Downey's failure was not a surprise, because it had a high level of nonperforming option-ARMs. The immediate catalyst for its collapse was a 68% drop in the holding company's share price, to 46 cents, on Nov. 11. That followed Downey's expression of doubt about its prospects in its third quarter report to regulators. This may have led to a run on deposits, although, of course, none of the regulatory press releases made any mention of liquidity concerns.
As we have been discussing all through the mortgage crisis, the option-ARMs, which, believe it or not, were still being offered by large banks and thrifts until recently, were among the riskiest of the loans that defined the run-up in the U.S. housing market.
Option-ARMs are residential mortgage loans that feature several monthly payment choices for borrowers, including an option to pay no principal and even pay less than the previous month's accrued interest. When the lowest option payment is made, the unpaid interest is tacked onto the loan's principal balance, while the lender books the unpaid interest as revenue. This increase in a loan balance is called "negative amortization."
When offering these loans, which would typically garner higher commissions for loan officers and mortgage brokers, a commonly used argument was that option-ARMs were appropriate for "sophisticated borrowers." Many of these sophisticated borrowers were tempted by teaser ads that directed attention to teaser rates and the lowest payment options, without mentioning in a clear way how easily a borrower could be hurt by an increasing loan balance, especially if home prices failed.