'Option ARM' mortgages were agressively marketed by banks because they generated huge amounts of phantom profits. Using generally accepted accounting principles, or GAAP, banks could count as revenue the highest amount of an Option ARM payment -- the so-called fully amortized amount -- even when borrowers made only the minimum payment. In other words, banks could claim "phantom income" that they never received and in the current scenario will never receive. This "phantom income" inflated reported earnings and allowed bank executives playing this game to receive enormous bonus income and enjoy dramatically inflated stock prices. Many now defunct banks, and soon to be defunct banks, reported inflated earnings that were bolstered by this phantom income. It was not unusual for "phantom income" to account for more than half of the earnings being reported.

James Grant wrote that negative-amortization accounting is "frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity."--Grant's Interest Rate Observer

He wrote this back in 2006.

Default rates on so called 'Option ARM' mortgages are rising fast.

As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance.

Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs.

This sobering news indicates that the bad news from the housing market is far from over and is not likely discounted in the stock markets.

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An 'Option ARM' is typically a 30-year adjustable rate mortgage that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, or a 30-year fully amortizing payment. These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

'Option ARMs' are particularly toxic because they allow the borrower to make a small minimum payment each month with the unpaid part of the monthly payment being added to the principle of the mortgage outstanding. In other words, these mortgages are subject to severe negative amortization. If you make the minimum payment, the principle amount you owe on the mortgage loan goes up each and every month. Current statistics indicate that 80 percent of the consumers owning these loans selected the minimum payment option.

Let's say, for example, that the fully amortized monthly payment is set at $1500. The homeowner decides to elect the minimum payment (the option) and pays $1000. The unpaid $500 is then added to the mortgage's principle balance outstanding. It only gets worse. Not only does the amount owed grow each month; this higher loan balance is immediately reflected in the next month's calculation.

The owner of an 'Option ARM' is borrowing the difference between the minimum payment and fully amoritized amount of the loan each month. In effect, the option arm mortgage holder is making a new loan each month and this amount is tacked onto the existing mortgage. Then the mortgage holder ends up paying interest not only on the increasing principle but also interest on interest. Sounds a little like loan sharking--doesn't it?

It is easy to see that the amount owed on an option ARM mortgage could grow fast. Imagine watching the amount you owe on your mortgage go up each month as you make the minimum payment. It only gets worse. This 'ticking time bomb" of a mortgage has another toxic feature built in--they reset once the principle balance owed hits 110-125% of the original loan. This fully amortized amount includes the original loan amount plus all the negative amortization. So while it appears that an 'Option ARM' works like a typical adjustable rate mortgage this in not true. A standard adjustable rate mortgages has an annual cap and the interest rate can only rise by 1-2% a year. This is true in an "option ARM" with one exception--when the 110-125% cap is hit the mortgage fully amortizes and the morgage resets to the market. This means a monster sized jump in the monthly payment. It is likely that the owner of the 'Option ARM' will see the monthly mortgage payment nearly double when the cap is hit.

Current owners of these "time bombs" are now in the unenviable postion of watching the amount they owe on the mortgage go up, the amount of their monthy payment skyrocket, and the value of the house drop like a lead stone. Talk about a double edged sword. Or is that three edges?

It appears most American's are making an easy decisions on these loans--walk away, stop paying, and go to foreclosure.

Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication.

Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders.

Interestingly, most 'Option ARMs' were issued to people with an above sub-prime credit rating. However, it is well known that many of these mortgage holders bought homes they intended to sell "quickly" for a profit. In effect, they were speculating in the housing market. What better way to keep the payment low than with the 'Option ARM' mortgage.

'Option ARM' mortgages were agressively marketed by banks because they generated huge amounts of phantom profits. Using generally accepted accounting principles, or GAAP, banks could count as revenue the highest amount of an Option ARM payment -- the so-called fully amortized amount -- even when borrowers made only the minimum payment. In other words, banks could claim "phantom income" that they never received and in the current scenario will never receive. This "phantom income" inflated reported earnings and allowed bank executives playing this game to receive enormous bonus income and enjoy dramatically inflated stock prices. Many now defunct banks, and soon to be defunct banks, reported inflated earnings that were bolstered by this phantom income. It was not unusual for "phantom income" to account for more than half of the earnings being reported.

James Grant of Grant's Interest Rate Observer wrote that negative-amortization accounting is "frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity."

He wrote this back in 2006.

Many banks moved defaulted 'Option ARMs' into "held for sale accounts". This shady accounting practice allowed banks to sequester or "hide" the loans from investors. Under normal economic conditions these loans would be sold to collection agencies or investors. However, given the enormous amounts of these loans, their uncertain futures, and the uncertainty in the market place they are now nearly impossible to sell.

When you hear proposals for the Federal government to buy "toxic assets" these are the types of loans that bankers want taxpayers to take off their hands. The bankers that issued three quarters of a billion dollars of Option Arms did so to enrich themselves.

• They have already received obscene bonuses and sold inflated stock bolstered by "phantom income".
• They now want to pass these assets to taxpayers via the bailout.
• They want us to bail them out so they can stay in their jobs.

I continue to wonder if anyone in Washington understands this scam? Or, are they going to perpetuate the scam and pass the buck to our children?

It should be mentioned that banks paid higher than usual commissions on these loans to the "hordes" of unregulated independent salespeople they used to "huckster" this product. It is already well documented that many of these so called "mortgage bankers" used pressure tactics to convince consumers that an 'Option ARM' was a good thing and that they would benefit. They might have failed to mention the onerous prepayment fees that came with these mortgages and it not likely that they explained the how negative amortization worked. I wonder if they fully disclosed that the loan became full amortized when the 110-125% cap limit was hit? Did they explain that the cap limit would be hit within five years if they made the minimum payment; and that, the monthly payment could nearly double or worse?

I believe most stock market investors think that the effects of the housing crisis has been discounted by the markets. This is not likely and the potential fallout from the coming 'Option ARMs' explosion is still to be seen.

We have not yet reached the worst part of the 'Option ARM' cycle. The news on these toxic loans is going to get worse beginning in April when thousands of Option ARM mortgage holders are going to see their monthly payments spike. This phenomena is going to continue until 2010 once it starts.

I wonder if investors understand how this will effect the banks that are still holding these loans? How the shock wave from this explosion is likely to effect banks that do business with these banks? How this might effect consumers, employment, and the psyche of investors? Uncertainty does not usually lead to sustained rallies in the markets. Of course, the market might take a tumble and discount this information at any time.

Option ARM--The Toxic Mortgage