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Minyan Mailbag: Washington Mutual's Accounting Magic?

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This is one of the things that keeps our chief analyst up at night.

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Prof. Succo,

I appreciate all the information you share with the site. I'm doing some work on banks in general, and negative amortization loans in particular and came across a table in Washington Mutual's (WM) annual report (bottom of page 55). It states that 47% of its Option ARM loans' final payment for the year 2005 resulted in negative amortization (up from 1% two years ago).

Can there really be that many of their ARM's deferring interest and not paying down principal? Or perhaps there is some accounting magic that makes the number insignificant?

2005 2004 2003
Balance of loans that experienced a net increase in negative amortization during the year (millions) 43,856 18,364 959
Percentage of borrowers whose final loan payment of the year resulted in negative amortization:
By number of loans 47.00% 21.00% 1.00%
By value of loans 55.00% 25.00% 1.00%


Also, they recently filed their 10Q and in one of the footnotes it states:

"Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $203 million and $25 million for the three months ended March 31, 2006 and 2005. "


Not looking for advice on the company, but rather a comment on the accounting technique of any bank booking earnings from negative amortization loans since this is a relatively new concept -- at least on this scale. And, perhaps on the trend that is emerging $25->$203 million year-over-year.

Also the $203 million is being subtracting from earnings ($985 million) on their cash flow statement. They don't describe it as negative amortization but I'm sure it's the same number described in the footnote.

Capitalized interest income from option adjustable-rate mortgages
(203)
(25)


The sad part is many people are set up on autopay for their mortgage payment and don't even realize their principal amount is increasing. When the homeowner's interest rate increases (way up from the introductory teaser rate), Washington Mutual does not automatically increase the amount deducted each month from the borrower's bank account. The homeowner has to fax in a signed form to them.

A back-door way of increasing the velocity of money.

-Minyan Dave


Minyan Dave,

This is one of the things that keeps our chief analyst up at night.

A conventional fixed rate mortgage holds the interest accrual rate and the payments constant over the life of the loan and a portion of each monthly payment reduces the outstanding principal of the loan. Negative Amortization adjustable rate mortgages are structured such that the outstanding principal balance may increase even though payments are current. Negative amortization occurs when the borrower makes a payment at an interest rate that is lower than the accrual rate; therefore the monthly payment is insufficient to cover the interest expense and the difference is added to the principal amount.

In theory, if lenders carefully underwrite NegAm loans with prudent loan to value percentages and monitor the loans closely the added credit risk can be small and manageable. In practice, the credit performance of NegAms loans is particularly vulnerable in an economic environment of rapidly rising interest rates and stagnant or falling property values. Indeed, WaMu's actions, while legal, would fall under that aggressive category that requires extra attention.

Lenders may record NegAm as income in the form of capitalized interest. The lender does not actually receive the negative amortization amount as payment from the borrower. Under GAAP the lender capitalizes (adds to the loan balance) the negative amortization interest amount and recognizes the amount as income as long as the borrower's ability and willingness to pay (unfortunately the willingness to pay can be influenced by the size of the loan relative to the property value). An increasing capitalized interest balance may indicate increasing credit risk, as it might indicate declining borrower equity and less available payment shock protection for the portfolio. A high level of capitalized interest may also create cash flow or liquidity concerns for the lender.

In short, WM's numbers relative to the size of the bank are not disastrous, nor by themselves are NegAm mortgages. But in this environment, it certainly creates more concerns than the incremental income gains may be worth.

You are correct in that these types of loans increase the velocity of money: they keep more cash in the pockets of borrowers. But the cost is obvious: higher risk to the sytem.

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