California’s Outstretched (Option) ARMs

Barring a significant slowdown in foreclosure activity, California homeowners are projected to lose more than $600 billion in equity by the end of 2012, according to a policy brief from the Center for Responsible Lending (CRL).

To quell the destabilizing and far-reaching effects of foreclosures in the state, servicers should be encouraged to use loan modifications that reduce outstanding principal balances, CRL concludes.

The brief, published in November, also recommends upping the transparency of servicers' loss mitigation practices – a proposal that has at least modest support in the state Assembly, in the form of Assembly Bill 1588.

California currently has about 2.4 million mortgages that are in negative equity, according to First American CoreLogic data. That number is likely to balloon in the next three to four years as the state's high concentration of pay-option adjustable-rate mortgages (ARMs) reset. The Golden State, which, in the past decade, has epitomized both extremes of an abnormal housing market cycle, was home to more than half of the nation's option-ARM loans originated between 2004 and 2008.

Citing estimates from Deutsche Bank, the CRL brief notes that as many as 89% of option-ARMs, the loan product of choice for stated-income borrowers banking on continued home-price appreciation, could be underwater by 2011. While lawmakers in the state have taken steps to prevent more option-ARMs from flowing into the pipeline – A.B.260, signed by Gov. Arnold Schwarzenegger in October, bans products with negative-amortization features – attention is now turning toward damage control.

In October, Attorney General Edmund G. Brown asked the nation's largest servicers to outline their plans for dealing with option-ARMs. Brown requested, among other details, data on the number of option-ARMs serviced by each shop and information on whether the servicers contact borrowers ahead of their mortgage reset dates. He also inquired about principal reductions, asking each of the 10 companies if they are considering such write-downs.
‘Homeowners with pay-option ARMs are sitting on ticking time bombs that the lending industry has the power to defuse,’ Brown told reporters.

A report from First Federal Bank of California, a Los Angeles-headquartered subsidiary of First Fed Financial Corp., indicates the relative flexibility portfolio lenders have in managing option-ARMs. According to an October statement, the bank has modified more than one-third of its option-ARM portfolio. Many of those loans were converted into 10-year fixed-rate notes, and First Federal Bank of California says about 90% of its loans were current at modification.

Wells Fargo, which took on approximately $119.7 billion of option-ARMs with its purchase of Wachovia last year, has begun offering borrowers interest-only loans – an approach the company admits hinges on a housing market rebound.

‘We're banking on the fact the economy will improve and recover over time,’ Wells Fargo's Mike Heid told the Wall Street Journal last month.

Once piece of legislation that lawmakers hope will encourage more aggressive loan modification activity is A.B.1588, which Assemblymember Pedro Nava, D-Santa Barbara, introduced in September. The bill proposes the creation of a Monitored Mortgage Workout program – a foreclosure mediation process similar to those established in more than a dozen states.

Under the terms of the bill, state-appointed monitors would oversee servicers' workout efforts. The monitors would have access to servicers' net-present-value models and data input, be tasked with ensuring servicers work with borrowers in good faith, and be able to recommend foreclosure alternatives in situations where the parties fail to agree on a workout.

‘We're talking about a significant economic drain on our country,’ Nava told the San Francisco Chronicle late last month. ‘I'm, quite frankly, growing impatient with the excuse that banks don't know how to do it.’

Nava told the Chronicle that California's Legislature will take up A.B.1588 for consideration in January, following a winter recess.

(Please address all comments regarding this article to John Clapp, editor of Servicing Management, at


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