By ANDREW JEFFERY

This post first appeared on Minyanville.

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.

By ANDREW JEFFERY

This post first appeared on Minyanville.

With millions of homeowners falling behind on their monthly payments, one in 6 underwater, and countless more struggling to keep up, politicians and banks alike are jumping on the loan modification bandwagon.

A modification – or “mod,” as it’s known in the industry — is simply the bank agreeing to change a borrower’s loan to make it more affordable. Mods usually result in a lower interest rate, principal forgiveness or some combination thereof.

For banks, adjusting loan terms is a way to keep cash coming in the door - even if it’s less than they’d been hoping for when they originally wrote the loan. For troubled borrowers, mods can provide an alternative to default and eventual foreclosure. It’s for these reasons that FDIC Chairman Sheila Bair and big banks like JPMorgan (JPM) and Bank of America (BAC) are aggressively promoting mods as the best way to fix the housing market.

The flood of troubled mortgages has also fostered a cottage industry that caters to distressed borrowers. Some are honest folks aiming to help struggling borrowers by using their mortgage expertise and contacts to negotiate better deals on behalf of their clients.

Others, however, are less upstanding.

According to Mandana Nejad, a real estate attorney and founder of Silver Lining Legal Group, a loan modification firm based in California, troubled borrowers have a lot to be wary of.

“Most loan modification companies are compromised of former lenders and brokers who put homeowners in these horrible loans in the first place,” says Nejad. ”Meanwhile, credit repair and debt consolidation firms are simply out to collect fees, regardless of whether or not they can actually successfully modify a loan.”

Last year, the Bush administration formed HOPE NOW, a government-led effort to get banks and the loan servicers who collect payments on their behalf to step up loan-modification efforts. By most accounts, results were underwhelming, as HOPE NOW counselors often asked for too much, and banks gave too little.

Data show that mods done at the outset of the mortgage crisis ended up in default, despite the lower payments. Without proper screening criteria, mods simply delay the inevitable.

For a mod to work, lenders and borrowers must be able to find common ground. Falling home prices, job losses and massive fraud at the time of origination have exacerbated the challenge of finding new loan terms that make sense for both parties. To complicate matters, if a loan has been packaged into a security, loan servicers are obligated to follow predetermined modification standards set by myriad third-party investors.

Borrowers looking to handle modifications on their own face a maze of legal and bureaucratic complications - not to mention the stress of negotiating to save one’s own home. Nejad tells her clients that anyone can attempt to modify their loan themselves, but doing so requires knowledge of the best strategies for success.

Banks treat mods almost like a fresh loan. In order to get the best deal, borrowers must submit a complete application, write a compelling hardship letter, include verification of income, and often support the home’s current value with an appraisal.

While this is no easy task, troubled borrowers shouldn’t run out and answer the first debt consolidation or mortgage relief advertisement they hear on the radio.

Upstanding modification firms should offer:

• Money back guarantees with no exclusions
• At least one experienced attorney assigned to each case
• Direct access to the borrower’s lender(s)
• No more than a 50% charge up front
• Verifiable success stories, not just web testimonials

Still, successful mods require lenders to take losses. Armed with billions in bailout money, banks are now in a better position to allow their borrowers more affordable loans, even if it means more writedowns and less interest income going forward.

Time will be the true arbiter for the success of Bank of America and JPMorgan’s recent plans, but as pressure mounts to seriously curtail foreclosures, more and more federal money will be thrown at the problem. Other banks are likely to follow suit.

Wells Fargo (WFC) has yet to announce a plan of its own, but – given its recent purchase of Wachovia (WB) and its inheritance of a massive portfolio of California option-ARMs – we shouldn’t have to wait too much longer.

While mods are by no means the magic bullet many are searching for to fix the housing mess, they do offer a way for lenders to retain a cash-generating loan – and borrowers to keep their homes.

This post first appeared on Minyanville.

The mortgage bailout parade marches on.

Just days after rival Bank of America (BAC) announced plans to modify hundreds of thousands of mortgages, JPMorgan (JPM) released details of a homeowner rescue plan of its own on Friday afternoon.

Following its takeover of both Bear Stearns and Washington Mutual, JPMorgan’s inventory of distressed mortgages has risen dramatically in the last 8 months. The bank’s modification efforts, which mirror Bank of America’s plan, are focused largely on subprime loans and option ARMs. The acquisition of WaMu saddled CEO Jamie Dimon’s firms with billions of these loans - $16 and $54 billion, respectively, according to the Wall Street Journal.

JPMorgan plans to identify borrowers with both the willingness and ability to pay, lower interest rates and, in some cases, forgive loan principal. For Option ARMs, borrowers may have the opportunity to replace their negatively amortizing mortgage with a safer, fixed rate 30-year loan.

Look out for more of these plans coming from the remaining big American banks, particularly Wells Fargo (WFC): Its recent acquisition of Wachovia (WB) included the Charlotte-based bank’s massive option ARM portfolio.

The plan is certainly a step in the right direction. It’s nice to see that some of the recent $25 billion injection from the government will be funneled toward the taxpayers that ponied up the money in the first place.

Both JPMorgan and Bank of America’s new programs, are, however, evidence of the government’s – and banks’ — inclination to deal with problems that already exist, rather than ones that are on the horizon.

This post first appeared on Minyanville and our sister site Dawn Patrol.

The bailout is done! Time to breathe a sigh of relief.

Or is it?

As details emerge about the financial bailout package that was jammed through Congress over 10 days of political theater at its most nauseating, there’s still a striking omission from the plan to right American’s economic ship.

The failure of bureaucrats and regulators to propose a realistic solution for the foreclosure problem is emblematic of their inability to treat the root cause of an issue, focusing instead on simply applying band-aids to the visible symptoms.

The bailouts of Bear Stearns, Fannie Mae (FNM) and Freddie Mac (FRE), and AIG (AIG) all claimed to remove the cancer – but all they did was hasten the patient’s demise.

Treasury’s plan will deliver money into the banking system to sop up toxic assets sitting on the balance sheets of our financial institutions. This is a necessary — albeit unfortunate — step, but it still doesn’t address the root of the rot: Milions of homes are worth less than the outstanding balance of the owner’s mortgage.

Billions of dollars in negative equity are destroying Main Street’s balance sheet even as it devours Wall Street, eroding the value of the very securities Taxpayers are about to start buying.

As long as Washington tries to fight foreclosures with ineffective loan modification programs that simply prolong the problems, foreclosures will continue to set records. Modifying a mortgage for someone who is barely scraping by is sort of like rescuing him from the side of a cliff, only to leave him on the edge, dangling by one arm.

Foreclosures are often blamed for spiraling home prices and the resulting collapse in value of securities tied to the mortgages used to buy those houses. According to Bloomberg, the government’s aid package is designed to support “financial companies reeling from the record number of home foreclosures.”

Foreclosures don’t cause houses to lose their value. Foreclosures happen when a home loses value such that it’s worth less than the mortgage used to buy it, and the homeowner can’t sell or refinance if his interest payments become overwhelming.

Defaults become delinquencies, which become foreclosures, which become evictions, which become repossessions, which flood the market, depressing prices as supply outstrips demand.

Back in what seems like ancient history, when home prices only went up, banks weren’t too concerned with defaults, since homeowners could almost always sell themselves out of a problem. Foreclosures stayed low because the liquid, appreciating housing market bailed out troubled homeowners on its own. That’s part of the reason the industry is so ill-equipped to handle the scope of the current problem: it never had to before.

But now, with so many borrowers underwater — owing more on their house than it’s worth — defaults result in not only eventual liquidation of the property, but profound distress in the homeowner’s life and real losses for investors. Furthermore, delinquent borrowers are less inclined to pay for upkeep or security, and many foreclosed homes are seriously damaged by the time a bank is able to take possession of it.

Being underwater is debilitating. To sell, not only does a homeowner have to pay a Realtor 6% whether he gets a raw deal or not, but he has to pay the bank the difference between where his home sells and the outstanding balance of his loan.

For many who have seen the value of their homes fall hundreds of thousands of dollars, this is an impossibility. Most homeowners, once they’re upside down, just want to stay in their homes.

A more effective plan to curb foreclosures would require an independent reviewer to evaluate each delinquent mortgage, determine the borrower’s ability to pay going forward and the amount, if any, of negative equity that needs to be destroyed to bring the loan amount back under the home’s value.

Since the notion that buying Wall Street’s toxic assets will result in windfall profits is a willfully distributed fallacy aimed at getting the public on board for the bailout, Taxpayers would be well-served dumping money into a blender that’s at least in their own backyard.

British Prime Minister Gordon Brown recently proposed a similar plan, where the government will buy delinquent mortgages from banks for the outstanding balance of the loan. The home is then rented to the existing tenant or a new one and managed by a local housing association.

The government would absorb the difference between the loan amount and the resale value, which would hasten increase sales activity, clearing out the glut of homes listed too high for the simple reason that the owner can’t afford to sell at a lower price.

This type of personalized bailout, unfortunately, reeks of moral hazard. Many individuals who made bad financial decisions will get to keep their homes, albeit without actual ownership. But the current socialization of our free markets is simply moral hazard be design, so if Congress is so hell-bent on bailing out Wall Street, why not share the spoils with Main Street.

If Congress wants this bailout to help the American people and keep the financial system in tact, a sizable portion of the funds should be directed at fixing the asset that’s at the center of this turmoil: the residential property.

Home prices need to come down further. They will come down further. It’s only a matter of time. We can either let home prices bleed down, slowly eroding the value of the securities they support and violently uprooting families, or the government can plug the hole.

Washington Mutual (WM) is already off the field, as JP Morgan (JPM) continues to play widowmaker for the financial system. Wachovia (WB) isn’t likely to remain independent for long. The sooner the rebuilding process begins, the better.

This crisis, and the resulting ebb and flow of what remains of the free market has already tipped the scales, started us sliding down a path of deflation in everything from stock prices, to cereal boxes, soda bottles, not to mention homes.

This is a good development. The hardest lesson Americans will learn from this crisis, should learn from this crisis, is that sometimes it’s necessary to live within our means. There is virtue in simplicity. More is not always better. Bigger is not always better. Sometimes, amazingly enough, less is often better.

This progress is the only true way we’ll make it out of this mess.

This post first appeared on Minyanville.

When Bank of America (BAC) agreed to buy Countrywide, it didn’t just take on a mountain of questionably valued mortgage-related assets. It also took on huge legal liability.

San Diego City Attorney Mike Aguirre, who has a penchant for punitive lawsuits that rarely result in much more than a media frenzy, is accusing Countrywide of defrauding thousands of San Diego homeowners. A lawsuit has already been brought at the state level by California Attorney General Jerry Brown, as well as in several other states, including Washington and Illinois.

San Diego’s suit takes aim at Countrywide’s alleged practice of coercing borrowers into risky adjustable rate mortgages (ARMs). Aguirre hopes to make San Diego a “foreclosure sanctuary” by preventing foreclosure proceedings on any property secured by a subprime ARM where the borrower owes more than the home is worth. (For more on what the glut of upside-down homeowners means for the future of the housing market, please read Finding the Bottom in Housing.)

The litigious City Attorney isn’t satisfied with just taking aim at Countrywide (and, by extension, Bank of America). Aguirre said he’s planning similar suits against Washington Mutual (WM), Wells Fargo (WFC) and Wachovia (WB).

While Aguirre’s heart may be in the right place, foreclosure moratoriums aren’t part of the road to recovery for the housing market. Opportunistic mortgage market participants are buying delinquent mortgages on the cheap, forgiving some part of the debt and giving borrowers a fresh start. Government intervention in this process will simply scare off lenders, since they’ll have limited recourse if the loan goes sour.

At best, such suits will simply drive up the cost of new mortgages. At worst, they’ll bring the recovery process to a standstill.

Foreclosures are nasty, painful and tragic. They are, however, a necessary part of the mortgage process, enabling lenders to recoup losses on bad loans.

Mandating an end to foreclosures is like telling the IRS it can’t go after tax evaders or preventing cops from chasing down burglars. This is not to say victims of foreclosures are criminals or necessarily deserve to be thrown out on the street, but living in a law-abiding society means that contracts must be enforced.

The moment we waive one group’s obligation to honor their collective word, the floodgates are open.

This certainly isn’t the last lawsuit we’ll see following the collapse of the mortgage market. In fact, it’s just the tip of the iceberg. A couple years from now, when Option ARMs begin to reset, class action lawsuits will bear down on lenders like a rumbling avalanche rolling down a steep slope.

Banks would be wise to get long some lawyers.