Down Goes Downey

This post first appeared on Minyanville and Cirios Real Estate.

Looks like all those option adjustable rate mortgages (ARMs) weren’t such a good idea after all: 1% teaser rates and loans that grow, rather than shrink, over time just aren’t meant for questionable borrowers buying overpriced homes.

Newport Beach-based Downey Savings (DSL), the fifth largest originator of option ARMs, was seized by federal regulators late Friday. The scraps were sold to US Bancorp (USB) for a song, which included almost $10 billion in deposits. Pomona First Federal, another Southern California lender highly levered to the real estate market, was also taken over by Minneapolis-based US Bank.

According to Bloomberg, the 2 failures will cost the FDIC more than $2 billion to clean up. US Bank agreed to assume the first $1.6 billion in losses from the banks’ loan portfolios, but anything above that will be split with the FDIC.

Each of the 5 biggest option ARM writers have now collapsed. Countrywide was purchased by Bank of America (BAC) in July; IndyMac collapsed into the arms of the FDIC just a few weeks later; Washington Mutual was scooped up by JP Morgan (JPM) in September; October saw Wells Fargo (WFC) best Citigroup (C) for the right to buy Wachovia (WB); now Downey is gone.

It didn’t have to end this way.

Traditionally meant for savvy borrowers capable of managing multiple payment options, Washington Mutual is often cited as having invented the option ARM in the early 80s.

The loan gives a borrower a series of payment choices, the lowest of which is so tiny the loan balance increases each month instead of being paid down. ARMs also typically include a teaser rate -- sometimes as low as 1% -- which can last anywhere from1 month to 5 years.

Ideal for real estate investors, salespeople with choppy income or families hopping between 1 and 2 earners, the flexible payment options and strict underwriting guidelines made option ARMs some of the best performing loans on the market.

But that was then.

As securitization took off, interest rates fell and the housing market heated up, lenders turned these once-safe loans into jet fuel for their ballooning mortgage businesses.

Option ARMs came to epitomize the irresponsible lending that ran rampant during the boom. Lenders abused their ability to qualify borrowers at absurdly low rates, jamming them into homes they could never afford once their mortgage payments rose.

Due to their complexity, mortgage brokers and loan officers rarely bothered to make sure borrowers fully understood the loan terms. A complete explanation would have lasted hours, providing adequate cover for the fraud already so prevalent in the business.

Banks loved option ARMs because accounting rules allowed them to book the fully indexed mortgage payment as income, even if the borrower made the minimum payment each month. That meant a juicy bottom line, even if cash barely trickled in the door.

Mortgage brokers and loan officers loved option ARMs because they could earn fat commissions on loans that were easy to sell - since they never had to explain them.

And borrowers loved option ARMs because they could buy their dream homes, rationality be damned.

Option ARMs flourished in boom states like California, Florida, Arizona and Nevada since homeowners could simply sell or refinance their way out of any problems as home values kept rising. Delinquencies remained remarkably low, creating years of "historical" data upon which to base assumptions about future loan performance.

Back in New York, Bear Stearns pioneered Wall Street’s foray into Option ARMs. The mortgage gurus at Bear figured out how to turn them into highly profitable mortgage-backed securities.

After that, it was a race to the bottom. Bear, Countrywide and IndyMac literally competed for business based on who could buy the loans faster - and with less scrutiny.

When home prices stopped rising, however, it all came crashing down.

Faced with a rising loan balance, higher monthly payments as teaser periods ran out and falling property values, borrowers were stuck. Defaults rose, losses mounted and banks couldn’t unload the paper without taking significant hits. Instead, they chose to hold on and try to ride it out.

We now know how that strategy ended.

As I have written previously, in the face of unprecedented government intervention, the free market has still managed to punish the mortgage boom's worst offenders. Not every guilty party will be brought to justice, but the firms that have failed thus far were deserving of their fate.

To be sure, not every employee at the likes of Bear, Lehman, Countrywide and Downey were culpable, but when the dust settles, the weak hands will have been truly cleaned out. Banks that maintained even marginally prudent lending standards are now reaping the benefits.

This fact gives me hope - hope that despite their best efforts, bureaucrats will always lose in their battle against the free market.