Pomona First Federal and Downey Savings are the newest members of the bank meltdown of '08. Here are some facts:
1. 22 banks have failed in 2008
2. 2 huge banks (including the biggest ever - WaMu) have collapsed
3. The biggest may still be yet to come - Citi
I completely understand why WaMu and Downey failed. Both of these institutions promoted and wildly sold the 'option ARM' home loan. This loan literally turned your house into a credit card. The borrower was basically allowed to make a chose as to which payment the wanted to make.
- minimum amount due
- interest only
- 30 year amortized
- 15 year amortized
Let me illustrate a little further. You went to buy a house for $300,000. The prevailing interest rates are (hypothetically) 6%. The 30 year fixed rate payment would be $1,798.65 principle and interest. The 5 year interest only payment would be $1,500.00. However, the 'option ARM' payment coupon would look like this:
$964.86 - minimum (based on 1% amortized 'start rate')
$1,325.00 - interest only
$1,665.91 - 30 year amortized
$2,419.51 - 15 year amortized
The last 3 were based on the 'current interest rates' for the option ARM. The rates for the option ARM were calculated by adding a margin (bank profit) to an index (MTA, COFI, COSI, CODI, LIBOR). All of these indices were operating at unbelievably low rates during '03, '04, '05 and parts of '06. However, the dirty little secret of the option ARM was that the interest rate was adjusting EVERY month. It was only moving inches at a time, but over 2 or 3 years inches become a mile.
Ok, we haven't gotten all of the nuances of this loan out yet. Probably the most dangerous part of the option ARM was the promise that the loan payment would NEVER increase by more than 7.5% per year. How does that work? Well, it simply means that the minimum payment on our above hypothetical will look like this...
$964.86 - year 1
$1,037.22 - year 2
$1,115.01 - year 3
$1,198.64 - year 4
$1,288.54 - year 5
Also, the difference from the minimum due and the interest only option was added to the back of this loan. Meaning any money you did not pay each month was added to your principle balance.
Lastly, after 5 years this loan recast itself. Meaning that it became a 'regular' loan from that point on. By regular I mean, you had to start paying it back! So, how does this effect our example above?
First, let's assume that interest rates stayed flat for 5 years. Second, we are going to assume that the buyer makes the minimum payment option (c'mon this is America). So, we are going to come up with the 'best case scenario' for this buyer.
$4,321.68 - deferred year 1
$3,453.36 - deferred year 2
$2,519.88 - deferred year 3
$1,516.32 - deferred year 4
$437.52 - deferred year 5
$12,248.76 total deferred
So, now our buyer is getting their loan recast. But, instead of it being $300,000 - it is $312,248.76. And, instead of it being 30 years, it is 25 years. So the new monthly payment is - $2,011.83. Meaning that their payment is approximately $750.00 per month more in month 61 than it was in month 60. To compound matters the real estate market is tanking (the house they owe $312,248 for is worth $200,000) and interest rates are up (LIBOR was 1.339 in January of 2003, it was 3.9091 in January 2008).
The last bit of bad news about this is that most Americans did not buy the $300,000 house. They bought the $600,000 house because they could afford the minimum payment and could for the next 5 years - because their loan officer could show them the 'fixed' minimum payment for 5 years.
This is just one of the "toxic debt" instruments that is weighing down the financial institutions in America (and the world). Alan Greenspan actually supported this loan during his tenure as the head of the FED but it may turn out being the loan that brings this country to our knees. Wachovia may be the next big bank to fall because they actually started this loan when they were World Savings.
