BusinessWeek's Sept. 11 cover story is the best article I've seen yet on option ARMs, the exotic mortgage loans that allow borrowers to make very low payments in the initial years of the loan. The story clears up some of the confusion I may have caused in my post about negative amortization last week. (Thanks to the Housing Bubble Blog for the tip.)
The key point: while borrowers can make minimum payments that don't even cover the amount of interest accruing on the loan, thus resulting in their unpaid balance rising each month instead of declining, lenders are legally allowed to book as revenue the maxinum payment, that is, the payment borrowers would need to make if they wanted to pay off the full amount a standard mortgage would require.
"According to generally accepted accounting principles, or GAAP," says Businessweek, "banks can count as revenue the highest amount of an option ARM payment -- the so-called fully amortized amount -- even when borrowers make only the minimum payment. In other words, banks can claim future revenue now, inflating earnings per share."
"For many industries, so-called accrual accounting, which lets companies book sales when they contract for them rather than when they receive the cash, makes sense. The revenues will eventually come. But accrual accounting doesn't apply well to option ARMs, since it's more difficult to know if unpaid interest will ever cross a banker's desk. 'This is basically an IOU that may never get paid,' says Robert Lacoursiere, an analyst at Banc of America Securities. James Grant of Grant's Interest Rate Observer recently wrote that negative-amortization accounting is 'frankly a fraudulent gambit. But what it lacks in morality, it compensates for in ingenuity.' The Financial Accounting Standards Board, which is responsible for keeping GAAP up to date, stands by its standard but told BusinessWeek in a written statement that it is 'concerned that the disclosures associated with these types of loans [are] not providing enough transparency relative to their associated risks.'"
There's much much more in the BusinessWeek article: it's a must read for anyone interested in this topic. But for our purposes, this is the crux: as more and more loans enter a state of negative amortization, lenders are still sitting pretty, legally booking as revenue money that may never materialize. If the housing bust worsens, those paper profits will vanish. As BusinessWeek notes,"more than a fifth of option ARM loans in 2004 and 2005 are upside down -- meaning borrowers' homes are worth less than their debt. If home prices fall 10 percent, that number would double."