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Countrywide’s Option Arm Nightmare

Option arm loans, the ones that allow borrowers to choose from four payment options, will likely come back to haunt Countrywide and the investors who bought securities containing the loans for years to come.

According to an analysis prepared for The Wall Street Journal by UBS AG, a whopping 3.55% of the loans originated by Countrywide in 2006 are now at least 60 days past due.

It’s the highest delinquency rate of the six companies analyzed by UBS, and well above the industry average option-arm delinquency rate of 2.56%.

UBS analyst Shumin Li said, “they were giving these loans to riskier and riskier borrowers.”

According to UBS, Countrywide held $27.8 billion in option arm loans as of June 30th, with 5.7% at least 30 days past due, up from 1.6% a year earlier.

Another $122 billion have been packaged and sold as mortgage-backed securities on the secondary market, likely as prime mortgages despite the fact that many are now seemingly considered “subprime”.

Of all the option arms issued last year, 91% were limited documentation, and almost 29% had a combined loan-to-value of 90% or greater thanks to a piggyback second.

A year ago, CEO Angelo Mozilo said he was shocked that so many borrowers chose to make the minimum, or negative amortization payment, leading to a sampling of homeowners to find out why.

The sampling revealed that borrowers chose the minimum mortgage payment option because they felt their home was appreciating faster than the negative amortization, though the revelation looks dubious.

Either way, it’s clear that appreciating home prices won’t save borrowers trapped in these loans anymore, with many finding that their mortgage balance now outweighs the value of their home.

Countrywide claims that it sent brochures to homeowners who chose option-arm loans, though it’s unclear how many read them, and if those who did understood them.

From my experience, the only payment borrowers were interested in was the minimum payment, allowing loan originators to push the margin and subsequent yield spread premium up as high as the maximum allowed.

In fact, according to a former employee at a Countrywide branch in California, employees could win prizes such as a trip to Hawaii for selling the most option arm loans.

But no, there was clearly no incentive for selling certain types of loans to borrowers.

Oh yeah, and between 2009 and 2011, $229 billion in option arms will readjust, forcing borrowers to pay the substantially higher interest-only payment.

The result will likely be more loan defaults, foreclosures, and trouble for Countrywide and investors who hold those mortgage-backed securities.

Countrywide is set to announce its third-quarter earnings on Friday, clearly the headliner of a busy month for financial earnings calls.

The top U.S. mortgage lender is expected to announce a huge loss, with analysts predicting losses between $600 million to more than $2 billion.

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