With assets of more than $800 billion, Wachovia is the nation’s fourth-largest banking institution. By every measure Wachovia is an important part of the lending community, so when it does something new or different in the mortgage arena the impact can be significant.
Like many lenders, Wachovia has announced that it’s getting out of the option-ARM business, what it calls Pick-A-Pay mortgages. More significantly — and unlike Wachovia’s competitors — it’s making it easier for borrowers to dump option-ARMs by waiving the prepayment penalties routinely associated with such loans.
“Effectively immediately,” says the company, “Wachovia is waiving all prepayment fees associated with its Pick-A-Pay mortgage to allow customers complete flexibility in their home financing decisions. This includes all Pick-A-Pay mortgages on 1-4 unit residences. Additionally, for all new loan originations, Wachovia is discontinuing offering products that include payment options resulting in negative amortization.”
“This is one of the most-enlightened decisions by a major lender in the past 18 months,” says James J. Saccacio, chief executive officer of RealtyTrac.com, the nation’s largest source of foreclosure listings and data. “Wachovia has created a model that other lenders can now follow. If that happens, the Wachovia plan may well be responsible for saving tens of thousands of families from foreclosure.”
On Capitol Hill, both the House and the Senate have passed measures that would allow the FHA to insure up to $300 billion in special mortgages for those facing foreclosure. These replacement FHA loans would require borrowers to pay big fees and likely share profits with Uncle Sam. Lenders would take a loss on every loan refinanced under the new FHA program and they would also give up the right to charge prepayment penalties.
Should a ban on prepayment fees be included in the FHA bill? You can bet that lenders vehemently oppose such language but now the debate is over: If Wachovia can waive such fees why not other lenders?
We saw this last year when lenders opposed efforts to end prepayment penalties prior to interest rate re-sets with ARMs. Such opposition effectively ended when WMC Mortgage Company — a part of General Electric — said it would end prepayment penalties 60 days prior to the first interest rate reset date on new loans.
This new prepayment policy, said Laurent Bossard, WMC’s chief executive officer, “provides borrowers with enhanced flexibility to avoid prepayment fees.”
“Just as in the case with WMC, the Wachovia initiative will change the mortgage debate in Washington,” added RealtyTrac’s Saccacio. “Efforts to perpetuate prepayment penalties in the face of harsh marketplace realities will now be impossible to defend.”
Pricing loans is a complex task and many factors impact value when loans are packaged and sold in the securities market. One significant factor is whether or not a mortgage includes a prepayment penalty.
The purpose of prepayment penalties is to keep loans — and the interest income they generate — outstanding for as long as possible. More income translates into more value to the loan owner, meaning that the loan can be sold and re-sold for a higher price in the marketplace. And if it happens that a loan is paid off early and the prepayment penalty kicks-in, then thousands of dollars go to the lender’s bottom line.
By electing to waive option ARM prepayment penalties, Wachovia is essentially writing down the value of its option ARM loans, which is not a minor undertaking. No doubt Wachovia will be criticized for this by securities analysts, but the company has actually done a favor to shareholders.
By dumping prepayment penalties Wachovia has made it easier for borrowers to refinance option ARMs. Yes, the company is giving up potential penalty income but the bigger issue is this: It’s better and cheaper for Wachovia to have loans refinanced and removed from its books than to have loans fail.
Here’s why. There are many situations where Wachovia would not collect prepayment penalties anyway. In effect, waiving prepayment penalties that may not be collected is far better than losing homes to foreclosures and short sales.
Wachovia is also trying to make the best of a bad situation in another way: If it can get option ARMs refinanced it may be able to capture some of the “negative amortization” owed by borrowers.
The great attraction of option ARMs is simple: You can borrow a lot of money and pay very little each month. In fact, for the first few years of the loan you can pay so little that your monthly check doesn’t even cover the tab for interest. The interest not paid does not disappear however, instead it’s added to the loan balance in a process called negative amortization.
A quick example looks like this: You borrow $500,000 and during the first five years of the loan and pay about $1,665 per month. At the end of the start period you owe roughly $548,000 and your new monthly payment more than doubles to $3,700 for principal and interest — if interest rates remain steady. Taxes and insurance are extra.
If home prices have risen sufficiently the borrower and the lender both win with option ARMs: The borrower sells or refinances and those new and higher payments go away. In either case, the lender collects the original loan amount, monthly payments for five years plus negative amortization.
So far so good — but only if values rise. If home values stall or drop then accounting for negative amortization may need to be revised.
Negative amortization is typically booked as lender “income” at the time it’s created. However, negative amortization is not actually collected until a loan is paid down or paid off.
In other words, if an option ARM is not fully repaid the lender’s loss is not just the principal it originally advanced, the loss also includes the negative amortization claimed as “income” in past reports to Wall Street.
By making it easier for borrowers to refinance option ARMs, Wachovia is addressing phantom income which has accrued on the books but has not actually been paid. If some or all of the negative income owed by borrowers can be realized by refinancing option ARMs, then Wachovia will be very much ahead when compared with foreclosure situations.
The reason home prices have been falling for the past 18 months is a gross imbalance between supply and demand. Real estate values will not rise until the inventory of unsold homes is reduced.
Part of the unsold inventory includes large numbers of homes which have been foreclosed and are now owned by lenders. Lenders and local markets would be far better off if fewer properties were foreclosed.
By eliminating prepayment penalties for option ARMs, Wachovia is removing a major refinancing barrier. If home values had risen prepayment penalties could be resolved by simply refinancing with a larger loan. However, because values in many communities have fallen, borrowers now need cash at closing to pay off prepayment penalties and remaining loan balances — cash they routinely don’t have.
By waiving prepayment penalties for option ARMs Wachovia has substantially reduced the cost to refinance such loans. In those cases where home values have gone up borrowers can refinance without borrowing additional dollars. Where values have gone down, homes can be refinanced with smaller loans than would otherwise be necessary.
“Every option ARM that can be refinanced without a prepayment penalty under the Wachovia program means there’s likely to be one less potential foreclosure,” says Saccacio. “That means there is one less property that might be added to the local inventory. This reduces the pressure to lower neighborhood home prices and that’s good for everyone. Wachovia should be congratulated because it’s made a difficult business decision, but one which is very much in the interest of both its shareholders and the public.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.