Golden State Mortgages May Tarnish Wachovia

Don Truslow, Wachovia's chief risk officer, highlighted this problem on the company's fourth-quarter earnings call,

Many of Wachovia's mortgage losses (generally in California) "came from people that otherwise have the capacity to pay but have basically just decided not to, because of the selective loss on equity value in their properties," he told analysts.

Wachovia spokesman Don Vecchiarello says this phenomenon is not the primary driver of defaults, but it is popping up anecdotally. He says Wachovia does not track the percentage of loan defaults being driven by homeowners facing negative equity in their homes.

To get a feel for what's going on with Wachovia's option ARM borrowers, take the following hypothetical example.

Wachovia states that the average option ARM loan was written at 73% loan to value. For simplicity's sake, assume a borrower buys a house for $100,000 and takes out this average loan. That means the loan balance is $73,000 at inception.

Each month, Wachovia homeowners are given the option of four different payments (in order of least amount of money required): the minimum payment, the interest-only payment, the 30-year fully amortized rate, or the 15-year fully amortized rate.

Wachovia says about 60% of the borrowers in the Golden West option ARM portfolio are currently paying the minimum payment (but this can change in any given month).

The difference between the minimum payments and the 30-year amortization payments results in negative amortization, and the borrower's total loan balance increases.

Wachovia allows borrowers to let their balances run up to a maximum of 125% of the original loan balance, compared with 110% at First Federal and Downey. Thus resets are coming at a slower pace at Wachovia.

The borrower in our example who runs his mortgage to 125% of the $73,000 loan value now has a loan balance of roughly $91,000.

If the loan balance hits this 125% threshold through negative amortization, then the loan resets to a higher rate. And if the value of the house during this time frame fell 10% from $100,000 to $90,000, then the borrower is now facing negative equity in the home.

In many cases, housing prices have dropped more than 10%, putting the borrower further into negative equity. (Big enough housing-price drops create negative equity, even if the 125% negative amortization threshold hasn't been met.)

An important factor in the process is whether the Wachovia mortgage borrower also took out a second lien or home-equity loan against his house.

While Wachovia likes to cite the average 73% loan-to-value ratio on its option ARM portfolio, the bank does not provide information on how many of those loans are ones where the borrower also took out a second mortgage, or second lien, from another lender in order to finance the house as high as 100% loan to value.

In such situations, negative amortization on the first mortgage plus falling house prices is putting the highly leveraged borrower even further underwater.

"The second lien increases the probability of default," says an analyst at a hedge fund that is shorting Wachovia.

Vecchiarello, the Wachovia spokesman, says the company doesn't publicly disclose what percentage of the bank's option ARM borrowers also carried a second lien.

"It is impossible for us to say how many of our customers have gone and gotten a second mortgage externally," he said.

Vechiarello instead stressed that Golden West did not originate so-called piggyback loans on top of the option ARMs. Such piggyback loans allowed borrowers to take a second mortgage at inception in order to provide a down payment of less than 20% of the home price.