The Interest-Only Loan “Extend and Pretend” Strategy

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One of the worst kinds of sub-prime loans was the infamous “pick-a-pay” (Payment Option ARM) under which borrowers had the choice of how much payment to make each month, with the lowest options being negatively amortized, i.e., reducing the equity in a property every month. These loans took the concept of house-as-piggy-bank to another level entirely. Human nature being what it is, the majority of borrowers took the easy way out and opted for the lowest payments they could make as long as they could get away with it. Sooner or later, of course, they have to pay the piper – these loans typically only permit the minimum payment for a limited period of time (such as five years) or when a specific level of negative equity is reached (110%-125%). After that, the real pain begins. Of course, once the financial crisis came along these loans were revealed to be particularly toxic – and borrowers started to default in droves, especially once the lowest-payment option period had been used up.

Many banks simply foreclosed. Others, such as Wells Fargo, have taken a different route. Wells Fargo, according to the Wall Street Journal, has converted thousands of such loans to interest-only loans, and, at least in some cases, have reduced the principal balance. Though derided as “extend and pretend” (that the borrowers won’t ultimately default), Wells’ move seems laudable to the extent that it can keep homeowners in their homes and reduce the number of foreclosures in the near future, which drag down the prices of other properties like a dog chasing its own tail.

However, a dose of reality is probably warranted. By now, as everyone realizes, the government loan modification program has turned out to be a spectacular failure. First, it has done nothing or virtually nothing to help out in many of the hardest hit areas, as people were too far underwater to qualify. Worse, perhaps, even those loans that got modified are defaulting at high rates: within six months after modification, almost a quarter of the mortgages that had monthly payments reduced by 20 percent or more were 60 or more days past due according to the Office of Thrift Supervision.

Either Wells Fargo is making an extremely smart business decision; or they are chumps. Time will tell how many Wells former pick-a-pay customers will fold their cards and walk away from the table before the real estate market has recovered.

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