Goldman Hired To Scrub Wachovia’s Portfolio, Are Option ARMs Dead?

Wachovia, the last name-brand player besides Countrywide still active in neg-am Option ARMs, has hired Goldman Sachs to evaluate its loan portfolio. Wachovia’s slogan on their wholesale broker rate sheets is “We Lend Our Own Money, We Make Our Own Rules.” That seems likely to change as outsiders exert more influence over the process.

But from my limited work with Wachovia (I’ve only ever done business with them in the past 3 months–and this includes their predecessor firm World Savings), their underwriting seems extremely cautious, and they are one of the few jumbo lenders left who practice common sense underwriting. They do all their own appraisals, and if there’s anything they don’t like about a property or a market, they won’t do the deal. They will lend up to 80% of a property’s value, but only for the right client profile. And their underwriters truly understand how to analyze tax returns and assets to determine which client profile fits on a case by case basis.

The concern is obviously managing LTV risk … if a loan with a negative amortization option can increase in value, and property prices are decreasing, this is a problem which warrants analysis. But there are a couple important points that you will never hear in the press:

(1) Negative Amortization is an OPTION, Not A Qualifying Guideline: Borrowers can pay whatever payment they want: Principal+interest 30yr, interest-only or less-than-interest. But Wachovia qualifies debt-to-income ratios using the highest possible payment at the highest possible payment. This wasn’t always the case with Neg-Am option ARM lenders who used to use lowest payment to qualify.

(2) NegAm Can Replace Hard-To-Find HELOCS: While debating Option ARMs with a Wachovia executive earlier this year, he proposed an interesting argument to me: HELOCs are becoming harder to get. So if a borrower with enough equity to qualify for a Neg Am option on their Wachovia loan needs cash out periodically, they can elect to make the low payment, in essence taking cash out in the same manner they would with a HELOC. This is a valid point. And the right risk-controlled underwriting can determine which clients can use this responsibly and which clients can’t.

(3) No-Neg Am & 30-Yr Fixed Conversions: Not all Wachovia loans have neg am options, and borrowers can convert to a 30year fixed rate at any time from month 13 to month 84. Also if a client has a shorter time horizon of 1-3 years, the Wachovia loans follow the CODI index which lags Fed Funds by about six months. So if the client elects to float this loan instead of taking a 30fix option, these loan rates will beat the market by about 1-2% over this time horizon.

Again, it’s all about good underwriting and the operative word in ‘Option ARM’ … Options. I think Wachovia is wise to seek an evaluation because their credit score and documentation requirements prior to 2008 were definitely flimsy, but I don’t think responsibly underwritten Option ARMs should be completely banned from the industry (and this is coming from a loan originator who can count on one hand how many option ARMs I have in my entire client portfolio). The option ARMs going bad are the ones what were underwritten irresponsibly. They’re a complex product so it’s easy to shun them, but there are appropriate client profiles that benefit from them.

Goldman will find plenty of junk in the Wachovia option ARM portfolio just like Bank of America will find when they dig deeper into the Countrywide portfolio. One outcome is that Wachovia is put on the block and an acquirer like JP Morgan Chase will sort it out. Another outcome is that Option ARMs will disappear. Hopefully that won’t happen, and hopefully for the sake of Wachovia borrowers they retain and emphasize their 30yr fixed conversion options — that seems to me the way to retain all the best clients in the portfolio going forward.

Basis Point of Disclosure: The author of this post is a practicing mortgage banker/broker, and has placed two clients in Wachovia loans in 2008. One has a negative amortization option and one does not. From 2003 to 2008, he never placed a deal with Wachovia nor its predecessor World Savings.