‘Pay option’ mortgages could swell foreclosures

John W. Schoen Senior producer • Profile • E-mail

Some time after Sharren McGarry went to work as a mortgage consultant at Wachovia’s Stuart, Fla., branch in July 2007, she and her colleagues were directed to market a mortgage called the “Pick A Pay” loan.  Sales commissions on the product were double the rates for conventional mortgages, and she was required to make sure nearly half the loans she sold were "Pick A Pay," she said.

These “pay option” adjustable-rate mortgages gave borrowers a choice of payments each month. They also carried a feature that came as a nasty surprise to some borrowers, called "negative amortization." If the homeowner opted to pay less than the full monthly amount, the difference was tacked onto the principal. When the loan automatically “recasted” in five or 10 years, the owner would be locked into a new, much higher, set monthly payment.

While McGarry balked at selling these pay-option ARMs, other lenders and mortgage brokers were happy to sell the loans and pocket the higher commissions.

Now, as the housing recession deepens, a coming wave of payment shocks threatens to bring another surge in defaults and foreclosures as these mortgages “recast” to higher monthly payments over the next two years.

“The next wave (of foreclosures) is coming next year and in 2010, and that is primarily due to these pay-option ARMS and the five-year, adjustable-rate hybrid ARMS that are coming up for reset,” said William Longbrake, retired vice chairman of Washington Mutual. The giant Seattle-based bank, which collapsed this year under the weight of its bad mortgage loans, was one of the biggest originators of pay-option ARMs during the lending boom.

The next wave may be even more difficult to handle than the last one.

“It’s going to get tougher to modify loans as these option ARMs come into their resets," Federal Deposit Insurance Corp. Chairwoman Sheila Bair told msnbc.com this week. "Those are more difficult than the subprime and traditional adjustable rates to modify because there is such a huge payment differential when they reset."

Monthly quota: 45 percent
With 16 years of experience in the mortgage business, McGarry didn’t believe the “pay option” loan was a good deal for most of her customers, so she didn’t promote it.

“I looked at it and I thought: I’m 60 years old. If I were in these peoples’ situation 10 years from now, where would I be?” she said. “Do I want to be in a position that 10 years from now I can’t make this higher payment and I’m forced to make this payment and be forced out of my home? So I wouldn’t do it.”

Her job description included a requirement that she meet a monthly quota of Pick A Pay mortgages, something she said wasn’t spelled out when she was hired. Still, she said, she continued to steer her customers to conventional loans, even though her manager “frequently reminded me that my job requirement was that I do 45 percent of my volume in the Pick A Pay loan.”

In June 2008, her manager wrote a “Corrective Action and Counseling” warning, saying she wasn’t meeting the bank’s “expectation of production.” McGarry soon left Wachovia after finding a job with another mortgage company. On June 30, the bank stopped selling mortgages with negative amortization. In October Wachovia, suffering from heavy mortgage-related losses, agreed to be acquired by Wells Fargo.

A spokesman for Wachovia said that generally the bank doesn't comment on internal marketing policies. But he said commissions on Pick A Pay mortgages were higher because the loans were more complicated and required more work to originate. He also noted that when Wachovia's Pick A Pay loans recast, the payment increase is capped for any given year, which helps ease borrowers' burden of meeting a higher payment.

The first wave of home foreclosures that hit in late 2006 and early 2007 followed the resetting of subprime adjustable mortgages with two- and three-year "teaser rates" written during the height of the lending boom earlier in the decade. But pay-option ARMs — which often don't "recast" for five years — have a longer fuse. Unless defused by aggressive public and private foreclosure prevention programs, the bulk of these loans will explode to higher payments in 2009 and 2010.

The scope of the problem was highlighted in September in a study by Fitch Ratings, one of the bond rating agencies that assesses the risk of defaults on mortgage-backed investments. Of the $200 billion in option ARMs outstanding, Fitch estimates that some $29 billion will recast in 2009 and another $67 billion in 2010. That could cause delinquencies on these loans to more than double, Fitch said.

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