more bubble stories

[Michael Perelman <michael@xxxxxxxxxxxxxxxxx>]

LONG & SHORT By JESSE EISINGER

Sore ARMs? A Peek Inside Potential Mortgage Troubles August 10, 2005;
Page C1

California isn't the best place to go looking for canaries -- unless
they're metaphorical ones.

The state has one of the frothiest housing markets, and banks have been
enablers. Investors looking for early warnings of trouble in the
mortgage industry should give Downey Financial's numbers a look.

Two weeks ago, I wrote about the rising popularity of option
adjustable-rate mortgages1, especially in the land of Schwarzenegger.
Option ARMs give borrowers the ability to make a minimum monthly
payment that results in the balance of what's owed going up. Lots of
people are doing that, seemingly oblivious to the risk: Interest rates
are rising, and if housing prices fall, homeowners could end up unable
to afford the monthly nut on a home they'd have to sell at a loss.

But, as I noted, investors haven't been able to gauge banks' exposure
adequately because the disclosure generally is poor, though that
problem has improved a bit recently. At Downey, disclosure is good;
it's the exposure that's bad. A small Newport Beach, Calif., bank with
a stock-market value of $2 billion, Downey writes option ARMs like
Californian plumbers write screenplays.

Downey had a blockbuster second quarter. It reported earnings of $2.29
a share, beating estimates by a whopping 75 cents a share. The stock is
down a notch since then, but it's up more than 30% for the year.

Other measures disclosed last week in quarterly SEC filings are more
troubling.

To remind readers, if a borrower chooses to make that minimum monthly
payment, a bank nevertheless books the entire monthly amount owed as
earnings. That's noncash earnings, which is fine -- as long as the bank
isn't allowing people to buy wildly overpriced homes they might not be
able to afford as interest rates rise.

As of June 30, $12 billion, or 87% of Downey's ARMs are option ARMs.
Its customers have racked up $72 million in additional balances on
those mortgages by choosing to make minimum monthly payments. That's
called negative amortization.

Right now, Downey's negative amortization is a mere 0.6% of its ARM
portfolio. But that measure understates its significance. Its negative
amortization balance is accelerating, from $51 million in the first
quarter and $37 million in the fourth quarter of 2004.

These noncash earnings were 20% of Downey's earnings per share in the
second quarter. If that trend continues, more than 40% of Downey's
current-quarter earnings would be noncash. Analysts already expect
earnings to decline to $1.79 a share in this quarter, so it would be a
bigger slice of a smaller pie.

In other words, the bank's earnings are being increasingly driven by
sales of a product to inherently risky customers. Downey Finance Chief
Tom Prince says concerns about option ARMs are exaggerated and that his
bank previously has had even more exposure to them without problems.
"I'm not particularly concerned about it," he says.

So far, the bank has had little problem selling off option ARMs into
the secondary market. But the company has cautioned that profit margins
on those sales are likely to go down.

Since Downey has been disclosing negative amortization figures for a
while, we can see what the customer patterns are. They don't bode well.
Banks argue that these loans are appropriate for customers who want
flexibility or who have variable salaries, like salespeople who work
for high, but unpredictable, commissions and bonuses.

That should mean, then, that rising interest rates wouldn't necessarily
lead to an increase in people choosing to make minimum payments. Yet
the percentage of payments by Downey customers that are big enough to
make their principal go down is falling (as a portion of the loans).

Why? Probably because some customers are only repaying their mortgages
by refinancing their homes, not when they get paid that big bonus. With
mortgage rates unlikely to head down soon and housing prices
potentially stalling, customers aren't going to get that chance much
anymore. Those bonuses better be pretty good.

The Office of the Comptroller of the Currency is looking broadly at ARM
practices. Regulators there would be even more concerned if a bank's
capital were at risk. At Downey, there's no sign of that for now.
Negative amortization represents 6% of the bank's equity. But that
could be 9% at the end of this quarter, based on recent trends.

This canary is looking a bit peaked.




--
Michael Perelman
Economics Department
California State University
Chico, CA 95929

Tel. 530-898-5321
E-Mail michael at ecst.csuchico.edu