment to other banks following suit is the effect that further write downs will have on their capital requirements. The illusion of maintaining negative amortization was completely erased when JP Morgan (JPM) aggressively wrote down WaMu’s option ARMs in the takeover.

To the distain of many conservatives, the activist judicial system is doing the job that banks and their regulators have neglected. Eventually, all mortgages will have to match the ability of their borrowers to pay. In a dead real estate market, foreclosure is rarely more profitable than loan modifications. Even though Congress was unsuccessful in allowing bankruptcy judges to modify mortgages, it looks like the courts still have the power to initiate change.

Disclosure: Author is long BAC and WB.

Comments

[Ishortyou:]

The problem with this model is that the FDIC is taking over the banks and send them to bankruptcy before they are able to implement it and recovered themselves, so time is in essence the most important thing and the FDIC is not providing it.

2008 Oct 07 09:00 AM

[Chris B:]

One would think that there would be an agressive, bustling business in loan modification so that banks could avoid dealing with foreclosures in a dead housing market. For example:

1) Suspending the mortgage for 2-3 years and having the bank just require a payment the equivalent of rent. Then after 2-3 years restarting the mortgage with the additional payments added to the end of the loan. Even if the loan eventually defaults, the bank gets 2-3 years of rent and 2-3 years of time out of the deal. I'd certainly rather auction a house in 2-3 years than now.

2) Interest rate cuts. They have to be cheaper than foreclosure! Why aren't banks cutting their losses?

3) Write-offs of the negative equity portion of the loan. It's not like the bank would ever get this money anyway. After taking this loss, you have a loan that is sellable because it matches the value of the collateral. Plus you've harvested some losses for tax purposes.

Of course, the problem preventing the implementation of any of these solutions is the fact that these individual loans are "securitized" and are owned not by the local banks that could implement the plans, but by foreign companies and SWF's. There is a disconnect: the banks need funding from these investors and these investors need the banks to salvage the loans.

Expect somebody to become a billionaire figuring out how to unpackage these mortgages, individually work solutions out, and resell the stabilized loans.

2008 Oct 07 09:55 AM

[olduw:]

ishortyou hit the nail on the head--PLUS the fdic needs to be investigated--when banks can go from ok to insolvent overnight someone has been asleep at the switch--if the situation for wachovia was suddenly so dire--why didnt the fdic prop up the nations 4th largest bank rather than chop it up and sell it (for a nice $15 billion in preferred stock)---something really stinks here and I think it's the FDIC,,,,,,,,,,,shareho... must vote down either deal until this is investigated

2008 Oct 07 09:58 AM

[helplessobs...:]

In normal times foreclosure keeps discipline in the mortgage market. These are not normal times so new procedures are required. I expect eventually many people will be kept in their houses with minimum and or token payments to keep the home from crumbling to debris. A hole in the roof and a basement turned into a cesspool will destroy value faster then taking a lower return on your investment.

2008 Oct 07 11:00 AM

[countr307:]

Yes. I got suckered in in countrywide adjust. mortg. At the closing signing of thousands pages they told me that this mortgage was interest only and it would change montly. I know that I should have walked away.
But I was in a bind and they new it.

2008 Oct 07 11:48 AM

[Economics:]

Countrywide’s new rates will be as low as 2.4% will sure help anyone with a mortgage, too bad it is for such a small segment of the population. I guess these people did not have mortgages with Countrywide, www.buymyhousebeforeth... and there is no relief for them.

2008 Oct 07 12:25 PM

[Philip Gvinter:]

The problem with taking this approach is that it essentially requires capitulation. Eliminating the neg-am would involve losing the majority of the interest accrued on the loan over the first two or three years, and because these loans were most popular in FL, NV, CA and a few other overheated markets the principal reduction is somewhere in the neighborhood of 20% or more. This is a HUGE hit to take and requires the institution to essentially predict a default rate of >12% on the portfolio in order for the alternative to seem economical. At that point the FDIC has to step in because an institution that is overweight these kinds of loans is insolvent.

2008 Oct 08 09:03 AM