Wachovia Drops a Bomb…The ‘Pay Option Implosion’ Has Begun

Posted on April 14th, 2008 in Daily Mortgage/Housing News - The Real Story

First, they moved up their earnings date four days to today. Second, they miss horribly – analysts were expecting 40 cents and they announced NEGATIVE 14 cents. Third, they cut their dividend drastically. Fourth, they raised $7 Billion in combo of common and preferred shares. Terms of their offering…$3.5 bil in preferred shares at 7.5% coupon and 30% conversion premium PLUS 146 million common shares at $24. Given they are one of the largest Pay Option ARM holders in the world, this is likely only their FIRST capital raise despite what Goldman is trying to push this morning.

Wachovia, who bought World Savings/Golden West a couple years ago and inherited $120 BILLION in Pay Option ARMs in the process, is having trouble. The is undoubtedly due to their massive expose to the Pay Option ARM. As you all know, Wach adopted the Pay Option ARM as their primary portfolio mortgage since the acquisition and are still doing commercials to this date with people dancing around their house shaking their bodies and dancing because they can make a much lower mortgage payment when they want to and accept negative amortization (mortgage balance INCREASES). Absolutely irresponsible! Pay Option ARMs were in part responsible for the massive losses from all the players who were the largest players in the program including American Home Mortgage, Countrywide, IndyMac, Downey, First, Fed Bank United, Lehman and Bear. In addition, when they go bad they are total losses in many cases because most are in a severly negative equity position.

We have learned in the past few months, that negative equity is a leading cause of loan defualt, even more so than periodic ARM adjustments. This is why Pay Option ARMs are essentially worthless and Wachovia will be stuck with these in perpetuity awaiting their default or modifying loan balances lower one by one.   

Pay Option ARMs have just started to implode with the big bang coming from 2010 – 2012 unless housing magically appreciates some 5-9% per year going forward (compensate for neg-am) and somehow makes back most of the losses already taken before these loans implode. Remember, this loan programs was the fastest growing from 2005-2007 when prices were at their peak, meaning this group of loans should be some of the worst performing going forward. The ratings agencies just have not got there yet, as usual.

Pay Option factoids…80% of these loans were done in bubble states, 80% of the people pay the minimum monthly payment and accept the neg-am; most of those have an increase in mortgage balance of 5-9% per year, and in 2006-2007 80% were stated income. There are reports out saying at least 50% of all Pay Option ARM borrowers have a second mortgage as well.

This is a great chart of the ARM reset catastrophe  – take a look at the Pay Option Implosion coming soon. This could make the ‘Subprime Implosion’ look like a walk in the park because Pay Options cut across all socio-economic boundaries with these loans being most prevalent in higher-priced bubble regions. -Best, Mr Mortgage


9 Responses to “Wachovia Drops a Bomb…The ‘Pay Option Implosion’ Has Begun”

  1. Interesting chart, but as you mentioned in your post, resets are not the primary driver of defaults, so the fact that there are many mortgages resetting in the next couple of years doesn’t necessarily translate to higher defaults, or more importantly, additional writedowns.

    Speaking of writedowns, a mortgage trader told me that the Wall St. writedowns include not just subprime, but all mortgage related re-valuations, including Alt-A, prime, home equity lines/HELOCs. That’s not to say everything has been written down to a market clearing level, but it suggests that Alt-A and HELOCs are not being held at par or near-par. If this is true, expectations of additional writedowns should center on defaults being higher than currently forecast, rather than on the notion that banks are holding non-subprime mortgage securities at par.

  2. But keep in mind, once pay options reset, they hold a principal balance of 110 to 125% of the original balance. The borrower cant refi or sell unless they bring in tons of cash. They could chose to make the 2 to 3x payment of course. But they won’t in many cases for a home with 20-40% negatibe equity.

    On the write downs, Wells has taken $1 billion on a $84 billion Home Equity loan/line portfolio. These are selling at 3-5 cents on the dollar. They also hold $25 billion of subprime. No write downs.

    We are in the early innings.

  3. i can’t wait to see Buffett’s indecent proposal to Wells after it takes shudderingly heavy losses on the aforementioned option ARMs and HELOCs. that guy comes up w/ some creative (albeit insulting, but hey that’s the market) offers.

  4. I also got an analysis for typical OA package from 05-07. The one I displayed is from CFC and you guys can see where to look for red flags based on that example.

    WB is kinda tricky, they portfolioed their stuffs so there isn’t much data about their OA loans.

    But as u said yes it will be just another cut that looks like this, perhaps with better LTV cuz Golden Gate is historically more decent (but I dont think it matters this time given the crash CA is gonna get, like 30-50% HPA drop).


  5. youy option arm analysis into MBS of their competitors will hold true with their portfolio loans to a great degree. Remember, although WB was tougher on appraisals/ltv and forced a higher minumum monthly payment, they were much easier on credit standards. Six of one, half dozen of another. Not all options arms were created equally, but the consumer behavior towards negative equity with no way out is all created equally.

  6. I must appreciate your work. from last couple of days i was searching for something interesting and this post is really nice.

    Thanks for this nice post.


  7. It’s amazing how stupid some of these banks are when their investors are literally strangling them to find a way to increase value. The acquisition of Golden West will go down as one of the all-time worst acquisitions EVER….not because Golden West wasn’t run well, but because the timing of the purchase could not have been any worse. And there were plenty of financial pundits out there saying “Wachovia, what the hell are you doing???” and Wachovia said something like “Oh, Golden West has been doing this a long time, and we bought it at a good price, so everything will be just fine, you little peasants….take a seat and learn from the masters here.” And now they have to slink back to the investment community and say “Well, in hindsight it doesn’t look too good…”

    At the same time, when the old guy and his wife sold Golden West, I thought “Now there’s a guy who knows how to build his own retirement fund!” Same thing with Sam Zell selling Equity Office Properties, and Blackstone actually flipping some of those commercial buildings to Macklowe who was left holding the bag.

    Mr. Mortgage, I’ve been waiting for someone like you to start a blog like this for over a year…a mortgage insider who knows how bad the situation really is, and can speak intelligently about the problems we face now and in the coming years. I’ve been reading real estate blogs like crazy and learning how all these mortgage products work, but most blogs cannot speak about the issues intelligently enough. Good work here!

  8. thanks Chris…I appreciate the support. Help me out with ideas on subjects you want to hear about.

  9. Mr. Mortgage, I’ve just started reading your blog & watching your videos on YouTube as of May 2008. You have no idea how refreshing it is to get the real truth from an insider who knows the mortgage/financing biz. I’m a realtor in Texas. Although I don’t profess to know all the ins/outs of mortgages, at least I try to educate myself a little on the subject. I’m amazed at what’s happening in the financial markets, and the fall out for the real estate industry. I am interested in hearing what your comments are in regards to what led up to the depression in the 1930s (historically speaking, the markets). Are we doomed to repeat history? This is a little far fetched, but I’ve been following RonPaul2008.com and his videos on YouTube discussing his thoughts about a political shadow government: http://www.youtube.com/watch?v=gAcxGD6-c-E (1 of 29). I don’t believe everything I read, but the more research you do, the more this sounds plausible. What are your thoughts? Signed–a greatfull fan in Texas! 🙂

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