Defaults exposing truth of "liar's loans"

The no-worries lending that inflated the housing bubble is resulting in a flood of soured option-ARM loans, adjustable-rate mortgages that allow borrowers to pay so little every month that their loan balances rise rather than fall, sometimes sharply.

Numbers from industry trackers suggest that these borrowers — most of whom boast respectable, often top-tier credit scores and appear to have substantial incomes and home equity — are starting to create a second tide of defaults in addition to the subprime-loan meltdown.

Countrywide Financial, the top option ARM lender, will be hit hard. Already reeling from the subprime mess, Countrywide was rescued from possible bankruptcy last week by Bank of America, which agreed to acquire it for about $4 billion.

The option ARM trouble stems from the loose lending practices that inundated the subprime business. Loans often were granted on the basis of stated income, not proof of a borrower's income, giving rise to their nickname, "liar's loans."

"This is not a subprime crisis. This is a stated-income crisis," said Robert Simpson, chief executive of Investors Mortgage Asset Recovery in Irvine, Calif., which works with lenders, insurers and investors to recover losses related to mortgage fraud.

Option ARMs present borrowers with a choice every month: Pay the interest due and some of the principal; pay interest only, leaving the loan balance untouched; or pay less than the interest due, making the loan balance rise.

After a specified time, typically five years, the options disappear and regular payment obligations kick in, often at a level two or more times the initial minimum.

This jolt can occur after only three years if the borrower has been making the lowest payments and the balance rises high enough.

Traditionally, good candidates for stated-income option ARM loans were self-employed professionals, small-business owners and salespeople with complicated finances and fluctuating earnings. But many others received them in recent years.

Simpson said loan officers routinely inflated earnings of workers with regular paychecks. On some written requests to confirm a borrower's employment, officers would specify that an employer should not provide a salary figure, he said.

Now the delinquencies are piling up.

The more recent loans appear to be faring the worst, reaffirming the conclusion that lending standards had become overly lax throughout the mortgage industry in recent years, as competition for fewer good loans intensified amid skyrocketing home prices.

"It is astonishing how fast the credit deterioration has occurred," said Paul Miller, an analyst with Friedman, Billings, Ramsey who follows the savings and loans that specialize in these mortgages. "It took me and everybody else by surprise."

The quality of option ARMs appears to have deteriorated quickly when Wall Street began buying them to create mortgage bonds in the middle of this decade, drawing IndyMac, Countrywide and others into the business, Miller said.

Loan Performance's study, which looked at loans bundled up by lenders and Wall Street firms to back mortgage bonds, found that 8.8 percent of such option ARMs made nationally in 2005 were 60 days or more in arrears as of Oct. 31.

Falling home prices and exaggerated appraisals are exposing the risks of stated-income ARMs, experts say. And many option ARMs were done with stated income during the boom.

"When you combine one of the riskiest loans — the option ARM — with one of the riskiest loan features — stated income — it's not exactly a model for safety," said Redwood City, Calif., mortgage broker Steven Krystofiak, president of the Mortgage Brokers Association for Responsible Lending.

"Yet they were extremely popular in 2004, 2005 and 2006, and some people were telling borrowers and investors they were safe," said Krystofiak, who has testified to the Federal Reserve about high-risk loans.

Stated-income loans made during the housing boom have proved to be riddled with exaggeration, according to the Mortgage Asset Research Institute in Reston, Va., which investigates lending fraud.

The institute said one of its customers checked 100 stated-income loans against tax documents and found that nine in 10 overstated income by at least 5 percent.

"More disturbingly, almost 60 percent of the stated amounts were exaggerated by more than 50 percent," the institute reported, saying the mortgages clearly deserve their "liar's loan" handle.

Among critics of recent practices in granting option ARMs is Herbert Sandler, former chief executive of Golden West Financial. Sandler's World Savings, now part of Wachovia, was among the S&Ls that pioneered the use of option ARMs in the 1980s.

World Savings was known for making stated-income option ARMs, often to borrowers with lower credit scores than other lenders would permit.

But unlike newcomers to the business, World limited its loans to 80 percent of the property's value unless the loan was insured.

It also conducted its own conservative appraisals and kept the loans on its own books so it retained the risk of loss.

Defaults were few.

The new wave of lenders "destroyed that loan," Sandler said, "and that's what disgusts me."