Risky and Calculating

So over the last few years I have become a fairly regular reader of Calculated Risk. It's a blog devoted mostly to economics and housing, with a focus on clear presentation of data. At some point, a commenter with the handle "Tanta" was invited to write regular posts, which she did until her death in the autumn of 2008 (I still think of her as Tanta, though it has been revealed that her name was Doris Dungey). Tanta spent most of her career in the mortgage industry and wrote most of her posts about the intricacies of mortgages and related public policy. Many of her posts are compiled here and here.

Anyway, everything I know about mortgages I learned from Tanta, and I thought I would use that knowledge to critique this piece in the New York Times, which was actually linked from Calculated Risk.

The Times seems to have engaged in its incredibly obnoxious habit of changing the headline on an online article. I believe the headline was originally "Adjustable Mortgages Loom as Threat to Housing Recovery" (which is the text under which Calculated Risk linked to it). Now the headline reads "Loans That Looked Easy Pose Threat to Recovery."

The article, under its original headline, caught my eye because adjustable-rate mortgages (ARMs) should not be a problem right now per se. The whole point of ARMs is that the interest rate adjusts as a function of some benchmark, and interest rates generally are extremely low right now. I read the article because I was interested to see why ARMs would be a problem - perhaps because rates will inevitably rise when the recession ends?

But no, it turns out that we're not talking about ARMs generally, but rather "option ARMs." What is optional about an option ARM is amortization - the borrower chooses whether to make the full amortizing payment, to pay interest only, or to pay some specified lesser amount. If the borrower pays less than the interest, then the unpaid interest is added to the principal amount of the loan. After a certain amount of time, or after the principal balance grows to a certain level, the borrower is required to make fully amortizing payments.

Many borrowers used option ARMs as an "affordability product," meaning that they chose an option ARM because they could afford the minimum required payment. But remember, that minimum payment does not even cover the interest on the loan, so if that's all you can afford, you will have an escalating loan balance. Some people considered this a worthwhile risk to take when house prices were rising rapidly and it was easy to refinance into another loan before the higher payments kicked in.

So right off the bat, it's clear that the "option" part is much more troubling than the "ARM" part. And that becomes even more clear as the article profiles Harvey Clavon, who refinanced his home 3 years ago:

Mr. Clavon, 63, was planning to sell the home in a few years and retire to Palm Springs. So he got a loan called an option adjustable rate mortgage, or option ARM, which allowed him to pay less than the interest for the first five years.

On his annual salary of $100,000 as a television camera operator, he could afford the $2,200 initial mortgage payments. And he planned to sell the home before the mortgage reset.

. . .

Because Mr. Clavon made only minimum payments on his mortgage, his balance has risen to $680,000 from $618,000, on a house worth closer to $400,000.

“I don’t know what I’m going to do, ” he said. “I got duped into the loan, and I consider myself an educated man.”

There's a lot going on here, but let me focus on how Mr. Clavon ended up in such a difficult situation. We don't know why he was refinancing his house 3 years ago, but it's apparent that after the transaction he didn't have all that much equity in his house (or so we can assume based on how far underwater he is now). He then proceeded to make only the minimum payments for 3 years, racking up another $62,000 in debt. The housing bubble burst, and he now owes $680,000 on a house worth "closer to $400,00" (which doesn't narrow it down much). Assuming the house is worth $400,000, this means that if he sells it he will have to bring a check to closing to pay off the $280,000 that won't be covered by the purchase price.

Clavon claims to have been duped, but I can't think of a mortgage product that would have prevented this outcome. Clavon's problems are:

1. He didn't have enough money in 2006.

2. The housing bubble has burst and his house lost a lot of value.

3. He doesn't have enough money in 2009.

What kind of mortgage does he think would have solved any of these problems? If he didn't want to have such a large balance to pay off, why did he effectively keep borrowing money by not even paying the interest on his mortgage?

This last question is the key, I think. The truth is that Clavon couldn't afford whatever it is he needed to refinance for in the first place. Therefore he couldn't afford to pay off the debt he incurred in the refinancing, and therefore he only made minimum payments on his mortgage. A more responsible mortgage lender might not have written him an option ARM, but that means he probably couldn't have refinanced at all.

And that's probably what should have happened, but then it's not really the option ARM that has caused Clavon's problems.

Anyway, this doesn't change the fact that option ARMs are a problem in that many of them are toxic and will likely require more foreclosures. But if that's the point the article is trying to make, then I don't see why it spends so many paragraphs, right at the beginning, portraying Clavon as a victim of exotic financial products.

And I should note that I do sympathize with Clavon, who is in a terrible situation. The point here is to think about what can and what can't be blamed on option ARMs. Other than allowing him to live beyond his means, it's unclear what harm they have done to Clavon.